CHOOSING THE RIGHT BUSINESS ENTITY FOR YOUR COMPANY
(Not intended for a legal audience)
Congratulations! You’re about to embark upon the journey of entrepreneurship. You’re excited, but you don’t know which entity structure to select for your business. Your decision on business structure can have an immediate and significant impact on your business as well as a lasting impact on your ability to raise capital. The legal structure that you select will determine everything from how you pay taxes, the amount of paperwork involved, and the impact of a lawsuit.
This post should help to clarify many of those points. After reading this post, you should be more enlightened about the advantages of the various business structures and the tax implications of those structures. Here are some key points to consider as you proceed in your journey of entrepreneurship.
Types of Business Entities and Tax Treatment
Most for-profit businesses are generally formed under state law as:
Limited Liability Partnerships
Limited Liability Companies
For tax purposes, a business entity is treated as one of the following:
Disregarded entity – Pass-through taxation
A sole proprietorship is the simplest form of business to launch. A sole proprietorship can operate under the name of its owner or it can do business under a fictitious name (commonly referred to as a “DBA” or “doing business as”). There are no formal requirements to establish this business structure. Thus, it is not necessary to file any documents with the state or the IRS. Although, some states require that you register the fictitious name with the secretary of state’s office. This particular business structure is only available to married couples or individuals. There are no partners, shares, or membership interests in a sole proprietorship, which generally makes it difficult to attract investors without first changing the business structure. The biggest disadvantage of sole proprietorships is that the owners are not legally separate from the business. Therefore, the proprietor is personally liable for all debts and obligations of the business. If the business is sued, personal assets such as your savings, house, car, etc. are at placed risk.
A sole proprietor is required to report all business income and losses on their personal income tax returns; the business entity is not taxed separately. This tax treatment is commonly referred to as "pass-through" taxation because business profits pass through the business (avoiding corporate taxation) and are taxed on the business owner’s personal tax returns.
A sole proprietor does not have an employer to withhold income taxes from their paycheck. The proprietor must estimate how much tax will be owed at the end of each year and make quarterly estimated income tax payments to the IRS, and if required, to their state tax agency.
SOLE PROPRIETORSHIP AT A GLANCE
General Partnership (GP)
A general partnership is an unincorporated business owned and run by two or more people. General partners typically share in the day-to-day management of the business as well as the business’s profits and losses. Like sole proprietorships, a general partnership does not provide limited liability for the partners. Therefore, the partners are subject to unlimited personal liability for the debts and obligations of the business. In addition, each partner is responsible for the other partner’s liabilities, negligence, and misconduct.
General partnerships are also restricted in their ability to raise capital. Other than debt financing, partnerships often find it extremely difficult to get access to large amounts of capital. Although selling equity interests may be an option for partnerships to raise capital, it can be extremely difficult to do on a large scale because of the potential for personal liability and the limited resale market for partnership equity.
Limited Partnership (LP)
A limited partnership has two tiers of partners: at least one “general partner” who is actively involved in operating the business and is personally liable for business obligations and at least one “limited (investing) partner” who is not involved in running the business but shares in the business profits. The limited partner’s liability is limited to the amount that they invested in the business.
Limited Liability Partnership (LLP)
A limited liability partnership is similar to a general partnership. Unlike the other two partnership structures, all of the owners have limited personal liability; and therefore, are protected from the debts of the business as well as personal liability for the other partners’ negligence. LLPs are most often used by professionals such as lawyers, accountants, and physicians who want to avoid liability for their partners’ malpractice. Some states do not permit these professionals to form corporations or LLCs, so in order to protect their personal assets, these professionals are left with LLPs as a business structure.
Taxation Options for Partnerships
A business entity taxed as a partnership is regarded as a pass-through entity for tax purposes, which means it does not pay corporate taxes. The partnership's profits and losses are instead computed and allocated among the partners annually and pass-through to the partners, which include their respective share of those items on their personal income tax returns, irrespective of whether there has been a distribution of profits. It is important to note, however, that although the default taxation classification is pass-through taxation, a partnership may elect corporate tax treatment by filing the appropriate entity classification election forms with the IRS.
PARTNERSHIPS AT A GLANCE