Choosing Your Form of Business

When starting out, it is important to determine what form of business will work best for your specific situation. Based on potential liabilities, tax status, ease of starting up and attracting investors, you can elect to do business as a sole proprietorship, form a general partnership, form a limited partnership, incorporate or form a limited liability company.  The type of business you are starting and your future goals and aspirations for the company will be factored into your decision along with your need to raise capital.

Here, we outline the possible ways in which you can elect to structure your business, including some of the advantages and disadvantages of each form.  Since every business venture is unique onto itself there is no blueprint formula that every owner of any one specific type of business to follow.  Tax and liability issues, for example, will be determined in part by your own personal assets.

Sole Proprietorships

The most common and simplest form of business is a sole proprietorship.  Many small businesses operating in the United States are sole proprietorships.  An individual proprietor owns and manages the business and is responsible for all business transactions. The owner is also personally responsible for all debts and liabilities incurred by the business. A sole proprietor can own the business for any duration of time and sell it when he or she sees fit.  As owner, a sole proprietor can even pass a business down to his or her heirs.

In this type of business, there are no specific business taxes paid by the company. The owner pays taxes on income from the business as part of his or her personal income tax payments.

Sole proprietors need to comply with licensing requirements in the states in which they are doing business as well as local regulations and zoning ordinances. The paperwork and formalities, however, are substantially less than that of corporations, allowing sole proprietors to open a business quickly and with relative ease (from a bureaucratic standpoint).  It can also be less costly to start a business as a sole proprietor, which is attractive to many new business owners who often find it difficult to attract investors.

Advantages of a Sole Proprietorship:

• A sole proprietor has complete control and decision-making power over the business.
• Sale or transfer can take place at the discretion of the sole proprietor.
• No corporate tax payments
• Minimal legal costs to forming a sole proprietorship
• Few formal business requirements

Disadvantages of a Sole Proprietorship:

• The sole proprietor of the business can be held personally liable for the debts and obligations of the business.  Additionally, this risk extends to any liabilities incurred as a result of acts committed by employees of the company.
• All responsibilities and business decisions fall on the shoulders of the sole proprietor.
• Investors typically won’t invest in sole proprietorships.

Note:  If the business is conducted under a fictitious name it is up to the sole proprietor to file all applicable forms under the fictitious name or under “doing business as” (DBA). This, however, does not mean that the business is a separate entity from a legal standpoint. The sole proprietor remains liable even if he or she is doing business under a fictitious name.

Most sole proprietors rely on loans and personal assets to initially finance their business.  Some will elect to incorporate once the business has started to grow while other business owners maintain their sole proprietorship for many years.

General Partnerships

General partnerships consist of two or more partners who are both responsible for the business.  They share assets, profits, liabilities and management responsibilities for running the business.

General partnerships are typically formed by individuals. They are taxed in the same manner as a sole proprietorship, meaning each partner includes business income on his or her personal income tax return.  Each partner can also deduct pro rata losses from the business on his or her own individual tax return.

While general partnerships provide a means of raising capital more quickly and allow several people to combine resources and expertise several problems commonly occur including:

• Partners having different visions or goals for the business
• An unequal commitment in terms of time and finances
• Personal disputes

For these, and other reasons, general partnership agreements should be drawn up carefully with legal counsel and signed by all partners.  Additionally, there should be a means of dissolving the partnership in the case of death, disability or if one partner wants out of the business for any other reason.

General partnerships can be less expensive and require less paperwork and formalities than forming a corporation, but the partnership agreement is a key element and should be drawn up with due diligence on the part of all parties.

Advantages of a General Partnership

• Shared financial commitment
• Ability to pool resources, expertise and utilize strengths
• Limited start up costs
• Few formalities (mostly applicable licenses)

Disadvantages of a General Partnership

• Partners are generally personally liable for business debts and liabilities
• Each partner may also be liable for debts incurred by decisions made by, and actions taken by, the other partner or partners
• Disagreements in management plans, operational procedures and future vision for the business
• Difficult to attract investors

General partnerships can thrive when each partner brings a specific strength to the business.  If each partner takes on a defined role and there is general agreement on the business plan, goals and visions from the onset, a partnership can be advantageous.  Work can get done more quickly and having several partners involved will increase the potential for acquiring resources and attracting backers.  The success of such an endeavor depends largely on the personalities of the parties involved.

