How to Pick the Right Business Entity.
If you’re forming or just starting a new business, big or small, you have lots to think about. Be sure to set some time aside to consider what business entity structure is right for you. While you should consult an experienced attorney and tax professional to help you decide, educate yourself on some basics before diving into the good ol’ American dream of owning your own business. Without careful consideration and planning, that dream can quickly become a nightmare. Here are some common business entity structures:
- Sole Proprietorship: These are the most common, and considered the most simple to form and operate. Sole proprietorships are unincorporated and run by one individual (the owner). Thus, the business and the owner have no distinction. The owner is entitled to all profits while also responsible for all the business’s debts, liabilities, and losses. While sole proprietorships are affordable, afford complete control to the owner, and have lower operating maintenance, there are disadvantages, which include no specific tax benefits, no opportunity for growth, raising money can be challenging, and no legal personal asset protection (unlimited personal liability).[1]
- S-Corporation (S-Corp): S-Corps are corporations created through IRS tax election, which allows an eligible corporation to avoid double taxation (once via the corporation and once via the shareholders). Also, S-Corps are "considered by law to be a unique entity, separate and apart from those who own it." So, unlike sole proprietorships, these do have tax benefits and protection for your personal assets. Also, S-Corps have opportunities for growth (i.e. via shareholders), and are considered to be more credible with those you will do business with, e.g. customers, clients, vendors, and contractors. However, these benefits come with a cost. Formation and ongoing fees can be high, they often involve or require heavy paperwork and maintenance, and they are generally more highly scrutinized by the IRS.[2]
- Limited Liability Corporation (LLC): LLCs have become increasingly popular, as they combine the liability protections of corporations with the tax benefits and operational flexibility of partnerships. The "owners" of an LLC are referred to as "members," which depending on the state, can consist of one individual, or two or more individuals, corporations or other LLCs. They offer protection for your personal assets, since, unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Rather, all profits and losses are "passed through" the business to each member of the LLC. Additionally, there is no requirement to file a separate business tax return. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would. On the flip side, LLC members are still taxed at your personal tax rate in an LLC (though some states and the IRS may let you get taxed as an S-Corp under certain circumstances). Finally, LLCs have easier filing and management or maintenance requirements.[3]
Deciding which one of these is right for you requires a detailed evaluation of your needs and situation. For example, consider your personal tax situation--are you single or married? Do you have children? Do you own another business? Do you own property? Consider the cost of forming the entity--do you have any cash flow limitations? If so, this could restrict your business entity choice at the outset, as some entities are inexpensive while others are more costly to form. Your attorney can review potential costs and effects of these considerations. In addition, consider how much annual maintenance or filings you’re willing or able to deal with and what is required for the prospective business entity structures. Some entities will require annual maintenance and filings, and some do not. Discuss with your attorney what may be too much paperwork for you to deal with, while balancing the other considerations.
At the forefront of many business owners’ minds is the balancing of desired tax benefits with all other considerations of operating the business. The tax benefits of a certain structure may be significant enough to sway your decision, or it may not. Once you know the benefits, weigh them against the liabilities and your personal circumstances so you can make an informed decision with the help of your tax and business attorney.
Even after you’ve decided on which business entity best suits your needs, and that entity is formed, your good ol’ American dream should be given even more purposeful thought and planning. These considerations will be addressed in future topics in this series.
— By Keobopha Keopong, Esq., Barnes Law
Keo Keopong is an associate attorney with Barnes Law, licensed to practice law in California.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] https://www.sba.gov/content/sole-proprietorship-0
[2] https://www.sba.gov/content/s-corporation
[3] https://www.sba.gov/content/limited-liability-company-llc