When starting a business, most entrepreneurs will have to eventually ask themselves: Should I incorporate, what is the correct entity type, and how do I incorporate if that is the right move? To accurately determine the answer to these questions for each individual firm must look at a couple key considerations: tax and legal. The five main business structures to examine are sole proprietorships, partnerships, corporations, s corporations, and limited liability corporations.
*The following entity structure definitions come directly from the IRS website, irs.gov
Sole Proprietorships
A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.
Pros:
-Quick to start
-Maintain complete control of the business
-Free from many various regulations
-Pass through entity
Cons:
-Unlimited liability
-Difficult to expand past a certain size: hiring employees and obtaining financing
Partnerships
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return.
Pros:
-Easy to start
-Pass through entity
-Spreads risk among partners
Cons:
-Unlimited liability for all partners
-Less control over business decisions than sole proprietorship
-Any one partner can cause dissolution
-Must have at least two partners at all times
-Difficulty in transferring interests
Corporations
In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.
The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.
Pros:
-Limited liability
-Guaranteed continuity of life
-Can raise capital or financing through sale of stock
Cons:
-Difficult to set up
-Double taxation
-Faces regulations to doing business
-Multiple parties required to make decisions
S Corporations
S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income.
To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- including individuals, certain trust, and estates and
- may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have one class of stock
- Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
Pros:
-Limited liability
-Avoids double taxation
Cons:
-Limited size growth
-Formation costs
-Passive income limitation
-May be responsible for additional state taxes
Limited Liability Corporations (LLC)
A Limited Liability Company (LLC) is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.
Pros:
-Rather easy and inexpensive to establish
-Limited liability
-Pass through entity
-Possible to have a single owner
Cons:
-Difficult to issue stock for an IPO
-Self-employment tax
-Must operate as a distinct entity and not as part of owners’ personal affairs
Choosing an entity structure is not only about the particular tax burdens and legal requirements along the way but also about planning for the eventual liquidity event or exit. How the business will eventually end, in terms of the original owners, plays a part in the business’ structure as well. Certain structures are better geared towards particular exit strategies. For example, if the ultimate liquidity goal is an IPO, an LLC is not the best option. On the other hand, if the goal is complete, singular control over a firm, a sole proprietorship might be the owner’s best choice. In summary, one set of factors does not entirely dictate the entity structure decision. Look to all relevant factors before making the decision.
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