CHOOSING THE RIGHT BUSINESS STRUCTURE

So, you’ve come up with a brilliant idea and you think to yourself, “I should start a business … but where do I start?” With just a little research, you’ll soon discover that there are several different types of business structures, including the following:

• Sole proprietorship
• Limited Liability Company (LLC)
• General Partnership (GP)
• Limited Partnership (LP)
• Limited Liability Partnership (LLP)
• Corporation
• C-Corporation (C-Corp)
• Subchapter S-Corporation (Sub-S Corp or just S-Corp)

Determining which business entity is best for your situation is important. Failing to understand the differences between these options – and what they could mean for you – can lead to critical mistakes down the road. Take the time to consider your goals and how your needs may change in the future.

With that in mind, review the pros and cons of each business structure to determine which will best fit your needs. This is a big step, so you may want to seek out a professional who can help you make sense of the legal ramifications, tax implications and potential pitfalls of different business structures. The expert counsel of a tax professional – a Certified Public Accountant (CPA) or Enrolled Agent (EA) – or a business attorney can help guide you down the path that is right for you.

In many cases, a tax professional is a great place to start. First, they will examine your past tax returns, consider where your business is today, and help you plan for where you hope and expect your business to be years from now. Then they’ll help you narrow down your choice of business structure to one or two. CPAs and EAs are specifically qualified to evaluate your business plan, current resources, financial forecasting and tax situation, so they can assist you in making realistic projections and adjusting them down the road as your business grows.

Tax professionals also tend to have lower hourly rates than business attorneys, so they might save you a considerable amount of money. Whoever you hire – a tax professional or a business attorney – getting professional advice before choosing a business structure is worth an initial consultation, which they will typically do at no cost or obligation.

This is the most basic type of entity and perhaps the simplest form of business organization. A new business with only one owner usually defaults to the sole proprietorship structure. That’s because a sole proprietorship is not a legal entity separate and apart from its owner; you are the business and the business is you.

In a sole proprietorship, the owner holds the title to the business, conducts business for profit, and is directly and personally liable for all obligations of the business.

From an income tax standpoint, the business’ income and expenses flow directly through to the sole proprietor as an individual. Unfortunately, this entity provides no real shield to protect you and your assets; the government or creditors can take your personal assets (home, car and income) to rectify debts if the business fails and is unable to meet its liabilities.

Score:

• Ease of formation: 1
• Liability protection: 5

This is an entity created under state law that is owned by one or more “members.” LLCs combine the tax advantages of a sole proprietorship or partnership with the liability protection of a corporation. The main tax advantage is the “pass-through” of taxable income, so that the income is taxed only once (to the members) rather than at the entity level and then again to the members.

A single-member LLC can choose to be taxed as a sole proprietorship, a “disregarded entity” (that is, part of the member’s personal tax return) and/or a corporation. A multimember LLC must choose to be taxed as either a partnership or a corporation.

The LLC is one of the most popular structures and is extremely flexible. Like a corporation, an LLC offers limited liability protection to its owners, yet it has fewer corporate requirements and formalities and greater tax flexibility. One disadvantage is that profits may be subject to self-employment taxes.

Score:

• Ease of formation: 2
• Liability protection: 2

This is an entity with two or more persons as co-owners who choose to go into business together with hopes of making a profit. Many new businesses with multiple owners choose the general partnership structure.

A partnership is an entity separate from any of the individual owners. Like an LLC, it allows the pass-through of taxable income to the partners and isn’t taxed at the entity level. Co-owners in a general partnership personally share the risks and rewards of all phases of the business. Tax rules and regulations, however, can make partnerships increasingly complex entities.

Partnership agreements are critical to the success of a partnership; without one, the GP is subject to a set of default rules. For instance, upon the death or resignation of any partner, the partnership is automatically dissolved, requiring any remaining partners to re-form the business. This default can be avoided by the partnership agreement.

A key consideration for a GP is the fact that each general partner is jointly and severally liable for all the partnership’s obligations. Like sole proprietorships, a partner’s personal assets can be seized to satisfy partnership debts, even if another partner was responsible for making bad decisions.

Score:

• Ease of formation: 1
• Liability protection: 5

This is a special type of partnership with tax characteristics (such as pass-through of taxable income) similar to those of general partnerships. Like GPs, a limited partnership must have at least one general partner, who is responsible for managing and controlling day-to-day operations, and who also retains unlimited liability.

The main difference is that LPs also have at least one “limited” partner, who is not personally liable for any of the partnership’s liabilities.

Limited partners are restricted as to the amount they can participate in the business, but they have much less liability (typically limited to the money they invest in the LP) than the managing general partner, as well as all partners in a GP.

Score:

• Ease of formation: 3
• Liability protection: 1 for limited partners; 5 for managing general partner

This is a special type of partnership that exists under applicable state law. This is generally a favorable form of organization for professionals who are providers of professional services (for example, attorneys, CPAs and physicians). In most states, LLPs are a good alternative to LLCs, especially where professional service firms are not allowed to organize as LLCs.

Some advantages include pass-through taxation status and the flexibility to structure your ownership interest. In addition, most states give LLPs the same liability protection as LLCs. One disadvantage is, in some states, partners are personally liable for the debts and other obligations of the LLP.

Score:

• Ease of formation: 2
• Liability protection: 2 in states with same protection as LLCs; 5 in other states

The highest level of liability protection is in a C-Corp, and that is because it truly is a separate entity, removed from its owners. Most companies whose stock you can buy on a stock exchange are C-Corps.

A C-Corp does not benefit from pass-through of taxable income and expenses to the individual. Income is taxed at the corporate level, and to the extent that profits are paid out to shareholders (as dividends), those dividends are taxed (again) to the recipients. This is often referred to as “double taxation.”

Score:

• Ease of formation: 5
• Liability protection: 1

S-Corps, also commonly known as “Sub-S Corps,” offer a little less protection but the same amount of difficulty in formation. You might choose an S-Corp because the tax treatment can be considerably more advantageous than with a C-Corp.

S-Corps do get pass-through of profit taxability to individual owners (shareholders) at their own ordinary income tax rate, with no double taxation, just like sole proprietorships, LLCs and partnerships. When S-Corp profits are distributed, they are neither subject to self-employment tax nor treated as taxable dividends. Thus, while an S-Corp is still among the most difficult to form, it has better tax benefits.

Score:

• Ease of formation: 5
• Liability protection: 2