Selecting an Entity Type When Starting a Business

Introduction

Selecting the right entity type is a crucial decision for entrepreneurs when starting a business. Each entity type, such as partnership, corporation, entities electing S corporation tax status (S corporation), and limited liability company (LLC), offers distinct advantages and disadvantages in terms of liability, taxation, management, and other crucial aspects. This article aims to provide a comprehensive guide to help entrepreneurs make an informed decision on the most suitable entity type based on their business goals, risk tolerance, and long-term vision.  The selected entity type will have a profound impact on the business's legal structure, personal liability, tax obligations, and operational flexibility.

Partnerships

A partnership is a business entity formed by two or more individuals or entities with shared management and profits.  Partnerships can be structured as general partnerships (GP), limited partnerships (LP), limited liability partnerships (LLP), and limited liability limited partnerships (LLLP).  Each form of partnership offers varying forms of personal liability protection, but typically general partners have unlimited personal liability, while limited partners' liability is restricted to their investment in the partnership.  Utilizing the LLP and LLLP structure can provide added liability protection for general partners.

From a tax perspective, partnerships are considered "pass-through" entities, meaning that the entity itself does not pay income tax. Instead, profits and losses are "passed through" to the individual partners, who report them on their personal tax returns. Partnerships file an informational tax return (Form 1065) to report the business's income, deductions, gains, and losses.  Partnerships offer considerable flexibility in allocating profits and losses among partners. This allows for tax optimization based on individual partners' tax situations, potentially reducing the overall tax burden.  General partners are subject to self-employment taxes on their share of income.

Compared to corporations, partnerships generally have fewer formalities and less complex regulatory requirements. There is no need for shareholder meetings or extensive corporate record-keeping, making it easier and more cost-effective to operate.

C Corporations

A C corporation is a separate legal entity owned by shareholders, with a clear distinction between ownership and management.  Choosing corporate taxation provides limited liability protection to shareholders. The owners' personal assets are generally shielded from the corporation's debts and legal liabilities. This separation between the business and its owners protects personal assets in the event of lawsuits or business insolvency.

Corporations face double taxation, with income taxed at the corporate level, and shareholders taxed again on dividends received.  The corporation itself pays income tax on its profits, and shareholders pay taxes on dividends received.  Corporations are required to file Form 1120 to report their income and deductions to the IRS.  Shareholders do not pay self-employment taxes on corporate profits or dividends.

Corporations often face more complex regulatory and reporting requirements compared to other business structures. Filing corporate tax returns, adhering to corporate governance standards, and maintaining proper record-keeping can lead to higher compliance costs.  Additionally, in order to maintain limited liability protection, corporations must follow specific formalities, such as holding regular shareholder meetings and keeping detailed corporate records. Failure to adhere to these formalities may result in the loss of limited liability protection.

S Corporations

An S corporation, unlike the other business types discussed above, is not itself an entity type, but rather a tax classification that a corporation or a limited liability may elect.  By making the election, corporate income, losses, deductions, and credits are passed through to shareholders.  Like a C corporation, for an entity electing S corporation classification, shareholders enjoy limited liability protection.  The personal assets of the shareholders are generally shielded from the company's debts and legal liabilities. This protection extends to protect shareholders' personal assets beyond their investment in the corporation.

Similar to partnerships, entities electing to be taxed as S corporations are also "pass-through" entities for tax purposes. This structure allows for the avoidance of double taxation on profits distributed to shareholders. The entity must file Form 1120S to report their financial activities to the IRS.  Another similarity to partnerships is that shareholders pay self-employment taxes on their share of income.

To maintain limited liability protection, entities electing S corporation status must adhere to corporate formalities, maintain proper corporate records, and avoid any actions that may jeopardize the separation between the business and its owners. This may include conducting regular shareholder meetings, keeping accurate financial records, and observing corporate bylaws or operating agreements.

Limited Liability Company (LLC)

A Limited Liability Company (LLC) is a type of business entity that combines the limited liability protection of a corporation with a flexible taxation and management structure. It has become a popular choice for entrepreneurs and small business owners due to its simplicity and advantageous features.  The personal assets of the LLC's owners, known as members, are generally shielded from the company's debts and legal liabilities. If the LLC incurs debts or faces legal disputes, the members' personal assets, such as homes, savings, and other investments, are usually protected from the business's liabilities.

LLCs offer flexible tax treatment, providing various options for how the company's income is taxed. By default, an LLC is taxed as a pass-through entity.  If the LLC has multiple members, the LLC will default to being taxed as a partnership.  If the LLC has only one member, the LLC will be treated as a disregarded entity for tax purposes. The profits and losses will pass through to the members, and they will report them on their individual tax returns (Form 1040).  An LLC may also elect to be taxed as a C corporation or an S corporation by filing Form 8832, or Form 2553 if electing to be treated as an S corporation for tax purposes. Making this election is often done in specific circumstances where corporate taxation may be more advantageous for the business.  Self-employment tax reporting will be dependent on the tax structure chosen by the members.

Forming an LLC is relatively straightforward, with fewer formalities compared to corporations.  LLCs do not require holding regular shareholder meetings or maintaining extensive corporate records, making them less burdensome to operate.

Conclusion

Selecting the optimal entity type when starting a business is a critical step in laying the foundation for success. Entrepreneurs must carefully analyze the advantages and disadvantages of each entity type, considering their business objectives, risk appetite, and long-term vision. Seeking advice from legal, tax, and financial professionals is essential to make a well-informed decision tailored to the specific needs of the business. By conducting thorough research and due diligence, entrepreneurs can confidently choose the entity type that best aligns with their aspirations and ensures a solid framework for their venture.