Considerations When Choosing A Business Entity Type

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Whether you’ve put thought into it or not, your business entity type can have important consequences for you and your business. This article will discuss what business entity type is, the different types that are available to small business owners, and factors to consider when choosing a business entity type.

 

First off, what is business entity type?  A business entity is an organization that is created by one or more people to carry on a trade or business.  The business entity type (sometimes also referred to as “business entity form”) is the structure chosen for the business.  Common business entity types for small businesses include: sole proprietorship, partnership, limited liability company, s-corporation, and corporation.  Business entities are formed under state law by filing documents with a state-level agency.  The exception to the filing requirement are sole proprietorships and partnerships, which do not require filing documents with the state to create.  What this means is that if you are a person or group of two or more people operating a business and haven’t filed any paperwork with the state to create the business entity, you are automatically considered a sole proprietor (if you are the only owner of the business) or a partnership (if there are two or more owners). The different business entity types have different characteristics that will have implications on taxation, liability for the business owner(s), complexity for administration, and more.

The following business entity type comparison chart explains some of the differences between the various business entity types:

 

Sole Proprietorship

Partnership

Limited Liability Company

S-Corporation

C-Corporation

Ownership

One owner

Two or more people

One or more members (unlimited)

One to 100 shareholders; only one class of stock allowed

One or more shareholders (unlimited); no limit of stock classes

Owner Liability

Unlimited exposure

Unlimited if general partnership; limited to investment partner if limited partnership

Limited to investment, except for personal services

Limited to investment, except for personal services

Limited to investment, except for personal services

Separate Taxable Entity from Owner

No

No

Depends on tax status election (as sole proprietor, partnership, or corporation)

No

Yes

Federal Taxation

Entity not taxed; income or loss reported on personal tax return

Entity not taxed; income or loss reported on personal tax return

Entity not taxed; income or loss reported on personal tax return unless election is made to be taxed as a corporation.

Entity not taxed; income or loss reported on each shareholder’s personal tax return.

Corporation taxed on earnings and shareholders taxed on any dividends distributed.

DC Taxation

Entity not taxed; income or loss reported on personal tax return

Entity not taxed; income or loss reported on personal tax return

Entity not taxed; income or loss reported on member’s personal tax return unless taxed as a corporation at the federal level.

Corporation taxed on earnings and shareholders taxed on any dividends distributed.

Corporation taxed on earnings and shareholders taxed on any dividends distributed.

Registration Required

No

No

Yes

Yes

Yes

Management of the Business

Sole proprietor manages the business

General partners have equal management rights, unless they agree otherwise

LLC operating agreement sets forth how the business is to be managed; either member-managed or manager-managed

Board of Directors has overall management responsibility; officers have day-to-day responsibility

Board of Directors has overall management responsibility; officers have day-to-day responsibility

Capital Contributions

Sole proprietor contributes whatever capital is needed

General partners typically contribution money or services to the partnership, and receive an interest in profits and losses

Members typically contribute money or services to the LLC and receive an interest in profits and losses

Shareholders typically purchase stock in the corporation, only one class of stock is allowed

Shareholders typically purchase stock in the corporation, common or preferred

As a practical matter, when I initially speak to entrepreneurs who have questions about business entity type, I typically highlight three important features: (1) liability, (2) taxation, and (3) administrative flexibility.