Limited Partnership

A limited partnership differs from a general partnership in the role and responsibilities of the partners.  The limited partners typically provide capital and help arrange financing while not taking an active role in running the business.

They do, however, receive a share of the profits for their involvement as limited partners.  The general partner in a limited partnership runs the operations of the business.

Most states have statutes that regulate and define the obligations and responsibilities of partners in this type of business arrangement.  You are required to file with your secretary of state and must also file various reports.

The key to this partnership agreement is found in the area of liability, which falls on the general partners, and typically not on the limited partners.  For this reason individuals are reluctant to be general partners.  The general partner of a limited partnership can itself be a corporation or LLC to mitigate liability issues to the promoters of the limited partnership.  This, however, does not mean that a limited partner cannot be part of, or have a vote in, major decisions that affect the partnership. 

A limited partnership can be attractive for a limited partner who can provide funding but not expertise and does not have the time to devote to being a hands-on part of the business.  Taking on the financial risk of his or her investment but not the liability risk, is also more attractive to a limited partner.

For tax purposes, a limited partnership typically works like a general partnership in that it is a pass through operation with profits passing through to the partners who then include their allocated income on their personal tax returns. Limited partnerships are often formed to acquire, operate and hold real estate.

Advantages of a Limited Partnership

• Much easier to attract investors as limited partners
• Allows for general partners to use their expertise, make key decisions and manage the business
• Limited partners can leave the business or be replaced without the need for the limited partnership to be dissolved.

Disadvantages of a Limited Partnership

• Filings, formalities and state requirements
• General partners assume personal liability

An interesting aspect of the limited partnership is that partners are able to allocate profits, losses and gains as they see fit, regardless of the equity interest of a specific partner, subject to compliance with tax laws.  This too can be attractive to prospective investors.

C Corporation

The most commonly found type of corporation is the C Corporation, which is a for-profit, state incorporated business.  Articles of incorporation are filed and appropriate fees are paid to set up a corporation.

The corporation is established as a unique business entity, which takes on a distinctly separate business and tax identity from that of the owners (the shareholders).  Separate income taxes are filed (IRS form 1120) and corporate taxes are paid regularly for the business.  In return, the business owners are typically removed from personal liability for debt incurred by the corporation. Should the business go bankrupt, or be faced with a lawsuit, the owner’s personal assets are protected.  This is the most significant reason why many business owners choose to incorporate.   Additionally, as a separate entity, a corporation can own property, make business dealings or even sue another business independently of the shareholders.

To establish a corporation, there are several requirements and formalities that need to be addressed.  For example, a corporation needs to issue shares to stockholders.  In addition, state requirements usually include minutes be taken at shareholder and Board of Director meetings, appointment of officers and maintaining specific records as outlined by the state in which the incorporation documents are filed.  The shareholders have ownership in the corporation, the Board of Directors governs the business and elected officers manage the day-to- day activities.  Corporations must adhere to corporate tax laws and file corporate taxes regularly.  While corporate taxes can be higher, initially they may be lower than that of a sole proprietor who is paying a 28% rate on his or her personal income tax.

