Choice of Entity: Your Options and Why They Matter

Written by Steven Tennies on May 6, 2013 at 7:40 pm

Don't hang-upDeciding to start a business is an exciting decision. But determining how you should formally organize and structure it can be intimidating. At best, the determination is often the result of a kind of calculus that looks at formation expense, personal liability protection, potential tax savings, and the complexity of ongoing compliance formalities. At worst, the aspiring entrepreneur merely slides into business and ends up with a business structure they neither intend nor understand.

Nonetheless, one of the very first and most important decisions you must make is what type of business entity your new business will be. Its absolutely critical to your future success and survival.

The entity type you choose will have a profound impact on many things. Among them are: ownership options, credibility, raising capital, personal liability, and taxation. A clear understanding how each of these is affected by your choice of entity is imperative.

Unfortunately, most new entrepreneurs discount the significance of entity choice. They give little thought as to how their business should be organized. So they end up with the most basic business structure by default and are left exposed to unlimited personal liability and unnecessary taxation. On the other hand, when you are armed with a clear understanding of what your options are and take the time for some careful planning you can avoid the difficulties and risks that attend doing nothing.

When you create a business you have four primary entity types to choose from. They are: sole proprietorship, partnership, limited liability company, and corporation. For now, we’ll look at each entity type at the highest level. In subsequent articles I’ll go into each entity type in more detail.

Sole Proprietorship:

Ownership—If you are the sole owner and haven’t formally organized your company as a corporation or limited liability company then your business is a sole proprietorship.

Credibility—A sole proprietorship is often perceived as a less credible business structure due to the lack of formality and because of the very fact that you are the sole owner. There isn’t anyone else with skin in the game that you or your customers can depend upon. If you leave or die, the business leaves or dies with you.

Raising capital—You have only two reliable sources of capital: (1) your personal assets and (2) loans you personally guarantee and secure with your personal assets.

Personal liability—If anything goes wrong everything you own is at risk. You are personally liable for any and all business debts, taxes, obligations, and liabilities as well as any legal claims made against any of your employees that act within the course and scope of their employment.

Taxation—Business revenue and expenses are reported on your personal income tax—IRS Schedule C and IRS Form 1040.

General Partnership:

Ownership—If you and at least one other person own the business and you haven’t formally organized your company as a corporation, limited liability company, or limited partnership then your business is a general partnership.

Credibility—General partnerships are often perceived as a slightly more credible business structure due to the availability of more capital and because there are multiple owners. Third parties tend to feel more comfortable dealing with a business that has more financial and human resources.

Raising capital—In addition to your own assets and credit you have access to those of your partner.

Personal liability—As a general partner, you are 100% personally liable for any and all partnership debts, taxes, obligations, and liabilities as well as any legal claims made against any of your employees that act within the course and scope of their employment. To make matters worse, you can even be held liable for personal debts that your partner charges to the business.

Taxation—Your general partnership files an annual information return to report revenue and expenses but does not pay income tax. Rather, profits and losses pass through to each partner in proportion to their ownership interest. The profit or loss is then reported on each partner’s personal income tax return.

Limited Liability Company (LLC):

Ownership—If you formally organize your business by filing Articles of Organization (or a similar charter document) with the state, observe certain limited formalities, and remain in compliance with state regulations then your company is a limited liability company. There can be one or more owners, each of whom is referred to as a member.

Credibility—Limited liability companies are often perceived as a somewhat more credible business structure than a sole proprietorship or general partnership due to the formal commitment you make to your business. You make it known that you are serious about your enterprise and are willing to make the financial and time commitment necessary to make your business a viable enterprise.

Raising capital—Your ability to raise capital as a limited liability company very much depends upon whether you are a single-member or multiple-member company. As such, you will still depend upon your own assets and those of any other members. However, you have the added flexibility of selling membership interests to investors who can act as silent partners, an option not available to you as a sole proprietor. Also, the limited liability company has the ability to ultimately establish credit in its own name without the personal guarantee of any member.

Personal liability—As a member of a limited liability company you are not personally liable for the debts, taxes, obligations, and liabilities of the LLC or any legal claims made against any of your employees that act within the course and scope of their employment. Your personal liability is limited to your investment in the business.

Taxation—By default, for income tax purposes single-member LLCs are treated as a sole proprietorship and multiple-member LLCs are treated as a partnership. LLCs also have the option to elect to be taxed as a corporation.

Corporation:

Ownership— If you formally organize your business by filing Articles of Incorporation (or a similar charter document) with the state, observe certain enhanced formalities, and remain in compliance with state regulations then your company is a corporation. There can be one or more owners, each of whom is referred to as a shareholder.

Credibility— A corporation is generally perceived as a more credible business structure than a sole proprietorship, general partnership, or limited liability company due to the enhanced formalities required to maintain it and your commitment to run your business as a business. You prove your legitimacy and professionalism because you are willing to make the financial and time commitment necessary to stand above your competitors who “default” their choice of entity by not going the extra mile to formally structure and organize their company.

Raising capital—A corporation has the ultimate in flexibility to raise capital, both financial and human. A corporation can issue shares to investors and even be publicly traded. Furthermore, you can offer stock to potential employees as well as enhanced tax-free benefits, thus enabling you to attract top talent.

Personal liability— As a shareholder of a corporation you are not personally liable for the debts, taxes, obligations, and liabilities of the corporation or any legal claims made against any of your employees that act within the course and scope of their employment. Your personal liability is limited to your investment in the business.

Taxation—A corporation is treated as a separate tax entity that is distinct from its shareholders. As such, the corporation is taxed on all its profits. However, a corporation can elect to be taxed like a partnership by filing IRS Form 2553. When it makes this election it is referred to as an S-corporation.