Picking the best entity for your business should be fairly simple. Unfortunately, some business gurus offer advice on this subject that is more confusing than helpful.
Maybe you’ve seen one of those fancy charts that promises to sort it all out for you. The chart may list seven or eight types of business entities. Then, for each type of entity, the fancy chart gives you 20 or 30 legal and tax characteristics. Although the charts can be helpful, most of the time they simply cause information overload. Below is a simplified explanation that may aid you in your decision.
The Most Common Business Entities
First of all—probably 99% of small and mid-sized businesses operate as one of five basic business entities:
- Sole Proprietorship (the “DBA”)
- General Partnership
- Limited Partnership
- Limited Liability Company
But how do you choose from among the “Big Five”? Your choice becomes much simpler if you focus on liability and tax issues. Obviously, you should seek advice from an experienced lawyer and your CPA, but the key concepts are easy to grasp.
Sole Proprietorships (DBA) and General Partnerships
We can generally group sole proprietorships and general partnerships together because they share important liability and tax characteristics. Let’s begin with legal liability.
As a sole proprietor, you are personally liable for all business debts and any legal judgments rendered against your business. Similarly, in a general partnership, each partner is personally liable for all monetary obligations. In fact, in terms of asset protection, general partnerships can be even worse than sole proprietorships. What if one of your partners assaults and/or wrongfully terminates an employee who then sues the partnership? If that employee sues and wins a $100,000 verdict, each partner, including those who had no knowledge or participation, may be personally responsible for paying the full $100,000. To satisfy the six-figure verdict, the fired employee can go after your personal assets as well as partnership assets. Your personal assets, your personal bank accounts, and (in some instances) your homes and cars are all at risk. By doing business through a corporation or limited liability company (LLC), you can greatly reduce this risk.
As far as taxes are concerned, neither sole proprietorships nor general partnerships offer much flexibility. The profits from the business are reported on your personal tax return if you’re a sole proprietor. And with a partnership, you report your share of the partnership profits on your own tax return. In each case, you have “pass-through” taxation (which means that you won’t be “double-taxed”), but you are not able to control certain aspects such as allocations and distribution of profits and losses. In addition, there are often expensive “self-employment” taxes associated with sole proprietorships and general partnerships.
Some businesses—especially certain small start-up businesses—don’t mind being exposed to unlimited personal liability, nor do they mind having limited tax flexibility. In some circumstances, the business may feel that they can reduce liability risks with insurance, and they don’t care about having to pay taxes on every cent of the business’s income. But for the vast majority of businesses, the liability protections and tax benefits provided by the entities described below are invaluable.
Limited Liability Companies (“LLC”) and Corporations
It is easy to pair LLCs with corporations since they share important liability and tax characteristics.
For liability purposes, the law treats LLCs and Corporations as legal entities that are separate and apart from their owners. In an LLC, an owner is called a member. In a corporation, an owner is called a shareholder. For the most part, an owner stands to lose only what he or she has invested in the business. Except where a personal guarantee is involved, an owner normally isn’t liable for the debts of an LLC or Corporation. This means a creditor or judgment-holder can’t seize an owner’s personal assets.
Let’s return to the earlier example, but with an important variation. Suppose you and your partners form an LLC rather than a partnership. This time, if the employee wins a $100,000 verdict, you generally won’t be personally liable for paying the money (assuming you weren’t the one that committed the act). Be aware, however, that an LLC or Corporation doesn’t give you a 100% safety net. You can still face personal liability if you’re the person who intentionally causes harm to someone—such as sexual harassment or intentionally injuring a customer. That’s also true if you personally guarantee a business obligation like a bank loan.
On the tax side, by forming either an LLC or a corporation, you gain tax flexibility. You can choose to have pass-through taxation for your business like a sole proprietorship or general partnership. On the other hand, you can decide to have the business taxed as a separate entity. Because an LLC or a Corporation may be in a lower tax bracket than you individually, you may prefer this separate taxation if you’re going to leave profits in the business. Ask your CPA for details.
If you create an LLC and take no tax action, the profits will be passed through to the owners. To have the business itself taxed, you must file an election form with the IRS. With a corporation, a different rule applies. The corporation will be taxed unless you file a form declaring S Corporation status. Once you file that form, corporate profits will be passed through to the owners who will pay income tax on those profits. Once again, it is prudent to ask your CPA for details.
Limited Partnerships (“LP”)
Although LPs are used far less frequently than LLCs and Corporations, a brief description of the entity is merited. A LP is an association of one or more general partners together with one or more limited partners to conduct business for profit as co-owners. The most important feature of a LP is that the limited partner enjoys limited liability as long as he or she does not participate in the control of the partnership business. The general partners of the LP are the ones responsible for the obligations of the LP. Most of the time, a Corporation or LLC is formed to serve as the general partner of the LP in order to provide the same type of liability protections and tax benefits described above.
Making Your Choice
So which entity is right for you? In most cases, the LLC has a slight edge. It usually involves less paperwork than a Corporation to set up, and it’s generally easer to maintain. The LLC also gives you maximum flexibility in how you structure your business. For example, you don’t need a board of directors or traditional corporate officers like a president and secretary—although you can have them if you choose.
In a few situations, however, the Corporation may have an edge over the LLC. This might be the case if you have outside investors who would like to have corporate stock certificates to show for their investments. Or if you’re planning to offer ownership options to employees, the availability of corporate stock certificates may make the process easier.
If you’re already set up as an LLC or a Corporation, it probably doesn’t make much sense to change. Most of the time there is no legal or tax reason to switch to the other format. If, however, you’re just starting out or you’ve already formed a sole proprietorship or general partnership, now is a good time to think about whether to become an LLC or corporation.