  1. Liability. Liability for business activities is an important factor to think about when planning and operating your business.  Different business entity types have different consequences when it comes to liability.  For sole proprietorships and general partnerships, while easy to set up relative to other business entity types because no government filings are required to create the business,[1] there is no separation between the owners and the business.  Sole proprietors and partners in a general partnership are personally liable for business debts and liabilities.  This means that if someone files a lawsuit against your business and wins, your personal assets – like your car, personal bank accounts, and home – may be taken to satisfy the judgment.  For other entity types that are created by filing paperwork with the state, such as limited liability companies, s-corporations, and corporations, a separate legal entity is created.  Owners of these types of businesses generally do not have personal liability for the business’s debts or liabilities; liability for business activities is contained to the business entity, so long as the business’s activities are properly conducted through the business entity.
  1. Taxation. The tax status of a business entity determines whether the business income is passed through and taxed through the business owner’s personal tax return or taxed as a separate entity.  The chart above provides details on federal tax treatment based on entity type and the DC government’s tax treatment of the various entity types, which may differ in other states.  On one end of the spectrum, we have sole proprietorships and general partnerships, which are not considered separate from their owners; likewise, the business income from these entity types are reported on the owners’ personal tax returns.  On the other end of the spectrum, you have corporations, which are created as legal entities separate from any of their owners (called shareholders).  Business income is taxed at the corporation level and, when dividends are distributed to the corporation’s shareholders, the shareholders must report and pay tax those earnings on their personal tax returns.  This is the concept known as “double-taxation” (when taxes are assessed at the corporate level and shareholder level).Between these two ends of the spectrum are entities that are considered separate legal entities from their owners, but can be taxed as “pass-through” entities, where income from the business is passed through and taxed on the owners’ personal tax returns and there is no double-taxation.  S-corporations are one such business entity type that are not considered separate from their owners for tax purposes.  However, in DC, it’s important to note that although the IRS recognizes s-corporations as pass-through entities,[2] DC doesn’t recognize pass-through tax status for s-corporations; therefore for DC income tax purposes, s-corporations are subject to the corporate level tax and then shareholders are subject to tax on dividends.  Limited liability companies are, by default, taxed as pass-through entities, but they can also elect to be taxed as an s-corporation or corporation.  The tax consequences of the business entity type you choose may be a factor in deciding which business entity type is appropriate for your business.  Consulting a CPA who can speak to your specific circumstances and give you tax advice relevant to your situation is recommended.
  1. Administrative Flexibility. The reality of being a business owner means that there are a million and one things for you to take care of – many of them having nothing to do with legal compliance for your business.  The various business entity types range from very little administrative requirements to relatively strict corporate formalities.  Sole proprietorships are easily the least administratively burdensome when it comes to government filing requirements.  Also, if you’re the sole business owner, then you make all the decisions and don’t have to wait on other owners to agree before moving forward.  The downside is that you bear all the risk associated with the business.  Corporations, on the other hand, require the observance of corporate formalities associated with creating and maintaining a separate legal entity.  A corporation has shareholders, a board of directors, and officers that all hold a stake in the decision-making process for the business; and bylaws that define the business’s purpose, how it will operate, how decisions are made for the business, and the responsibilities of the people in various roles in the business.  In addition to maintaining corporate filings with the appropriate state agencies, a corporation needs to keep minutes and memorialize major decisions and policies of the business.  Limited liability companies fall somewhere in the middle – state filings do need to be maintained on a regular basis; however, the governance requirements can be as simple or as complex as the owner or owners want them to be.  Instead of bylaws, limited liability companies have operating agreements that define the business’s purpose, how it will operate, how it will make decisions, and the responsibilities of people involved in the business.  State limited liability company statutes are less prescriptive when it comes to rules about how these types of business entities are to operate and generally provide more flexibility than rules governing corporations.

Of course, these are by no means the only considerations you should think about when choosing a business entity.  Other factors that might have future consequences may lead you to choose one business entity type over another.  Funding considerations also may play into what business entity type may work best for your business.  While business entity type is an important decision to make, keep in mind that it is possible to change your business entity type if the one you initially start with doesn’t end up being the right one for whatever reason.  Choosing a business entity type has important consequences and, while there may be a whole host of issues to think about as a business owner, this is one decision you don’t want to take lightly.

 

 

 

 

The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this page are for general informational purposes only.  Any scenarios used in this article to explain the legal concepts discussed above are simplified in order to illustrate the concepts and potential outcomes.  Real-life situations often involve complex facts, including varying contractual language, which may result in many different outcomes.  Please contact the appropriate professional to discuss your specific circumstances.

[1] While government filings are not required to create a sole proprietorship or partnership, there may be other local licensing requirements for the business, depending on the industry your business operates in.

[2] The IRS uses the term “disregarded entity” to refer to entities that are not regarded as separate entities for tax purposes.  Sole proprietorships and s-corporations as disregarded entities; however, the IRS does not recognize limited liability companies as a tax status, but rather considers limited liability companies as disregarded entities taxed as sole proprietorships.  

Photo by Laura Olsen on Unsplash.

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