Which Entity is Best for a Small Business?
You started your small business. As you became more successful you added employees, opened a storefront and contracted with outside vendors. With each of these events, you added additional liability. Liability that could harm you personally as a sole proprietor. That’s exactly why business entities exist. Business entities create a sustainable structure to operate while simultaneously shielding you personally from liability. Not all business entities are created equal. Choosing an entity to organize or incorporate can come with both benefits and consequences.
SELF-EMPLOYMENT TAX? DOUBLE TAXATION? HELP!
Tax structure represents one of the primary differences between business entities and is an important consideration. There are generally two types of taxation of business entities: taxation at both the entity level and the personal level, and “passthrough” taxation only at the personal level. Standard C corporations are subject to the double tax of both entity and personal taxation, while Limited Liability Companies (“LLCs”), partnerships and S corporations receive passthrough taxation, where the individual with an interest in the entity is taxed personally. There are disadvantages to this latter form of taxation, however, in that members of the LLC might also have to pay self-employment tax if they contribute significant services to the LLC. LLCs also can elect different tax treatment which gives LLCs a serious advantage.
LIABILITY
How much of your personal assets are you willing to risk on this business? LLCs and C and S corporations provide strong protection from personal liability (known as “piercing the veil”). Conversely, partnerships retain personal liability for all partnership debts. Limited partnerships allow a differentiation between general partners who are personally liable for all debts, and limited partners who are only personally liable for partnership debts to the extent of his or her stake in the partnership. Sole proprietorships retain all personal liability for business debts.
TRANSFERRING BUSINESS OWNERSHIP CAN BE DIFFICULT
Changing and transferring ownership is a relatively simple task in a C or S corporation, since ownership is based on shares owned and these merely need to be sold. Partnerships, however, must be terminated to change ownership. Sole proprietorships must be sold outright. LLCs are somewhere in the middle, as membership in the LLC is determined largely through the terms of the operating agreement. Still, ownership interests in an LLC are not as simple to sell as they are in a C or S corporation.
C CORPORATIONS ARE COMPLICATED
A C corporation adheres to rigid and timely formalities such as annual meetings and annual reports. Failure to perform these administrative tasks may result in dissolution of the corporation, so strict adherence to these tasks is necessary. Conversely, LLCs require very little in the way of formality for continued operation.
CAPITALIZING SMALL BUSINESSES
LLCs can become unwieldy with too many members/investors, which is why traditional C corporations are generally a better fit. The structure of an LLC can deter some potential investors as well, with limitations on liquidity and stock issuance. A C corporation is a more tried-and-true investment vehicle for acquiring capital.
No matter which form you choose, there will be benefits and drawbacks to your business. The best practice is to sit down with a professional who can guide you through the analysis and create an entity that best fits your goals for your business going forward. Contact Jeff Roper with any questions.
This article does not constitute legal advice.