Important Business Entity Details Uncovered

Business Entity Details

When starting a business, one of the first decisions you’ll need to make is what business entity to choose. This decision will affect how your business is taxed, who can own it, and a variety of other factors.

In this blog post, we will outline the key considerations for choosing a business entity and provide information on each type of business entity. We’ll also discuss the pros and cons of each type so that you can make an informed decision about which business entity is right for your startup company.

The Implications of Choosing a Business Entity

The business entity you choose will have implications for how your business is taxed, the level of personal liability you face, and the amount of paperwork you’ll need to file. It also determines who can own your company.

Entities are either what’s called “passthrough” entities or not. With a passthrough entity, all business income is passed through directly to owners and the owners report this income on their personal taxes. Examples include sole proprietorships, partnerships, LLCs, and S corporations.

Non-passthrough entities include C corporations and other entities that specifically elect to be taxed as such. With these types, there is double taxation as income is taxed at the corporate level and then again when it is distributed to shareholders as dividends.

So why would anyone want their business income to be taxed twice? C corporations can have unlimited shareholders, versus a limit of 100 for S corporations. These shareholders must also be US citizens or resident aliens for the latter, while the former provides the possibility of foreign owner and corporate ownership.

This means that C corporations can be owned by other companies, while S corporations cannot. The exception is that S corporations can be owned by 501(c)(3) companies.

C corporations also allow the creation of more than one class of stock. This is important for some because venture capitalists and angel investors often prefer to receive preferred stock.

Sole Proprietorship

A sole proprietorship is the most common form of business entity in the United States. It’s easy to form and offers several advantages, including:

  • Ease of formation: you can typically start a sole proprietorship by filing a business license or permit with your local government.
  • Pass-through taxation: as we mentioned, a sole proprietorship is a passthrough business entity, which means that business income is reported on the owner’s personal tax return. This can simplify your tax preparation process.
  • Control: as the sole owner of your business, you have complete control over all aspects of the business.

There are also some disadvantages to consider before choosing a sole proprietorship, such as:

  • Unlimited liability: as the sole owner of your business, you are personally liable for all debts and obligations of the business. This means that your personal assets, such as your home or savings account, could be at risk if your business is sued or incurs debt.
  • Difficulty raising capital: sole proprietorships can be difficult to finance because lenders view them as high-risk. You may have difficulty securing a loan or investment from a bank or other financial institution.
  • Limited life: sole proprietorships typically have a limited life span because they cease to exist when the owner dies. This can make it difficult to transfer ownership of the business to another party.

Partnership

A partnership is a business entity with two or more owners. The most common types of partnerships are general partnerships, limited partnerships, and limited liability partnerships.

Like sole proprietorships, partnerships offer some advantages, including:

  • Ease of formation: you can typically form a partnership by filing a partnership agreement with your local government.
  • Pass-through taxation: as we mentioned, partnerships are passthrough entities, which means that business income is reported on the personal tax return of each partner. This can simplify your tax preparation process.
  • Flexibility: partners can agree to divide profits and losses in any way they see fit. This can be helpful if partners have different levels of investment or expertise.

However, there are also some disadvantages to consider before choosing a partnership, such as:

  • Unlimited liability: partners are personally liable for all debts and obligations of the partnership. This means that each partner’s personal assets, such as their home or savings account, could be at risk if the partnership is sued or incurs debt.
  • Disagreements: partners may not always agree on major decisions, such as how to allocate profits or losses. This can lead to tension and conflict within the partnership.
  • Limited life: partnerships typically have a limited life span because they cease to exist when one of the partners dies. This can make it difficult to transfer ownership of the business to another party.

Limited Liability Company (LLC)

A limited liability company (LLC) is a business entity with certain legal protections for its owners. LLCs are hybrid entities that combine the characteristics of both corporations and partnerships.

LLCs offer several advantages, including:

  • Limited liability: LLC owners are not personally liable for the debts and obligations of the LLC. This means that their personal assets, such as their home or savings account, are protected if the LLC is sued or incurs debt.
  • Pass-through taxation: LLCs are passthrough entities, which means that business income is reported on the personal tax return of each owner. This can simplify your tax preparation process.
  • Flexibility: LLCs have more flexibility than corporations in terms of how they can be structured and operated. For example, LLCs can choose to be managed by their owners or by a group of managers.
  • Ease of formation: all it takes to start an LLC is registering articles of organization with the state and filling the accompanying paperwork. You can do this directly through your state’s division of corporations or equivalent government body. You are also not responsible for the in-depth compliance activities that are required of corporations.
  • Profit distribution: business profits can be distributed in any way as per the company’s operating agreement instead of being determined by the percentage of shares held in the company. For instance, a person who owns 10% of the company could receive 75% of the profits if part of the agreement.

