Basic Principles of Forming a Business Entity.
By Joe Sigety
Thinking of starting a new business? One of your first considerations should be which structure is right for you and your business. This decision will ultimately impact the ownership structure, taxation, financing, and personal liability of the owners and managers. This article will hopefully provide a starting point for thinking about the future structure of your business. Although creating a business entity may be done by the owners, seeking professional legal help from a qualified attorney is highly recommended. Spending a small amount of initial capital now to set up your business correctly is an investment; it will likely prevent higher costs and frustrations in the future.
The business entity that you choose will depend on three main factors: (1) Taxation; (2) Liability; and (3) Record-keeping. With those in mind, here is a quick summary of the most common forms of business entities:
(1) Sole Proprietorship. This structure is the most simple and common form of business entity. A sole proprietorship is a single individual who has chosen to operate the business as an extension of his or her own finances and taxes. The owner of this business has complete control over management, and the creation of a sole proprietorship is quick and easy. The business will pay taxes by the owner through his or her own personal tax return. While simple, a sole proprietorship carries high risks. An owner does not have limited liability for any damages caused or financial obligations that are incurred.
(2) Partnership. A partnership is similar to a Sole Proprietorship, except that the expenses, profits, management, and liability are shared by two or more people. Many people view this as a benefit because it allows the owners to operate the business as individuals, but share the risks associated risks of liability among several partners. The profits or losses of the business are “passed through” to the partners as individuals to report on their tax returns. Again, a partnership does not provide limited liability to its owners. Each partner is personally liable for the financial obligations of the partnership.
(3) Limited Liability Company. The LLC has rapidly gained in popularity since Wyoming first passed its Limited Liability Company Statute in 1977. LLC's are now widely recognized throughout the United States as a popular business structure choice. And they are popular for good reason. An LLC is basically a hybrid of the benefits of a partnership and a corporation. The owner(s) of the LLC (called "Members") enjoy the same benefits of pass-through taxation that partnerships enjoy. Members can also take advantage of the same limited liability protection that a corporation provides. Further, a LLC does not carry the same cumbersome record-keeping requirements as a traditional corporation. As far as taxation goes, you have choices: The LLC may be taxed as a partnership, or you may elect to have the LLC be taxed as an S-Corp instead. Whether you elect for your LLC to be taxed as a partnership or an S-Corp will depend on your business's unique needs. Consider consulting with a tax professional before deciding which tax structure is right for you.
(4) Corporation. Corporations are different in the sense that they are a completely unique entity upon themselves. Meaning, they are separate from you in every way. Creating a Corporation is almost like creating another person. The primary benefit of forming a corporation is the additional liability protection provided by the law. A corporation will be held legally liable for its actions, and only in rare occasions will the owners be held personally responsible. If the corporation takes on debt, the shareholders are not personally liable to repay that debt. If a corporation injures a person or otherwise causes damages that lead to a lawsuit, the business will be the responsible party.
Because Corporations are legally separate entities, they also have a much different tax structure. They pay their own separate taxes at a corporate tax rate instead of a personal tax rate. This tax is assessed on the profits (the money that is left over at the end of the year) as opposed to the business’s gross income. There are two predominant forms of corporations which varies the taxation structure: the C-Corp and the S-Corp. Under a C-Corp structure, the corporate entity is taxed on profits, and once the distributions or dividends are handed out to the shareholders, the individual shareholder pays income tax on that amount. In essence, the money that the C-Corp makes is subject to "double taxation." An S-Corp avoids this problem because the corporate profits are “passed through” to the entity directly to the owners, or shareholders. Like a partnership, the shareholders then pay income tax on the amounts received. For this benefit, S-Corps have additional restrictions. Namely, the S-Corp must be a domestic company, there can only be one class of stock, and ownership is limited to no more than 100 shareholders who must be individuals (with a limited exception for certain estates and trusts).
Because corporations provide additional benefits and specialized tax structures, a corporation is subject to significantly more regulation and record keeping requirements. Federal and state laws require corporations to file annual reports, financial statements, meeting minutes, and bylaws.