How to Choose an Entity Type for Your Small Business
Joan and Ann decided to start a small retail business together. They found the ideal downtown location, decided on a name and started ordering merchandise. They discussed the business plan and goals at length and believed that they agreed on most of the major issues relating to their business. However, Joan was recently divorced and was concerned about the potential impact on her personal assets if the two of them had a disagreement regarding how to manage the business. Ann had recently built her dream home and wanted to ensure that debts of the business could not encumber her home.
To address these issues, Joan and Ann decided they would create a separate entity for their business. They knew that they wanted to protect their personal assets, but didn’t want to make it too complicated. The women began looking at different entity types, but had difficulty deciding what was the best fit for them and their business. Like many business owners, they just didn’t know where to start.
There are several options for business structures, with each option having its own benefits and drawbacks. New business owners should consider each of these options prior to starting a business to make sure they structure a business entity in a manner that works for their particular business.
A partnership is an agreement between two or more individuals for a business or trade. Each person contributes money, property, labor or skill. Each partner shares in the profits and losses of the business.
A partnership is a “pass through” entity for tax purposes. This means that the partnership itself does not pay income tax, instead any profits or losses are passed through to its partners. Each partner is required to report his or her share of the income on his or her personal tax return.
The advantage of a partnership is simplicity. General partnerships do not require filing anything with the Secretary of State, and partnership agreements can be fairly simple. The management in a partnership is simple as well because the partners typically manage the business and a separate board of directors is not required.
Partnerships can be general or limited partnerships. A general partnership is essentially the default business entity created when two or more individuals begin a business together. No special filing or registration is required to form a general partnership.
A limited partnership is a more formalized type of partnership that requires the filing of articles with the Secretary of State. Once the limited partnership is formalized, it provides limited personal liability for the individual partners for the debts of the business. There are various types of limited partnerships which reduce personal liability including a limited partnership, limited liability partnership and a limited liability limited partnership, each with its own requirements and restrictions.
However, partnerships, especially general partnerships, do have significant drawbacks. The most significant drawback of a general partnership is the fact that the personal liability of the individual partner is not limited. This means that creditors of the business may be able to collect from personal assets of the partners. Also, unless it is set out by a partnership agreement, partnerships have the potential for gridlock in decision making if two partners cannot agree on an important business decision.
To avoid these pitfalls and reduce potential personal liability, many business owners utilize other entity types such as a corporation or limited liability company.
A corporation is a separate legal entity that exists separately from its owners. As a separate entity, it has its own rights, privileges, and liabilities apart from the individuals who form it.
A corporation requires a board of directors, which are the managers of the company. The shareholders are individuals that invest in and own the company. The shareholders must have an annual meeting at which they elect a board of directors. The board of directors manage the company and make policy decisions for the company. The board of directors in turn vote on and appoint the corporate officers who manage the company's day-to-day business.
The most significant advantage of a corporation is that it affords limited liability to its shareholders. This protects the personal assets of the owners from the personal assets of the business. Further, corporate stock can be easily sold and transferred. The sale of corporate stock provides for a relatively easy method to raise capital. A corporation can continue on after the death of or transfer of shares by one or more of the owners, which provides estate planning advantages. Shareholders that are also employees of a corporation may also have additional tax-free benefits that they may also take advantage of such as health insurance.
However, corporations are more complex entities to form and administer than partnerships or other types of business organizations. To form a corporation, you must file Articles of Incorporation with the Secretary of State. A corporation must have bylaws to guide the general organizational structure of the entities, including how and when meetings will take place, voting and other administrative issues. Typically a corporation will also have a shareholder agreement to govern how shares can be sold or transferred. For many small businesses, corporations may have too many formalities to maintain and too many “hats” for the owners to manage so they consider alternative business formations.
A C corporation is subject to double taxation. This means that the corporation pays taxes on its profits and its shareholders pay taxes on any capital gains from dividends. The profit of a corporation is taxed to the corporation when it is earned by the corporation, and then these profits are taxed to the shareholders when the profits are distributed to shareholders as dividends. Obviously this can provide disadvantages from a tax perspective, especially for small business owners.
An S corporation is a separate type of corporation that elects to pass corporate income and losses through to their shareholders for tax purposes. This allows S corporations to avoid double taxation. A corporation can make a Sub Chapter S election by filing a special tax election form with the IRS. All of the other formalities of a corporation must still be followed in an S corporation.
To quality for S corporation status, the corporation must meet separate requirements. To qualify for S corporation status, the corporation must be a domestic corporation. Also, the corporation can have no more than 100 shareholders and the shareholders must be individuals, certain trusts and estates. Partnerships, corporations and non-residents cannot be shareholders of an S corporation. Further, an S corporation can only have one class of stock; it cannot have separate voting classes for stock. There are also certain types of business such as financial institutions and insurance companies that cannot register as an S corporation.
For a small business that meets these requirements, an S corporation can be beneficial. S corporations provide the limitation on liability to protect personal assets of the owners, while avoiding double taxation on the corporate tax. However, because all of the other formalities of a corporation must still be followed in a S corporation, some business owners decide they do not want the additional administration involved in an S corporation.
Limited Liability Companies
A Limited Liability Company (“LLC”) is a hybrid between a partnership and a corporation. Members have limited liability protection similar to a corporation but reduced administration and additional flexibility in management similar to a partnership.
Owners of an LLC are called members. Unlike S corporations, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members, and a sole individual may create a single-member LLC.
LLCs also have increased flexibility in tax treatment. The LLC can elect to be taxed as a corporation, partnership, or a “disregarded entity” (meaning the LLC pays taxes through the owner’s individual tax return) by filing specific tax election forms with the IRS. If the LLC does not make a separate tax election, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes.
Members of an LLC enjoy limited personal liability with increased flexibility in tax treatment and management. However, to effectively manage the company and protect personal assets, an LLC should have a well structured operating agreement between the individual members of the LLC. The operating agreement should set how additional members may join the business or withdraw from the business, and what happens to an owner’s interest in the event of their untimely death, bankruptcy or other life event.
Seek Professional Advice
Ultimately, Joan and Ann decided to discuss their business with a business attorney and decided that an LLC was the best choice for their particular business. They felt the balance between limited personal liability, ease of administration and management flexibility would provide significant benefits for them. However, every business owner should carefully consider the various business entity structures prior to starting a business and seek professional advice.
A business attorney can advise you how to structure your business, as well as discuss the benefits and drawbacks of specific types of legal entities for your particular business. The decision about the specific legal structure for your business will impact your tax liability, ownership rights, and business operations. Making the right decision about the legal and corporate structure of your business is critical to your long-term success, so discuss your options with your tax advisor and business attorney to determine what is right for your specific business. While creating a separate entity for your business will not ensure that your business will always be successful, it can help protect your personal liability and help organize the structure and management of your business.
For advice regarding incorporating, creating a separate legal entity or general business law, contact Measure Law, 406-752-6373.
Measure Law attorneys provide expert legal advice with regard to Business Planning along with Real Estate Law to help protect you grow your wealth while protecting your assets. See our Practice Areas page for more details.