Overview of Business Entities

Choosing the best way to legally structure your business is one of the most important decisions you will make. No single business structure will suit every kind of business.
Considering the owners (or owner), their financial condition and what acivities the business will be engaged in, you must decide whether your requirements will be best met by a sole proprietorship, partnership, corporation, or limited liability company (LLC).

The overview presented here is intended as a brief introduction to the different ways businesses can be organized. It is not intended to serve as a substitute for professional assistance. Since state statutes vary, it may be advisable to seek more detailed advice from local professionals who are familiar with the specific requirements of the state in question. And, since taxes are a prime consideration, it is important to consult with your accountant or tax advisor.

While you can always change the legal and/or tax structure of your business if and when it makes sense to do so, it is not always simple and easy to do so. A wise decision now could pay dividends for years to come.

4 Important Considerations When Choosing Your Business Entity Type

When considering the business structure that will be right for your business, we suggest you primarily focus attention on four important areas of concern:

1. Potential liability
2. Income taxes
3. Investment needs
4. The cost to establish and maintain the business entity

1. Potential liability is a major concern no matter what kind of business you operate. Who can tell when some unexpected turn of events that will cause the business to go bankrupt? Owners could not only lose everything in the business but part or all of their personal assets. So protecting the owners' personal assets from any unsatisfied debts, judgments from lawsuits or other obligations of the business could well be number one on your agenda.

Unless owners are willing and able to accept any and all risks that cannot be adequately and reasonably covered by business insurance, failing to take advantage of the limited liability offered by a corporation or limited liability company (LLC) could be a costly mistake.

2. Income taxes are a very serious factor. In general, "pass-through" taxation applies to sole proprietorships, partnerships, S Corporations and limited liability companies (LLC's), unless the LLC has elected to be taxed as a corporation. With these "pass-through" tax entities, all of the profits and losses pass through the business to the owners, or members, who report their share of the profits (or deduct their share of the losses) on their personal income tax returns. One should remember with pass-through taxation, owners must report and pay taxes on their entire share of the net profits of the business even though those profits were not actually taken out of the business.

On the other hand, corporations themselves pay income taxes at special corporate tax rates that are lower than those for most individuals: but the owners pay taxes only on any dividends, salaries and bonuses they receive. Paying little or no dividends allows corporations to build up capital (in "retained earnings') for the furtherance of their business - a major advantage of corporations.

3. Investment needs can determine whether you need to be incorporated. A corporation's stock can make it easier to raise investment capital and transfer ownership. And stock options and stock bonuses can be used to attract and retain employees. But if a business does not need stock options or stock offerings, a limited liability company (LLC) presents a more flexible alternative that is simpler and easier to operate.

4. Cost to establish and maintain the business entity should also be considered. Sole proprietorships and partnerships are the least expensive since they do not have to be registered with the state and their operation is not subject to any special rules or requirements.

On the other hand, both corporations and limited liability companies (LLC's) must pay fees and file required documents with the state. Limited liability companies are more flexible and simpler to operate, and they are not, as are corporations, required to elect officers, document important decisions, or hold and keep minutes that record mandatory meetings of stockholders and a board of directors. And in the case of a C Corporation, the additional level of taxation adds some complexity to filing and paying taxes.

Sole Proprietorships

Just go into business by yourself and you have a sole proprietorship, the simplest form of business. Unlike a corporation or a limited liability company (LLC), a sole proprietorship does not have to be registered with the state. Anyone can establish a sole proprietorship at anywhere and at any time.

For tax purposes, business income and expenses are reported on the owner's personal tax return. You should be aware that, in the eyes of the law, the owner and the business are one and the same. Therefore the owner will be personally liable all of the obligations and liabilities incurred by the business. If you want the business name to be other than yours, you will need to apply for a DBA (doing business as) from the appropriate government agency.

Even though a sole proprietorship may be the simplest, cheapest and quickest way to get into business, it may not be a wise choice if personal liability is a concern.

A sole proprietorship works best for sole owners who want ease of operation with as little paper work as possible and are willing to accept the disadvantage of being personally liable for the debts and obligations of the business.

General Partnerships

The primary difference between a general partnership and a sole proprietorship is simply that it is a business owned by two or more persons. When two are more people start a business, it is automatically a general partnership unless it is specifically organized as a corporation or LLC, or the partners choose to operate it as a limited partnership.

