Choosing the right entity for your new business can pose a tough dilemma. Following are the type of business entities to consider for your enterprise along with their benefits and disadvantages.
Type of Entities
Types of entities include (in alphabetical order):
- C Corp
- S Corp
- Limited Liability Company (LLC)
- General Partnership
- Limited Partnership
- Sole Proprietorship
C Corp – Double taxation of income: corporate income tax plus dividend income that’s taxable to recipients. Double tax can be avoided if corporate income is retained or reinvested rather than distributed as a dividend or the corporation pays the owners a salary or bonus rather than dividends.
A C corp offer ease in the transferability of corporate stock. However, corporate formalities can be burdensome, requiring resolutions, annual meetings, minutes taken, and financial record-keeping.
C-corp taxation issues include “trapped” losses in that any losses are “trapped” inside the corporation and can’t be deducted or offset against other income by the C-corp owners. Income splitting is a corporate tax strategy in which the business owner takes a salary, but leaves some income in the corporation, resulting in corporate income being split between the owner and the business entity.
C-corp owners have limited liability. They’re not personally liable for business debts, can be personally liable as a result of torts they commit (e.g., negligence or fraud), and the corporate veil can be pierced to hold owners personally liable.
S Corp – Limitations on ownership: 100 or fewer owners (individuals, estates, or certain trusts) and no non-resident alien owners. Multiple classes of stock aren’t permissible. Tax-free distributions to the extent of owner’s basis with possible exception being if the S corp was formerly a C Corp. Also, S-corp shareholders don’t increase the basis for all S corp debt.
All S-corp owners have limited liability. Self-employment tax is due on a “reasonable” salary. Income allocation is on a per-share, per-day basis, and special allocations aren’t permissible. Basis is obtained through capital contributions or loans made directly to the S corp with S-corp shareholders obtaining no basis for corporate debt.
Limited Liability Company (LLC)
This is a hybrid form of business organization, combining features of partnerships and corporations. It provides limited liability for all members and flexible operation and management. No tax is due at the entity level; income and losses pass through to the members.
An LLC is, by default, taxed as a partnership. Pass-through taxation offers no tax at the entity level as partners are taxed on the allocable share of the partnership’s income. Form 1065 is the partnership information return—see Schedule K and Schedule K-I.
General Partnership – A general partnership has general partners only. It exists by default when two or more people go into business together.
General partners are personally liable for partnership debts. Daily management and power to bind a limited partnership is generally reserved to general partners.
In regards to profit and loss sharing, the general partnership default rule is that profits are shared equally among partners regardless of differing contributions; losses are shared in proportion to profit sharing.
Limited Partnership – A limited partnership has two types of partners: at least one general partner and one limited partner. To be formed, a limited partnership requires filing a certificate of limited partnership.
Limited partners are generally not liable for partnership debts. Limited partners may have governance rights as to certain very limited matters.
In regards to profit and loss sharing, the limited partnership default rule is that profits and losses are shared in proportion to partners’ respective capital contributions.
This is the default entity for single-member business ventures. The major benefit is the ease of startup. However, it’s not a separate tax entity from the owner so business profits and losses flow through to the owner. In addition, earnings may be subject to self-employment tax, and the owner has unlimited liability for all business debts.
In conclusion, there are so many aspects to consider when trying to identify the right business entity for your enterprise that it would be beneficial to consult with a legal professional.
ABOUT THE AUTHOR
Debra DeCarli, Attorney at DeCarli Law, has been practicing law since 1994. She also holds a Master’s degree in Public Affairs. After many years as a litigator representing consumers all over the country, she opened an office in Mendocino. She focuses on estate planning, wills, and trusts and advising small business clients.
DeCarli Law is located at 45100 Main Street, P.O. Box 690, Mendocino, CA 95460. Ms. DeCarli is available for private consultations.
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