Advantages of a C Corporation

• The corporation is a separate legal entity, and if it is adequately capitalized and proper corporate formalities are followed, the shareholders should generally have liability protection from the debts and obligations of the corporation.
• Corporations can utilize corporate benefit health plans, which often offer better retirement options and benefits than those offered by non-corporate plans.
• 100% deductible health insurance for all employees as well as group term life insurance up to a specified amount per employee
• If a stockholder dies or wishes to sell out, the corporation continues
• Easier to raise capital as a corporation than as a sole proprietorship or partnership
• Can offer employee incentive stock plans

Disadvantages of a C Corporation

• “Double taxation”.  This means that besides paying corporate income taxes, any dividends to shareholders are taxed again at the applicable tax rate.
• Formalities and regulations must be followed very closely in conjunction with the laws regarding incorporating in a specific state.  Failure to do so can create a situation where shareholders may be held liable.
• Costlier to start than a sole proprietorship or partnership
• More time and effort to maintain

While the idea of “double taxation” is very troublesome to many new business owners, it is not usually significant for small businesses, where it is unlikely that there will be large dividend payouts.  Rather, the money is paid out in the form of salaries and benefits.  As the owner, you can pay yourself a reasonable salary and handle any number of duties in the corporation.  By incorporating, you have the luxury of leaving some of the money in the corporation if you foresee significant personal income from other sources.  This way you can reduce your own personal income tax payments.

Taking the time, making the effort and paying the additional expenses to incorporate are usually considered worthwhile by a business that foresees potential liabilities and/or seeks investors.    

S Corporations

An S Corporation is initially formed in the same manner as a C Corporation, by filing incorporation documents with the state of incorporation.  Once the business has incorporated, the owners may decide to file as an S corporation, within approximately 75 days of incorporating.  To do so, they need to file an IRS form 2553.  This does not create a separate type of corporation, but changes the tax structure of the corporation.

The S Corporation has shareholders and is taxed like a sole proprietorship or a partnership rather than a C Corporation, which is taxed as a separate business entity.  Income is passed through to the shareholders who report their pro rata income, or losses, on their individual tax returns.  The corporation still files a federal return (form 1120S) and possibly a state return as well, if required by individual state law.  The S Corporation shows profits and losses as they pass through to the shareholders and the corporation generally does not pay federal income tax as a separate entity.  Some states, however, do tax S Corporations in the same manner as C Corporations.  Check your state tax laws before electing S Corporation status.

Advantages of an S Corporation

• Corporate losses can be passed through to the shareholders and as the owner (and shareholder) you may be able to take the loss against income that appears on your personal return.
• You can have the protection of limited personal liability without having to pay corporate taxes.
• You can minimize self-employment tax and FICA tax.  Profits, as a shareholder, are not taxed in this manner.
• It is easier to raise capital as a corporation than as a sole proprietorship or partnership.

Disadvantages of an S Corporation

• Numerous regulations and requirements that must be upheld by an S Corporation including a limit on the number of shareholders (see list below).
• Like a C Corporation, it can be costly to set up and follow formalities.
• Close scrutiny by the IRS of shareholder-employees, who must receive reasonable compensation (subject to employment taxes) before any non-wage distributions may be made to that shareholder-employee.

Other regulations imposed on S Corporations include:

• All shareholders must be U.S. citizens.
• All shareholders must vote in favor of the S Corporation.
• Benefits such as health or accident insurance for employee shareholders (with at least 2% ownership) may not be deducted by the corporation.

A corporation that plans to pass through dividends regularly to shareholders, may want to elect S Corporation tax status.  Also, a business owner who may want to take business losses on his or her own personal tax return, possibly to offset income earned by his or her spouse, may opt for this type of corporation.  It is worth noting that if you do set up an S corporation and later decide that there is a better alternative for your business, you can vote to drop S corporation status.

Like other corporations, the S Corporation can limit the personal liability of the owners.  Creditors can go after the assets of the corporation and not the owners if there are outstanding debts.  It is important, however, that the owner keeps his or her personal financial records and those of the S Corporation completely separate to avoid legal entanglements.

Limited Liability Company (LLC)

The hybrid answer to choosing the form of business for your company may be to go with a Limited Liability Company (LLC), which combines the pass-through taxation of a sole proprietorship, or general partnership, with the limited liability of a corporation.  A relatively new form of business, LLCs have become popular over the past ten years.  An LLC operates as a separate legal entity, but without being a corporation.  Therefore, there are no federal corporate taxes imposed on the LLC as a separate entity.  To start an LLC, a member, or members, must file the specific forms with the secretary of state.   Information that is required will include the latest date at which the LLC is to dissolve and a statement explaining whether the LLC will be managed by one manager, several managers, or the members.

