Selecting the Right Corporate Entity for Your Business
The first step when forming a business is to decide what type of entity is the best form for the business. There are number of forms of business entity available—sole proprietorships, general partnerships, limited partnerships, limited liability companies, S corporations, and C corporations. Which entity is the best form depends on structure, liability, management and tax considerations. Non-tax factors usually are the primary considerations because in many instances an entity can choose how it is treated for tax purposes.
Many small businesses operate as sole proprietorships because of the lack of formalities and ease of operation. If an individual starts a business and does not create another form of business organization, he or she will have a sole proprietorship. There are, however, two disadvantages of sole proprietorships. The first disadvantage is that a sole proprietorship can only have one owner, and if a business will have two or more owners, another form of entity must be selected. The second disadvantage of a sole proprietorship is that the owner is personally responsible for all of the debts and liabilities of the business. If the business encounters financial difficulties or customers or others are harmed by the activities of the business, the owner’s personal assets as well as the assets of the business must be used to pay any resulting claims.
Partnerships and limited partnerships must have two or more owners, so they do not suffer from the first disadvantage of a sole proprietorship. But all owners in a general partnership and at least one of the owners in a limited partnership are personally responsible for the debts and liabilities of the partnership. Partnerships, though, provide advantages under certain state tax regimes and in connection with more complex investments involving partners that do not actively participate in the business. For instance, in Pennsylvania limited partnerships are often used in connection with real estate investments because they are not subject to the state’s capital stock tax.
Limited liability companies and S corporations, on the other hand, avoid both of the disadvantages of a sole proprietorship. While all states permit S corporations to have only one owner and limited liability companies may have one owner in most states, these forms of entity work with two or more owners as well. In addition, both limited liability companies and corporations offer their owners the protection of limited liability. A limited liability company or corporation is a separate entity, and the entity alone is responsible for the debts and liabilities of the business. If the assets of the business are insufficient to pay these debts and liabilities, the business may fail, and the owner will lose his or her investment. But the owner’s home, personal investments, and other assets are not available for payment of the debts and liabilities as they are with a sole proprietorship, partnership, or limited partnership.
Limited liability companies and S corporation also share an additional attribute with sole proprietorships that is desirable for start-up businesses. This attribute is pass-through treatment for income tax purposes. With pass-through treatment, the income and loss of the business is not taxed to the entity but is passed through to the owners for them to report on their individual income tax returns. Pass-through tax treatment is desirable for start-up businesses because they often generate tax losses during their early years of operation, and the owners can offset these losses against income from other sources.
C corporations, which are corporations that have not elected to be taxed as S corporations, do not feature pass-through income tax treatment and as a result taxes are paid on income at the corporate level and again when distributed out to the owners. C corporations, though, do not suffer from many of the restrictions placed on S corporations (e.g. S Corporations cannot have more than 100 shareholders or more than one class of stock). As a result, the C corporation form of business entity is used in connection with more complex, mature businesses and is not used by many new small businesses.
Because they provide flexibility in terms of the number of members, limited liability protections, and pass-through income tax treatment, limited liability companies and S corporations are currently the most popular forms of business entity for small businesses with more than one owner, and these two forms are used by many one owner small businesses as well. Choosing between those two forms requires an analysis of the relationship of the owners to each other, the initial form and amount of capital invested, and the nature of the particular line of business.
This summary is just an overview of the major issues involved in choosing the right entity for a business purpose. Each type of business or transaction requires its own analysis to meet the goals of the owners, maximize the legal protections and tax savings, and provide a platform for growth. Accordingly, it makes sense to present the issue to your attorneys for consideration before launching any new business enterprise.
Daniel Fiore has extensive experience helping clients select appropriate entities for their corporate needs. In addition, since joining RRD, Mr. Fiore has been part of the business services group, practicing business counseling, reorganizations, debt restructuring, regulatory compliance, mergers and acquisitions, franchising, and trademark and copyright law. He also has substantial experience in the buying and selling of businesses, structuring multiple owner relationships, loan documentation, and commercial contract drafting.
For questions, comments or additional information, please contact Dan Fiore, Partner in our Corporate & Business Services Group, at firstname.lastname@example.org or via phone at 215.495.6533.