Choice of Business Entity
Business owners encounter the issue of form of organization early in the planning process for their new business, and they may revisit the question again as the business evolves and grows.
There are a range of choices for your business entity, and each of these has its benefits and shortcomings. The choices among business entities are numerous and have grown wider in the last few years with the advent of the limited liability company and the limited liability partnership. Below is a brief description of the most common forms of business organization. Your main entity choices are:
Partnership (includes general partnership, limited partnership, and limited liability partnership)
Corporation (which includes C corporation, S corporation, and nonprofit), and
Limited Liability Company (LLC).
The nuances of each format require careful consideration in light of the particular situation of the business or activity. The purpose of this section is to compare and contrast the various forms of business entity and to highlight the factors affecting the decision as to the format most suitable for your business.
In general, we recommend the sole proprietorship and general partnership formats only for very small enterprises that are not engaged in activities that involve contracting or active operations that could result in tort liability.
In general terms, service businesses that are not capital intensive can be structured as either S corporations or LLCs, while companies that require significant investment in capital goods or real estate are frequently better organized as C corporations.
A feature of S corporation taxation that makes that format attractive in some cases is that there is no FICA or self-employment tax on the portion of S corporation income that is deemed to be a profit distribution (as opposed to salary and wages).
C corporations enjoy lower initial income tax rates (15% on the first $50,000) than the combined personal income tax and FICA rate, which enables them to repay debt incurred for capital assets with funds taxed at lower rates than might otherwise be the case.
In the analysis that follows below, we will consider each form of entity from the standpoint of limited liability, continuity of life, transferability of interests, ability to contract, and taxation. A more detailed analysis of each form of entity appears elsewhere on this site. Links to those pages are provided in the sections below.
The most rudimentary form of business organization is the sole proprietorship, which is a single owner enterprise. There is often little or no formal organizational structure. The sole proprietor is personally liable not only for his own intentional acts and negligence, but also the acts of each of his employees in the performance of their employee duties. The duration of the sole proprietorship can be no longer than the life of the sole proprietor. Typically, the business of a sole proprietor is purchased or sold as a whole, and there is no provision for co-ownership.
The owner of the business may sue and be sued and enter contracts on behalf of the business. There is no separate entity with these capacities.
A sole proprietorship files no separate federal or state income tax return, but rather its income and expenses are reported on a Schedule C, of the owner’s individual Form 1040.
Next in line is the partnership, of which there are three distinct forms: general partnership, limited liability partnership, and limited partnership. A partnership is simply a business owned by two or more people that has not filed papers to become a corporation or a limited liability company (LLC). You don’t have to file any paperwork to form a partnership — the arrangement begins as soon as you start a business with another person, although in most cases we strongly recommend that you have a written partnership agreement. As in a sole proprietorship, the partnership’s owners pay taxes on their shares of the business income on their personal tax returns and they are each personally liable for the entire amount of any business debts and claims. More information: Partnerships.
Corporations, which have been commonly used for hundreds of years, are normally classified according to their tax treatment: regular or C corporations, subchapter S corporations, and nonprofit corporations.
A corporation is an independent legal and tax entity, separate from the people who own, control and manage it. An important feature of all three types of corporations is that they limit the owners’ personal liability for business debts and court judgments against the business. A “Regular” or C corporation files its own tax return and pays income taxes. An S corporation files an information tax return, but the income taxes are paid by shareholders who receive a K-1 form that shows items that they include on their personal 1040 returns. A corporation is a C corporation unless it has timely filed (generally within 45 days of organization) a Form 2553 with the IRS, electing S corporation treatment. More information: Corporations.
A nonprofit (or not-for-profit) corporation is organized for a non-business purpose. If the purpose is a charitable, educational, religious, literary, or scientific purpose, the nonprofit may apply for IRS recognition as a 501(c)(3) entity, which would enable it to receive tax-deductible contributions and raise funds by soliciting public and private grant money and donations from individuals and companies. An additional benefit of the 501(c)(3) status is income related to their nonprofit purpose is not taxed by federal or state authorities.
Limited Liability Company
The newest common form of business entity is the limited liability company or LLC. Like corporations, LLCs provide the owners with limited personal liability for business debts and claims. But when it comes to taxes, LLCs are more like partnerships: the owners of an LLC pay taxes on their shares of the business income on their personal tax returns. The difficulty and expense of establishing an LLC is similar to a corporation (filing fees are higher for LLCs in Nebraska), but LLCs do not require the annual maintenance that corporations entail. More information: LLCs.
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