Choosing the right entity is an important decision facing many small business owners and entrepreneurs. There are several business forms to choose from, each of which create different legal and tax consequences. Most importantly, there is no simple answer as to which entity is appropriate for each type of business owner or business industry.

Choosing the appropriate business form or entity can be a complex decision. Many factors need to be considered, including ownership requirements and the unique necessities of the individual business and the industry. Your decision in selecting an industry will also have far reaching tax consequences that should be carefully considered before making any decisions. The skilled business attorneys at Wellman and Warren LLP will take the time to learn about your individual needs as well as the unique requirements of your business industry. This article should be used as a preliminary guide in making the important decision as to the type of business entity you will select.  After reading this article you will be better prepared to discuss your entity options with an attorney.

The following illustrates the differences and similarities between five common business entity alternatives.

Sole Proprietorship

A sole proprietorship is a simple entity form that requires no incorporation forms and has one business owner. The most important advantage to this type of entity is the ease of creation and lack of regulatory requirements. All business income and business expenses are reported on the owner’s personal tax return. Additionally, the Sole Proprietorship is subject to self-employment social security and medicare taxes.

A Sole Proprietorship is not a separate legal entity from its owner. Therefore, the owner will be held personally responsible for the debts and liabilities of the company.

Partnership

The partnership requires two or more owners in an agreement to carry on a trade or business. Although this entity can be established very quickly with an oral agreement, it is a good idea to formalize your partnership arrangement with a document known as the partnership agreement. A partnership agreement establishes the intent of the business owners in the event of a variety of business occurrences. Typically the agreement will account for the sale of the entire business, the sale of a single individuals holdings or the disposition of ownership in the event of the death of a partner, and some partnership agreements even account for the divorce of a partner. The partnership is taxed in the same manner as the sole proprietorship with all the business cash flow and tax liabilities passing through the business to the business owners. One key disadvantage of this entity is that the partnership provides its owners minimal protection from business risk and the individual partners may be held personally liable for the debts and liabilities of the business.

Corporation

These entities can often be the most costly and time consuming entities to establish and regularly maintain. However, the corporation provides the greatest amount of liability and business risk protection to the business owner. Strict governmental regulations outline the company structure, reporting and disclosure requirements. Corporations enjoy perpetual life as the ownership rights can be easily passed on to designated heirs upon the death of an owner. Typically, the owner’s interest in the corporation can also be easily transferred from one individual to another willing buyer. The corporate entity has a great deal of income tax flexibility and can offer the broadest array of tax deductible benefits, but may also trigger a one major deficiency in the corporate form… double taxation.  Corporations are taxable on the income the corporation earns and the shareholders are usually indirectly taxed on the corporate income when the corporation distributes income to shareholders in the form of dividends.

S-Corporation

The S Corporation functions as a hybrid entity, copying many of the best features of several other entity types. The S Corporation is a legal entity that offers owners limited liability benefits, while allowing the company profits or losses to flow directly through to the business owners for income tax purposes, thus the S corporation avoids the dreaded double taxation. The legal requirements and costs associated with starting an S Corporation are moderate, as are the on-going regulatory requirements. There are important limitations on the number of owners within an S Corporation and there may be only one class of stock.  Additionally, there are statutes that regulate and limit who may be an owner.

Limited Liability Company

Like the S Corporation, the Limited Liability Company (LLC) combines many of the benefits of other entity types. In contrast to the proprietorship and partnership the LLC provides its owners (called members) with limited liability for the company’s debts and liabilities. The LLC also avoids the “double taxation” of the corporation by functioning as a “flow-through entity” for income tax purposes.

Conclusion

There are many factors to weigh when selecting a business entity.  The choices are complex and a poor decision can create huge financial consequences, liability issues, and tax burdens. Once you have your business plan finalized and a solid realization of your business goals you are ready to take the next step in starting your business.  The business attorneys at Wellman & Warren can be one of the most valuable assets you bring to your business.  Our skilled attorneys offer years of experience in starting businesses right the first time.