However, there are also some disadvantages to consider before choosing an LLC, such as:

  • Capital: it is more difficult to raise capital with this business entity than with a corporation. Investors usually want a share of business ownership in exchange for their investment, and LLCs do not have shareholders.
  • Self-employment taxes: although the company is not taxed on its income, owners are responsible for self-employment taxes to cover Social Security and Medicare. This currently amounts to 15.3% of income, which again gets reported on the individual’s personal tax returns.
  • Fees: LLCs must pay the state when forming and then again each year when filing their annual report. Depending on the state, these fees can be high. The initial and ongoing state fees for LLCs are usually even higher than those of corporations. A state-by-state list can be found here.

S Corporation

An S corporation is a type of corporation that offers certain tax benefits to its shareholders. S corporations are passthrough entities, which means that business income is reported on the personal tax return of each shareholder.

S corporations offer several advantages, including:

  • Limited liability: S corporations, like LLCs, provide a corporate veil of protection for owners. This means that, should the company be sued or incur other obligations, the owners’ personal assets are safe.
  • Passthrough taxation: as we mentioned, S corporations are passthrough entities, which means that business income is reported on the personal tax return of each shareholder. This can simplify your tax preparation process.
  • Dividends: there are no taxes on distributions paid to shareholders. The major caveat here is owners must be paid a reasonable salary first if they want to receive tax-free dividends without a visit from the IRS.

However, there are also some disadvantages to consider before choosing an S corporation, such as:

  • Complexity: this business entity can be more complex to operate than sole proprietorships or partnerships. This is because S corporations have more formalities, such as holding regular meetings and keeping minutes of those meetings.
  • Cost: S corporations can also be more expensive to set up and maintain than other business entities. This is because they often require the help of a lawyer or accountant to get started.
  • Taxable benefits: if a person owns more than 2% of the business, any fringe benefits like health insurance premiums paid are treated like wages and are therefore taxed

C Corporation

A C corporation is a type of corporation that is taxed separately from its shareholders. C corporations offer several advantages, including:

  • Limited liability: C corporation shareholders are not personally liable for the debts and obligations of the corporation. This means that their personal assets, such as their home or savings account, are protected if the corporation is sued or incurs debt.
  • Investor flexibility: C corporations have an easier time raising capital compared to sole proprietorships and LLCs. This is because they can offer shares of the company in exchange for investment. They can also issue preferred stock, which is a class of stock that usually provides a dividend and allows greater claim of company assets and earnings.
  • Accumulated earnings: this type of business entity enjoys preferable tax treatment on any earnings it retains. This makes it easier to expand the company. In contrast, an S corporation’s would-be retained earnings must be allocated to shareholders and taxed.

However, there are also some disadvantages to consider before choosing a C corporation, such as:

  • Double taxation: C corporations are subject to double taxation, which means that business income is taxed at the corporate level and then again at the personal level when it is distributed to shareholders in the form of dividends. This can increase your overall tax liability.
  • Complexity: this kind of business entity can be more complex to operate than sole proprietorships or partnerships. This is because C corporations have more formalities, such as holding regular meetings and keeping minutes of those meetings.
  • Cost: C corporations can also be more expensive to set up and maintain than other business entities. This is because they require the help of a lawyer or accountant to get started.

Conclusion

When it comes to choosing your business entity, you must weigh your options based on the individual characteristics of the business you’re trying to start. The amount of financial capital and involvement varies across different types, as does the tax treatment you are exposed to.

For most small business owners, an LLC is ideal because it can be run much like a sole proprietorship but with personal liability protection. If you dream of scaling your business and eventually going public, you will need the ownership benefits of a C corporation.

Keep in mind that each type has different compliance requirements as well. It all comes down to your capacity and goals as a small business owner. On a final note, it is worthwhile to contact an attorney for advice on establishing a new business entity if you are at all hesitant or don’t feel knowledgeable enough on your own.

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