Entity Selection

Sole proprietorship

The sole proprietorship is the simplest business form under which one can operate a business. The sole proprietorship is not a legal entity. It simply refers to a person who owns the business and is personally responsible for its liabilities. A sole proprietorship can operate under the name of its owner or it can do business under a fictitious name (d/b/a). The fictitious name is simply a trade name--it does not create a legal entity separate from the sole proprietor owner.

Advantages

  1. Owners can establish a sole proprietorship instantly, easily and inexpensively.
  2. Sole proprietorships carry little, if any, ongoing formalities.
  3. A sole proprietor need not pay unemployment tax on himself or herself (although he or she must pay unemployment tax on employees).
  4. Owners may freely mix business or personal assets.

Disadvantages

  1. Owners are subject to unlimited personal liability for the debts, losses and liabilities of the business.
  2. Owners cannot raise capital by selling an interest in the business.
  3. Sole proprietorships rarely survive the death or incapacity of their owners and so do not retain value.

Partnership

Businesses owned and operated by more than one individual may look to be structured as a partnership. Partnerships come in two varieties:

General partnerships

Partners manage the company and assume responsibility for the partnership's debts and other obligations. General partnerships maintain less administrative complexities than limited partnerships.

Limited partnerships

Has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners. This form of partnership is usually only recommended when there are many passive investors and requires more filings and administrative complexities than a general partnership.

Advantages

A partnership doesn't pay tax on its income but "passes through" any profits or losses (reported on schedule K-1) to the individual partners so it may be reported on their personal return.

Disadvantages

General partners are personally liable for the partnership's obligations and debts. More expensive to establish than sole proprietorships because they require more legal and accounting services. Partnership agreements are strongly suggested to avoid disagreements among owners.

Partnership Agreements

Partnership agreements should identify the following:

  1. Ownership interest of each partner
  2. Voting interest of each partner
  3. Determination of purchase price upon partner withdrawal
  4. Determination of payment timing upon partner withdrawal

Corporation

Business exists as a separate entity. Maintains many of the legal rights of an individual with a few restrictions such as the right to vote. Given the right to exist by the state in which they decide to incorporate. Corporations, if properly formed, capitalized and operated (including appropriate annual meetings of shareholders and directors) limit the liability of their shareholders. Even if the corporation is not successful or is held liable for damages in a lawsuit, the most a shareholder can lose is his or her investment in the stock. The shareholder's personal assets are not on the line for corporate liabilities. Corporations file Form 1120 with the IRS and pay their own taxes. Salaries paid to shareholders who are employees of the corporation are deductible. But dividends paid to shareholders aren't deductible and therefore don't reduce the corporation's tax liability.

Advantages

  1. Limited liability
  2. Ease in raising capital

Disadvantages

  1. Double taxation
  2. Usually expensive to establish and maintains a number of administrative burdens

S-Corporation

An S corp offers investment opportunities, perpetual existence, and that coveted protection of limited liability. But, unlike a c corp, s corps are not subject to double taxation.

Advantages

  1. Owners of the business enjoy limited liability for the business' debts, judgments and other liabilities
  2. Owners share the net profits and losses of the business and report their share on personal income taxes
  3. Investment opportunities. The company can attract investors through the sale of shares of stock.
  4. Perpetual existence. The business continues to exist even if the owner leaves or dies.

Disadvantages

  1. More expensive to establish than a sole proprietorship or partnership
  2. Only U.S. citizens and permanent residents can invest. Unlike the c corp and LLC (Limited Liability Company), you have to be a legal resident of the U.S. (no corporations)
  3. Limited ownership. An s corp may not have more than 100 shareholders.
  4. Can only have one class of stock
  5. The ownership interest of the various owners determines their respective incomes from the profits of the business
  6. Closer IRS scrutiny. Payments to employees and shareholders could be distributed as either salaries or dividends. Each are taxed differently, which is what leads the IRS to scrutinize that distribution more closely.

LLC

Limited liability companies are a state concept whereby the owner(s) (referred to as members) may flow through income onto their personal tax return  but also to protect themselves from personal liability for the business's debs. If no election is made with the IRS to be treated as a Corporation or S-Corporation, the default classification of an LLC is sole proprietorship (if only one member) or partnership (if more than one member). Since LLCs are a state concept, for federal tax purposes, the LLC formation does not have any tax implications.

Advantages

  1. Can create various classes of stock
  2. An unlimited number of individuals, corporations, and partnerships may participate as members in an LLC
  3. Limited liability
  4. Losses can be set against active income

Disadvantages

Transferability restriction test - ownership interest in an LLC are not easily transferable. Makes raising capital from outside investors more difficult.


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