There a probably a million blogs/articles written on entity selection so I will try to keep this light and get straight to the point. You and entity selection are a bit like Goldie Locks, too hot, too cold, just right! The different entity types of business can be formed under each have pros and cons. Like Goldie Locks, its about finding the right one for you, which can be a challenge. Depending on your needs each entity type has value, and that is what this article will discuss. Hopefully you will find this useful in helping your Goldie Locks (business) the right fit, or at least help you identify things to keep in mind during the selection process.
Sole Proprietor / Partnership
This is by far the simplest entity type. If you start doing business by yourself, or with others, you by default have formed either a sole proprietorship or partnership. One of the major benefit of these entity types are ease of formation. The second is the taxation of income. As a sole proprietor or partnership, the IRS allows the owner(s) to treat income of the business as personal income. The business is not taxed on income before the business owner is taxed on the income, i.e. there is no double taxation. This may sound like a good thing (and it is), however, there is one major drawback…the liability that you leave yourself exposed to. There is no insulating layer to protect you personally from liability of the business. Any person or business that has a claim against your business can pursue your assets to make good on the claim. For this very reason I generally, I advise my clients to at least form a limited liability company, otherwise commonly referred to as an LLC.
Limited Liability Companies (LLCs)
The reason I advise my clients to at least form an LLC, is because you get many of the same benefits of a sole proprietorship/partnership, but with the added benefit of limiting personal liability. This means you still benefit from pass through taxation, but with the added benefit of limiting liability. Additionally, administering an LLC is generally easier than a corporation because there are fewer statutory requirements for LLCs. These benefits make LLCs a very good option for a wide variety of small businesses. LLCs do have their limitations though. The flip-side of pass through taxation is self-employment tax. Another issue, or set of issues, revolve around transfer of ownership interest in the business. For instance, stock options cannot be given to key employees as a benefit/perk. Lastly, depending on your state, the laws governing LLCs can differ. To summarize, LLCs offer many benefits to business owners, but do come with limitations. Business owners should take the time to think through their ultimate goals before selecting this entity type.
For purposes of this article, we will be discussing S Corporations (S Corp). For treatment as an S Corp by the IRS, the corporation must submit a form to the IRS requesting S Corp treatment. Election to be treated as an S Corp provides many of the same benefits as an LLC, such as pass through taxation and limited liability. S Corps can be easier to transfer ownership interests in as well. There are limitations in place on who/what can be a shareholder in the corporation, which can serve as a limitation to some corporations. Generally, the limitations on S Corps are intended to limit the availability of S Corp benefits to small businesses. For instance, S Corps are limited in the number and type of shareholder they are permitted to have. Lastly, it should be mentioned that formation as an S Corp has the greatest burden of administration of the three discussed. The burden of administration should be weighed against the realistic needs of your business plan if you are considering formation as a corporation with the S Corp election.
All three of these entity options carries with it inherent pros and cons. It is about determining which entity type best suits the needs of your business. This article just skims the surface of each entity type, and an entire article could be written on each option. Within each entity type it is always a good idea create agreements, and bylaws specific to your business. In business it can be an expensive fix jumping from too hot to too cold, just to find that just right is your third choice. If you would like help determining which entity type is best for your business, and establishing your business, the attorneys at Loop Legal can help. Call today to schedule a meeting to discuss your business and getting the ball rolling on the entity selection process.