Choosing a Business Entity
By: Paul Loraas
Date of Publication: February 2006
There are many issues to consider when starting a business. Legal, accounting, and tax professionals can provide valuable advice and assistance when starting a business. Many factors must be considered when choosing the best form of business ownership or structure. The choices you make can have an impact on multiple aspects of your business, including liability, taxes, ownership succession and many others. New business owners have many choices in starting a new business and they often don’t understand the differences. The following sets forth a brief description of some of the more popular business entities used in starting a new business and explains some of the pros and cons of each:
Sole Proprietorships - A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain. The business has no existence apart from you, the owner. Its liabilities are your personal liabilities. You undertake the risks of the business for all assets owned, whether used in the business or personally owned. You include the income and expenses of the business on your own tax return. Sole proprietorships make up the majority of small businesses in the
Pros
- is inexpensive to start
- is simple to run
- has no double taxation on profits
Cons
- owner has unlimited personal liability for business liabilities
- business has unlimited liability for owner’s personal liabilities
- ownership is limited to one person
Partnerships - A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business. A partnership must file an annual information return to report the income, deductions, gain, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return.
Pros
- is a very flexible form of business
- permits ownership by more than one individual
- avoids double taxation
- has few legal formalities for its maintenance
Cons
- partners have unlimited personal liability for business losses
- partnership is legally responsible for the business acts of each partner
- general partnership interest may not be sold or transferred without consent of all partners
- partnership dissolves upon death of a general partner
Limited Liability Companies (LLC) - A limited liability company is a relatively new business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation. Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner. LLCs are popular choices to use in holding real estate, such as investment and income properties.
Pros
- members enjoy limited liability
- allows for “special allocation” of profits - the disproportionate splitting of member profits and losses (in different percentages than their respective percentages of ownership)
- a corporation can be a member which allows members to share the bottom-line profit
Cons
- members cannot pay themselves wages
- managing members’ share of LLC profits is considered earned income and is subject to self-employment tax
- members pro-rata share of profits represents taxable income - whether or not a member actually receives a distribution of profits
S Corporations - An eligible domestic corporation can avoid double taxation (once to the shareholders and again to the corporation) by filing an election with the IRS to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation’s shareholders include their share of the corporation’s separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss.
Pros
- provides limited liability to owners
- is easy to transfer ownership
- is easy to add additional owners/investors
Cons
- is more costly to set up and maintain
- requires separate tax returns
- only individuals can be shareholders
There are many business entities to choose from. The number of choices available and differences can be bewildering for the average person. Selection of the right business entity should be carefully made after consultation with your legal and tax advisor. The right choice will provide insulation from personal liability and significant tax advantages. The wrong choice could subject your personal assets to liability for the debts of the business and cause you to miss out on potential tax savings.
For more information on Business Entities , please contact Paul Loraas or call 218-722-0861.
The information in this article is not intended as, and does not constitute either legal advice or a solicitation of any particular prospective client. The reader should not rely on any information contained herein regarding your specific situation until you have consulted with a qualified attorney.
Circular 230 Disclaimer - Advice, articles and commentary included herein do not constitute an opinion and are not intended or written to be used, and they cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.
