Choosing
the form of entity under which a business will operate is one of
the first, and often most important, decisions a business owner
will make. Although the legal details underlying each entity type
are inherently complex, exploring three major variables may help
you determine which option is right for you; business control,
owner liability, and tax implication.
The major business alternatives
today include:
- Sole Proprietorship
- Partnership
- Corporation
- S-corporation
- Limited Liability Company
The following comparison illustrates the most dramatic
differences, and similarities, between several entity
alternatives.
Sole Proprietorship
As it’s name implies, a sole
proprietorship has a single owner, and is perhaps the most
simplistic of all entity types. The main benefits of the sole
proprietorship include it’s ease of implementation and lack of
regulatory requirements. In addition, the sole proprietorship
allows complete business control to a single business owner
(proprietor). Under a sole proprietorship, the business owner is
required to file a Schedule C (profit or loss from a business or
profession) with their personal income tax filing. The proprietor
personally assumes all liability and business risk, risks that can
often be “transferred” through the purchase of liability
insurance.
Partnership
The main difference between the sole proprietorship and the
partnership is the number of business owners. Although very easy
to establish, it is a good idea to begin a partnership with an
formal arrangement known as the partnership agreement. The
partnership agreement sets forth the intent of the business owners
in the event of a wide variety of business events such as the sale
of the entire business, the sale of a single individual’s
holdings or the disposition of ownership in the event of the death
of a partner. Like the sole proprietorship, the partnership
represents a “flow-through entity” where both cash flows and
tax liabilities flow through to the business owners. The
partnership provides it’s owners minimal protection from
business risk.
Corporation
Though often costly and
time-consuming to establish and maintain, the corporation provides
the greatest amount of liability and business risk protection to
the business owner(s). Strict governmental regulations outline
company structure, reporting and disclosure requirements.
Corporations have unlimited lives with ownership rights passing to
designated heirs upon the death of an owner. The corporate entity
has a great deal of income tax flexibility and can offer the
broadest array of tax deductible benefits, but may also trigger
“double taxation” of some corporate profits as they are taxed
at the corporate level as profits and again, potentially, at the
individual level as taxable dividends are paid to shareholders.
S-Corporation
The S Corporation functions as
something of a hybrid, assuming many of the best features of
several other entity types. The S Corporation is a legal entity
that offers owners the benefits of greatly limited liability,
while allowing company profits or losses to flow directly through
to the business owners for income tax purposes, thus avoiding
potential double taxation. The legal requirements and costs
associated with starting an S Corporation are modest, as are the
regulatory requirements. There are limitations on the number of
owners within an S Corporation, and a C Corporation may not be an
owner.
Limited Liability Company
Like the S Corporation, the Limited
Liability Company (LLC) combines many of the benefits of other
entity types. In contrast to the proprietorship and partnership
the LLC provides its owners, or members, limited liability for the
debt and business risk associated with ownership. The LLC also
avoids the "double taxation" of the corporation by
functioning as a "flow-through entity" for income tax
purposes.
Conclusion
Selecting a business entity can be a complex decision with
long-term effects on the ownership, owner liability and taxation
of a business. Once you have prepared a business plan and
evaluated your business ownership goals seek the advice of trusted
financial professionals in finalizing your business entity
selection.
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