Choose the Right Business Entity, because the Wrong One Can be Devastating to Your Business

Credit Suite Blog

Get current information on getting credit and loans to grow your business

CLICK HERE TO LEARN MORE

Choose the Right Business Entity, because the Wrong One Can be Devastating to Your Business

Published By Janet Gershen-Siegel at August 22, 2017

>

Business entities can seem confusing. You might be tempted to simply close your eyes and point to one. Don’t! The wrong one can spell disaster.

First, let’s talk about the more common business entities that are out there.

Types of Business Entities

Sole Proprietorship

The SBA defines a sole proprietorship as being an unincorporated business owned and run by one person. There is no difference between the business and the owner. That means that you, the owner, can get all of profits, but you are also responsible for all your business’s debts, losses, and liabilities.

Partnership

The SBA says a partnership is just a single business with two or more owners. Partnerships further divide into three types.

General Partnership

A general partnership operates under the assumption that the partners equally divide up all of the profits, liability, and management tasks. However, if you choose an unequal distribution, then the percentages assigned to each partner have to be documented within the partnership agreement.

Limited Partnership

This one is also called a partnership with limited liability. These are more complicated than general partnerships. A limited partnership allows the partners to have limited liability as well as limited input when it comes to management decisions. What a limit will be is dependent uponeach partner’s investment percentage. As a result, limited partnerships can be attractive to investors in short-term projects.

Joint Venture

A joint venture acts like a general partnership, but it is for only a limited period of time or it can be for just a single project. The partners in a joint venture can make it into an ongoing partnership if they continue the venture. However, they have to file that way (usually with the IRS and the applicable Secretary of State).

Corporation

A corporation (also called a C corporation) is an independent legal entity which is owned by its shareholders. Therefore the corporation itself, not the shareholders who own it, can be held legally liable for the actions and debts incurred by the business.

S corporation (sometimes called a Subchapter S Corporation)

An S corporation is a special type of corporation created by an IRS tax election (this is the IRS’s Subchapter S designation). An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) if it chooses to be treated as an S corporation.

An S corporation differs from a traditional corporation (C corporation) in that profits and losses can pass through to your personal tax return. The business is not taxed itself; only the shareholders are taxed. However, any shareholder working for the company must pay him or herself reasonable compensation. The shareholder must get fair market value, or the IRS may reclassify any additional corporate earnings as wages.

Limited Liability Company

A limited liability companyexists as a kind of hybrid legal structure. It provides the limited liability features of a corporation with the tax efficiencies and operational flexibility enjoyed by partnerships. Owners of an LLC are called members. Depending upon the state, the members can be a single individual (one owner), two or more people, corporations, or even other LLCs.

Unlike shareholders in a corporation, LLCs do not get taxed as a separate business entity. Instead, all of the profits and losses are passed through the business to each member of the LLC. Then the LLC members report all of the profits and losses on their personal federal tax returns, which is just like the owners of a partnership would.

There are two good reasons why you should care about which business entity you choose.

Tax Issues

While I’ve hinted at the tax issues above, here are the specifics:

  • Sole proprietorship – because the single owner and the sole proprietorship are one and the same, the owner is taxed on the sole proprietorship’s profits.
  • Partnerships – A partnership does not pay income tax. Instead, the business passes through its profits or losses to its partners. Then the partners include their respective share of the partnership’s income or loss on their personal tax returns.
  • Corporation – Corporations must pay state and federal taxes, and sometimes also local taxes. This includes paying income taxes on profits (unlike for partnerships and sole proprietorships). A corporation can end up being taxed twice: first when a profit is made, and second when dividends are made to the shareholders.
  • S Corporation – an S corporation is often chosen for tax savings purposes. Members of an LLC must pay an employment tax on the whole net income of the business, but only the wages of the S corporation shareholder who is an employee are subject to employment tax. Any remaining income is paid to the owner as a distribution. Distributions are taxed at a lower rate, if at all.
  • LLC – an LLC isn’t a separate entity according to the IRS, so it isn’t taxed. Instead, the members are individually taxed.

Legal Liability

Legal liability varies among these business entities. Here are the details:

  • Sole proprietorship – there are no limits to personal liability. If the sole proprietorship did it, then so did its one owner. You are responsible for all debts and obligations, and that includes any risks from actions of employees.
  • Partnerships – Partnership owners keep full, shared liability. As a result, partners are not only liable for their own actions; they are also liable for any business debts and decisions made by the other partners. Furthermore, all of the partners’ personal assets can be used to satisfy the partnership’s debt.
  • Corporation – In a corporation, the shareholders’ personal assets are protected. Shareholders can usually just be held accountable for their investment in the stock of the company.
  • S Corporation – In S corporation shareholder’s personal assets, like their personal bank accounts, cannot be seized in order to satisfy any business liabilities, such as verdicts against the company.
  • LLC – LLC members have protection from personal liability for business decisions or actions of the LLC. Therefore if the LLC incurs debt or it is sued, the members’ personal assets are usually exempt. But not always, hence the term ‘’limited liability’.

Which business entity should you choose?

It’s up to you. Consider the tax burden and how personal liability can affect you, particularly if you are running a business where there are known hazards, such as carpentry or exterminating. You might also want to take into consideration how much control you will have over your small business. While a sole proprietorship means you call all the shots, it also means you’re responsible for everything. If that’s too much to handle, then consider one of the other types.

Leave a Reply

Your email address will not be published. Required fields are marked *

Leave a Reply

Your email address will not be published. Required fields are marked *