Which Entity Structure Should You Choose for Your New Business?

Which Entity Structure Should You Choose for Your New Business?

Sona Sulakian
 | 
Are you starting a new business but aren’t which entity type to choose? Here’s an overview of the main business entity structures and key considerations for each.
 
General Partnership
All partners are owner-operators who share equal management rights. This entity type is ideal for someone who wants to form a business with at least 2 owners, doesn’t want formalities, doesn’t mind sharing management rights w co-owners, and doesn’t mind risking personal assets.
 
The business does not pay corporate taxes on profits. Instead, all profits and losses “pass through” to the owners’ tax returns, each of whom pay their fair share of the business’s tax at the personal income tax rate. Note that all partners are personally liable for partnership debts. Ownership interests also may not be transferred without other partners’ consent. 
 
Limited Partnership
A limited partnership requires at least one general partner and one limited partner. The general partner(s) manages the business and has unlimited personal liability for business debts. Limited partners have limited liability as long they do not participate in management of the firm and serve simply as silent investors. 
 
So this entity type is great for passive investors who want to shield themselves from general liability risk and want to put most of the management responsibility in a few expert hands. Limited partnerships has a few specialized uses, especially for real estate, venture capital funds, and family limited partnerships. 
 
Limited partnership also provides “pass through” taxation like general partnerships, avoiding the double tax in corporations. However, these entities are subject to passive loss limitation rules and the minimum franchise tax. 
 
Limited Liability Company (LLC)
LLCs combine the limited liability of a corporation with the flexibility in management structure and pass through taxation of partnerships. So unsurprisingly, LLCs are often used as investment vehicles like limited partnerships. 
 
LLCs can be structured to be owner managed (member-managed) or have centralized management in a few managers (manager-managed). Ownership rights can allow for free or restricted transferability. Uniquely, LLCs can elect to be taxed as a partnership, S corporation, or C corporation. 
 
However, LLCs are subject to an annual franchise tax and an annual fee based on the LLC’s income. LLCs are also subject to veil piercing, meaning that creditors may be able to get at personal assets, while a limited partnership structure avoids this outcome. 
 
Corporation (C, S, or Close Corporations)
By default, a corporation is taxed as a C corporation, resulting in double taxation of business profits—the corporate pays tax on profits at the corporate tax rate and shareholders pay tax on any dividends. Businesses that have large revenue streams and continually reinvest profits into the business will benefit from being taxed as a C corporation to minimize taxes because the corporate tax rate is lower than the personal one. 
 
Corporations must adopt bylaws to govern internal operations, including the election of directors and officers. Shareholders may enter into buy-sell agreements to restrict the transferability of shares, supermajority voting provisions. Shareholders elect the board of directors, who set the corporation’s goals and policies and elect officers, such as President and CFO. 
 
Shareholders may not participate in management, but may serve as directors and officers, while keeping limited liability  protection. Shareholders, officers, and directors enjoy limited liability protection, meaning they are not liable for the business’s liabilities, absent any wrongdoing. 
 
S Corporation
S Corporations can elect to be taxed as a partnership (pass through taxation) and keep the limited liabilities and other advantages of a corporation. An S Corporation files Form 2552 with the IRS to be taxed as a partnership instead of a corporation, and avoid double taxation. S status is preferred when losses are expected for the first few years because the “pass through” taxation allows owners to offset losses against current income.
 
To elect S state, a corporation must meet certain requirements
  • Maximum 100 Shareholders
  • Shareholders must be citizens or residents of the USA
  • Shareholders may only be individuals (no business entities allowed)
  • Only one class of stock allowed
 
Sole Proprietorship
The sole proprietorship is completely owned and operated by one person, and the business entity is not separate from the owner. This structure requirements few formalities, e.g. holding meetings. However, the owner is personally liable for the business’s debts, and the business entity does not continue beyond the owner’s life. 
 
Like partnerships, profits and losses flow through to the owner, who pays taxes on the business’s profits on his or her personal tax return. So a sole proprietorship works well for someone who is interested in setting up a business with only one owner, wants little formality, is willing to risk personal assets, and wants to avoid double taxation. 
 

This article is intended to convey generally useful information only and does not constitute legal advice. Any opinions expressed are solely those of the author, not LawChamps.


 
Sona Sulakian

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