Like a sole proprietorship, there are no organizational documents that must be filed with the state. It is easier to operate than a corporation since no meetings or reporting is required although it is advisable to have a partnership agreement setting forth the relationship between the partners. The partnership does not pay any income taxes but does file an informational return. Each partner reports their share of the business income and expense on their individual tax return. Each partner is personally liable for not just their share but the entire amount of the obligations and liabilities of the business. Like a sole partnership, a general partnership may not be the right choice if personal liability is a concern.

General partnerships best suit multiple owners of a business who want a business that is simple and easy to form and operate yet are willing to accept the disadvantage of being personally liable for the debts and obligations of the business.

Limited Partnerships

Limited partnerships are partnerships that are formed by two or more persons who choose to operate the business as a limited partnership instead of as a general partnership.

Like corporations, they are formed by filing required documents with the state. A limited partnership must have one or more general partners and one or more limited partners. In a limited partnership, the general partner(s) make decisions and run the business while all limited partners ("silent partners") do not take part in its operation. General partners are solely liable for the obligations and liabilities incurred by the business, allowing the limited partners to invest in the business without such liability. '

Protection of limited partners' personal assets is one of the major reasons business owners choose a limited partnership. Limited partnerships enjoy the same pass through tax treatment as other partnerships.

Limited partnerships may be the answer for those who want pass-through tax status without personal liability (for limited partners only) without forming an LLC or S Corporation. Setting up limited partnerships can be expensive and should not be done without consulting a specialist in this field first.

Limited Liability Partnerships (LLP's)

Limited Liability Partnerships are similar to LLC's. In some states, only professionals (required to have licenses to do business) are allowed to form a Limited Liability Partnership.

While partners are personally liable for their own negligent or wrongful acts when performing services for the partnership, they are protected by their limited liability from any personal liability for the acts of others as well as the debts and business obligations of the business although in some states this protection is less than the protection they would receive under LLC's or corporations. Protection of partners' personal assets is one of the major advantages of an LLP.

While an LLC or S Corporation is likely a better choice, some businesses previously prohibited from forming those forms of business now select a Limited Liability Partnership to avoid the higher cost of transferring from an existing general partnership to an LLC or S Corporation.

C Corporations

Official documents must be filed with the appropriate state in order to form a C Corporation. A C Corporation is recognized by the law as an individual entity, separate from its shareholders (owners), many times treated as a human being. Its most important characteristic is the fact that shareholders, directors and officers enjoy limited liability for the debts, obligations and liabilities of the business as well as liability stemming from possible legal action.

Protection of shareholders' personal assets is one of the major reasons business owners choose to incorporate. Normally, shareholders cannot lose more than the amount they invested in the corporation. If the corporation goes bankrupt, the shareholders will not be liable for its debts. Should someone sue the corporation and the corporation is found liable, they can take the corporation's property to satisfy the judgment but if that property does not satisfy the judgment, they will not be able to take a shareholder's personal assets, i.e. home, car, or bank account.

An exception to a shareholder's limited liability happens when the corporation has recklessly harmed people or has been used to perpetuate a fraud.

C Corporation shareholders do not report any of the business income and expense on their individual tax return. The corporation files tax returns and pays its income taxes (at generally lower tax rates than would individuals) while the individual shareholders report and pay personal income taxes only on monies paid them by the corporation.

It should be noted that shareholders are required to pay income taxes on income from dividends paid by a C Corporation even though income taxes have previously been paid by the corporation.

C Corporations best serve owners who want the limited liability, a more formal business structure, the ability to reduce overall income taxes and accumulate assets in the business, and ways to more easily raise capital

S Corporations

An S Corporation is formed by filing the same documents as for a C Corporation but then electing S Corporation status by filing an IRS Form 2553.

Like a C Corporation, an S Corporation is recognized by the law as an individual entity, separate from its shareholders (owners), many times treated as a human being. Shareholders, directors and officers enjoy limited liability for the debts, obligations and liabilities incurred by the business as well as liability stemming from possible legal action.

An exception to a shareholder's limited liability happens when the corporation has recklessly harmed people or has been used to perpetuate a fraud.

