Entity Crisis: Choosing the Right Legal Entity

Selecting the most appropriate legal entity for your business can be a confusing task. However, picking the one that strikes a comfortable balance between cost, complexity, liability protection and taxation can give you peace of mind at a time when you have much on your mind. Use this overview to see the big picture and begin to ascertain which will suit you best.

Sole Proprietorship

The sole proprietorship is the most common business type in the United States because of its simplicity and because it is the legal form that is automatically assigned to any business that is started by an individual who does not proactively organize in some other form. No formal registration is required and a sole proprietorship may change to one of the other entity types at any time. Sole proprietorships have only one owner, referred to as a sole proprietor, and all business income and expense is reported on the business owner's individual income tax return via Schedule C. A disadvantage includes the fact that there is no mechanism for sharing ownership, and liabilities of the business are all personal obligations of the owner.

Partnership

The partnership is a very old form of business association that may be formed when two or more persons (partnerships, corporations or other legal entities may also be partners in a partnership) wish to jointly enter into a business for profit. There are two common types of partnerships Ð general and limited. In a general partnership, all of the owners have full management power and are held personally liable for the actions and omissions of the other partners, and for the indebtedness of the partnership. In a limited partnership, partners are divided into two classes -- general and limited. General partners are as described above. Limited partners are essentially passive investors, and are not active in the management of the company. They are not held personally liable for the obligations of the partnership.

Partnerships, like sole proprietorships, are easy to form, require little ongoing paperwork, and are only taxed at the individual (partner) level. Use of the partnership has been in decline, however, as the S-corporation and limited liability company now offer attractive advantages in terms of flexibility and in insulating the owners from the liabilities of the business.

C-corporation

The C-corporation is the classic for-profit legal entity in the United States. It is unique in that it is taxed as an entity in itself, separate and distinct from its shareholders, and it may have its ownership interests (shares) trade on public exchanges. Forming a C-corporation is much more complex, however. The incorporation process requires that the shareholders adopt bylaws, distribute shares and elect officers who oversee corporate functions. There are ongoing requirements as well, such as annual meetings, disclosures and shareholder approval of certain types of actions. In exchange for these burdens, shareholders enjoy fairly significant protection from personal liability for company obligations, and ownership interests can be easily transferred. Moreover, at lower annual income levels, income tax rates are lower for C-corporations than they are for individuals. Dividends, however, are the only means for distributing company profits to non-employee shareholders and are subject to double taxation. Double taxation means that company distributions (dividends) are paid out of the corporation in after-tax dollars (i.e. dividends are not a deductible expense of the business), and then, the shareholder who receives the dividend will owe taxes on the amount received as the IRS requires that such receipts be included as taxable ordinary income to the shareholder.

S-corporation

The S-corporation has similarities to its C-corporation cousin, such as ease of ownership transfer and shielding of shareholders from the liabilities of the company. However, it has many differences as well. Significant ones include the fact that the number of shareholders it may have is limited, shareholders may only be United States citizens and it is taxed as a partnership (i.e. there is no tax paid at the corporate level). Benefits, such as life and health insurance and housing cost reimbursements, are treated as tax-deductible expenses in a C-corporation and are considered taxable compensation for shareholders who own more than a two percent share in the S-corporation.

Limited Liability Company

Coming into vogue in the 1990s, the Limited Liability Company (LLC) often appeals to businesses and professional groups that formerly formed partnerships. Similar to the S-corporation, the LLC is a hybrid creature, combining the beneficial tax treatment of a partnership with many of the owner-liability protections of a corporation. It also permits easy changes in ownership. Different from the S-corporation, however, the LLC can have unlimited shareholders (called members), who do not have to be U.S. citizens.

The above is meant to provide a very brief overview of the different types of legal entities. For the very small business, the sole proprietorship remains the most common. For larger, multi-owner businesses, the S-corporation and Limited Liability Company are the common choice today for reasons discussed above. If you need to select an entity type for a new or existing business, take this summary and visit further with your tax advisor about the characteristics and merits of each. Continue to research until you find the one that is right for you.