What makes the LLC unique is that it is formed by members, not shareholders, who draw up an operating agreement to run the business without the structural guidelines imposed on a corporation.  This allows for greater flexibility without formalities, such as Board of Director meetings, which are imposed on a corporation.  While most LLCs have two or more members, in many states, a single member can now form an LLC as a legitimate business structure.

Advantages of a Limited Liability Company

• Personal liability protection for members
• No need to meet the requirements and formalities of a corporation to maintain the business status
• Members can draw up their own contract, allowing for flexibility in management and responsibilities
• Greater flexible in allocating income to members than in a corporation.  For example, an LLC can have various classes of interest while an S Corporation can issue only one type of stock.

Making The Right Choice

Checklist

When deciding on which form of business will best serve your purposes you should take into account:

• Your own personal assets and liabilities
• Your existing capital and need for outside investors
• Your ability to attract outside investors
• State licensing, statutes and tax requirements
• The time commitment necessary to handle regulations and formalities
• The size, scope and type of business you are opening
• Start up costs including licensing and other fees

The Need For Funding

The need for funding is one of the first concerns for any new business and unless you have the personal assets or can tap into friends, family or your bank, you will be seeking investors.  Investors will look at:

• Returns on their investment
• Protection from personal liability
• Tax situation (their personal situation and that of your business)

While most businesses can only anticipate future returns, the business structure that protects personal assets and provides a favorable tax environment will be most attractive to investors.  If, however, you do not need investors or are not seeking shareholders when starting up a business, you may do what many business owners have done and start small as a sole proprietor and incorporate later as the business grows.

Other Determining Factors

Determining not only the type of business you are starting, but the type of customers you will attract and the manner in which you will attract them should also be factored into your decision making process.

The potential for liability from customer relationships or interaction impacts heavily on your liability risk.  For example, someone who is opening a business that will sell goods to customers via the Internet or through mail order is less likely to garner lawsuits than someone who owns physical store locations, where customer foot traffic (and potential injuries) could result in such a lawsuit.  However, some small business owners opt for coverage from insurance policies rather than going through the time and expense of incorporating.

Attorneys, brokers or financial consultants offering advice and personal services may run a greater risk of a lawsuit from someone claiming they received “bad advice”.  It will also be assumed that a professional business such as a law firm or accounting practice will have greater assets, making them greater “targets” in a litigious society. Therefore, such a business would more likely choose a form of business that protects their personal assets.  Likewise, someone who has already had previous business success and has significant assets from a previous business venture would also want to protect those assets closely.

How fast you anticipate the business will grow is also of concern when selecting your form of business.  If you expect it to take several years before you see a profit, you might select an S corporation so that shareholders can offset some of their personal income with losses from the business.

While a sole proprietorship is the optimal choice for many people starting small businesses, some people select this method primarily because it provides the easiest manner in which to start and open a business quickly.  Others become sole proprietors simply because they do not believe they can incorporate.  Apathy can come back to haunt a successful entrepreneur.  Therefore, it is wise to sit down with both an attorney and an accountant and discuss the details of the business that you are planning to start where you see it going in five or ten years.  Cover all the bases including liabilities, taxes, employee benefits and the need for investors before making your decision.  Then make the decision that is best for your new business from all aspects.

The Answer

So, what is the answer for the right business entity for an entrepreneur?  In a nutshell:

• Stay away from sole proprietorships and general partnerships.  The risk of personal liability for the debts and obligations of business are too great.
• LLCs and limited partnerships can be good for certain businesses (such as real estate), but can be complicated and expensive from a legal perspective.
• S corporations make a lot of sense if you can qualify.  You can always convert to a C corporation later.
• C corporations make sense if you plan to have sophisticated angel or venture capital investors.