Unlike a C Corporation, the S Corporation does not itself pay any income taxes. While an S Corporation with more than one shareholder does file informational tax returns, the individual shareholders (owners) must include their share of the corporation's income or loss on their personal tax returns, similar to sole proprietorships, partnerships and Limited Liability Companies (LLC's).

S Corporations are for those who want the limited liability and the more formal structure of a corporation but with pass-through taxation of the business profits.

Limited Liability Companies (LLC's)

Articles of organization must be filed with the appropriate state to form an LLC. While an operating agreement does not have to be filed, it is an important document that should set forth the members' rights and responsibilities, their share of ownership, their voting rights, their shares of profits and losses and their distribution rights, all of which can be different and without regard to their capital contribution. One or more managers make management decisions and "run the business" for the inactive members.

As its name implies, an LLC provides the same limited liability for its members as does a corporation. Members enjoy limited liability for the debts, obligations and liabilities incurred by the business as well as liability stemming from possible legal action.

Normally, members cannot lose more than the amount they invested in the LLC. If the LLC goes bankrupt, the members will not be liable for its debts. Should someone sue the LLC and it is found liable, they can take the LLC's property to satisfy the judgment but if that property does not satisfy the judgment, they will not be able to take a member's personal assets, i.e. home, car, a bank account.

Protection of members' personal assets is a major advantage of an LLC. An exception to a member's limited liability happens when the corporation has recklessly harmed people or has been used to perpetuate a fraud.

An LLC can choose to be taxed as a corporation or choose the pass through tax structure of proprietorships, partnerships and S Corporations. And the distribution of profits and losses can differ from members' share of ownership. While an LLC and an S Corporation are essentially alike, an LLC is much more flexible and is easier and less complicated to operate than a corporation.

For those who want the same limited liability as a corporation but without the formal structure and more cumbersome ongoing requirements, an LLC's flexibility and simplicity offer a distinct advantage over a corporation. An S Corporation does, however, offer the advantage of allowing owners to minimize self employment taxes.

Nonprofit Corporations

Nonprofit Corporations are formed for purposes other than making a profit, usually by groups involved in activities that typically benefit society in general.

Members occupy the position held by stockholders in a for-profit corporation and, along with the directors and officers, are entitled to the same limited liability afforded standard corporations.

Dues paid or donations made would normally be the most that members, directors and officers could lose. As with other corporations, limited liability does not apply if the corporate form has been used to perpetuate a fraud or evade the law.

Tax exempt status is not automatic and all nonprofit corporations are not necessarily tax-exempt. Nonprofit status is a function of state law but tax-exempt is a status is a function of federal law and in some states a nonprofit corporation must also apply for tax-exempt status at the state level as well. In order to qualify for tax exempt status, the corporation must be organized for one of the purposes allowed in the Internal Revenue Code. Obtaining tax-exempt status is generally required in order to be eligible to receive grants from the government and private foundations. A tax-exempt status also allows donors to deduct contributions from their income taxes.

In a nonprofit corporation, any money that remains as profits, after deducting expenses from gross receipts, cannot be distributed to the members, directors or officers but must be used to further the corporation's purposes.

Those uniting to provide services that will benefit society frequently form a nonprofit corporation in order to give its members, directors and officers limited liability protection and, when possible, enjoy the benefits of a tax exempt status.

Professional Corporations

Most states have special rules that apply to corporations whose owners will be providing professional services requiring a state license. Special Professional Articles of Incorporation are required instead of the standard articles for a business corporation.

While the professions to which these statutes apply vary from state to state, the following are likely to be included: Accountant, Architect, Attorney, Audiologist, Clinical Worker, Dentist, Doctor, Family Counselor Nurse, Optometrist, Pharmacist, Physical Therapist, Podiatrist, Psychologist, & Veterinarian.

In most cases, the licensed shareholders and employees of a professional corporation are personally liable for their own negligent or wrongful acts when performing services for the corporation but they are protected by their limited liability from any personal liability for the acts of others as well as the debts and business obligations of the corporation.

Like other corporations, a professional corporation is a separate taxable entity.

A professional corporation is for professionals who want the advantages offered by a corporation.

Professional Limited Liability Companies

All states allow for the formation of Professional Limited Liability Companies by certain professionals.

A Professional Limited Liability Company may be the answer for professionals who are considering a corporation but prefer pass through taxation.

View a chart comparing business entity types