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Apr
17

Choosing Your Business Entity

Entering startup

There are 4 main types of legal entities with benefits and drawbacks to each:

1. Sole Proprietorship
2. General Partnership
3. Corporation
4. Limited Liability Company

In this post, we will briefly outline the basics and discuss considerations for each of these types below.

Sole Proprietorship

1. Basics:  You and your business are one and the same.  You alone have control over business decisions and sole decision-making authority.  This is the default type of legal entity, so if you do nothing and do not file any legal formation papers, you will be deemed to be a sole proprietor.

2. Tax:  The business is not a separate entity for tax purposes.  Income is taxed to you, the owner, in the year that the business receives the income.  It will be included on Schedule C of the owner’s tax return.

3. Liability:  This type of entity has unlimited personal liability for the owner which means that for debts, lawsuits, and any other obligation, the owner’s personal assets will be considered.  Though sometimes costly, this risk can be mitigated through insurance.

4. Other Considerations:  The sole proprietorship terminates upon the owner’s death, and there is no transfer of ownership.

General Partnership

1. Basics:  This is a separate legal entity and can be formed in one of 2 ways, by either entering into a written partnership agreement, or by establishing through the regular course of conduct that a partnership exists, through joint decision-making, joint payments, and joint operations.  Each partner shares decision-making authority and control over the business.  The actions of one partner will be binding over the other partner and the partnership as a whole.

2. Tax:  “Pass through” tax treatment to each of the partners, but ALSO requires the partnership to file a separate tax return, Schedule K-1 prepared by the partnership and acknowledged by the partners.

3. Liability:  Like a sole proprietorship, there is unlimited personal liabiltiy to each of the partners.

4. Other Considerations:  The elimination or death of a partner constitutes automatic dissolution of the partnership.

Corporations

1. Basics:  Corporations are a separate legal entity formed by one or more individuals under your state law.  There are shareholders/owners, directors and officers.

2. Tax:  Corporations file a separate tax return.  There are 2 main types of corporations, both of which are taxed differently.

a) S corporations have “pass through” taxation.  The corporation itself does not pay taxes but does file an informational tax return under Schedule K-1.

b) C corporations have “double taxation” which means that the corporation pays taxes on its income, and when the profits are distributed to the shareholders/owners, they must pay taxes again on the same income.

3. Liability:  Corporations provide the protection of limited liability for shareholders/owners.

4. Other Considerations:  Ownership is readily transferable from one individual to another.  There are corporate formalities and related expenses and fees, including the written filing of the Articles of Organization and Bylaws, usually with the Secretary of State.  Each state has their own rules on filing for corporations, so look into your state’s requirements.

Limited Liability Company

1. Basics:  The LLC is a separate legal entity formed by one or more individuals under state law, and each state law varies on filing requirements for the LLC.  There is a great deal of flexibility in the rights of the owners and how the company will be controlled.

2. TaxFederal law and the IRS does not recognize the LLC as a business type for tax purposes.  LLC’s must choose either sole proprietor, partnership, or corporation for tax purposes.  For federal tax purposes, a single-member LLC will be disregarded for tax purposes, meaning it will be treated like a sole proprietorship.  State laws vary on tax treatment of LLC’s.

3. Liability:  One of the reasons for the popularity of LLC’s is that LLC’s enjoy limited liability for all members.

4. Other Considerations:  Like a corporation, ownership of an LLC is readily transferable.  There are some corporate formalities and additional expenses, such as drafting the Certificate of Formation and Operating Agreement.

Image by Flickr user dierken (Creative Commons)

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