If You're Starting a Business, Which Type of Business Entity Will You Choose?
If you're starting a business, one of the first and most important decisions you need to make is which type of business entity to set it up as: sole proprietorship, corporation, limited liability company, or partnership.
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If you're starting a business, you have several choices: The C Corporation, the S Corporation, the partnership, and the sole proprietorship. In addition, other forms of doing business are available, including the limited liability company (LLC) and the limited liability partnership (LLP). Some new businesses may even be structured using two or more of these entities to maximize the advantages offered by each.
First, what are your objectives?
To select the appropriate entity, you must determine your goals and objectives. The proper entity is one that fits with your total tax, financial, and legal situation and meets the client?s business objectives of what the entity is intended to accomplish. We can help clarify your business objectives and recommend entity choices that will meet those goals.
Most goal statements in entity selection relate to one or more of the following basic business objectives (these goals are discussed in the remaining parts of this section):
a. Insulating business owners against legal liability.
b. Minimizing taxes (including the avoidance of double taxation).
c. Providing ease of formation, operation, and administration.
d. Facilitating a future change to a different entity structure.
Other important goals include gaining access to capital funding through ownership flexibility, and facilitating future business succession to family members, fellow business owners, employees, and others.
Second, Identify the nature of your business operations
You must be familiar with the underlying factors of your operations, such as the?
a. Nature of the business
b. Number of and relationship among the organizers
c.Capital funding needs and the availability of capital
d. Amount and nature of the assets to be contributed at inception
e. Participation of organizers in management.
How will you insulate the business owners against legal liability?
Ask yourself this early on in the process: ?How important is it for the business owners to be insulated against the liabilities of the business enterprise?? The need for a liability shield must be weighed against other concerns relating to the choice of entity decision, including (a) suitability for intended purpose (e.g., operating a retail store or investing in real estate), (b) tax implications, (c) tax compliance costs, (d) set-up costs, (e) ease of operation, and (f) operating costs.
We highly recommend discussing liability exposure (and measures to minimize that exposure) with trusted legal counsel.
The table below lists specific indicators of liability exposure for business owners. The existence of one or more of these items indicates a need to (a) avoid the activity leading to the risk exposure or (b) limit the owner?s liability with a limited liability entity or other asset protection strategy such as insurance.
Common Sources of Liability Exposure
? Debts to creditors, vendors, and suppliers.
? Employing others.
? Employees whose actions can create liabilities (e.g., employees who drive vehicles to make deliveries).
? Hazardous nature of the business (e.g., toxic chemicals are handled or heavy equipment is used).
? Product liabilities (e.g., the products are hazardous by nature or can be mishandled in ways that can result in injuries or damage to property).
? Environmental liabilities (e.g., almost any manufacturing or processing business and any business owning real estate that may be contaminated or polluted).
Other methods to address liability concerns
In addition to addressing liability through the type of business entity you establish, you can also take other measures, including purchasing adequate insurance, hiring competent and trustworthy employees, using competent legal advisors, ensuring that employees are properly trained, properly maintaining buildings and equipment, and implementing other asset protection strategies.
Incorporation is a great way to shield your company from liability
Incorporating a company is an established way to shield your assets and company's assets from liability. If you decide to incorporate, you then must choose between a C Corporation, S Corporation, or a LLC.
Corporations require certain procedural details to separate a corporation and an owner as separate entities. As a corporation, you must:
If a corporation does not adequately follow the above measures to support the corporate structure, the corporation's existence may be ignored for legal and tax purposes. This is sometimes referred to as "piercing the corporate veil." Corporate status can be pierced for other reasons as well (e.g., where the corporation is undercapitalized).
The issue of veil piercing is unique to closely held entities. Large publicly traded corporations are rarely, if ever, disregarded. Closely held corporations are subject to piercing for many reasons. However, there are certain standards that have been developed over many years which provide guidance as to the best methods for preventing the loss of a corporation?s separate identity.
In many cases involving closely held businesses, the use of a corporation does not protect the owners from liability or debt owed to banks and other financial institutions, because these creditors often require the owners to personally guarantee such debt. This does not mean that a corporation offers no liability protection in such circumstances. For example, a corporation generally still protects owners from product liabilities and liabilities resulting from the acts of employees.
Generally, under state law, the use of a corporation does not protect professionals (doctors, lawyers, accountants, etc.) from liability for their own professional errors and omissions or for their own malpractice.
For liability protection purposes, there is no difference between a C Corporation and an S Corporation. The degree of liability protection offered by any corporation is a matter of state law and is not related to its tax status under the Internal Revenue Code (IRC).
The procedures for incorporating an S Corporation and a C Corporation under state law are the same. An S Corporation is simply a corporation that qualifies for special income tax treatment (e.g., freedom from double taxation of corporate income) under the IRC and then affirmatively elects S Corporation status. Once it has been decided that incorporation is appropriate because of liability concerns, the next issue is to address whether the potential tax benefits of S Corporation status can or should be used.
Limited partnerships can be an effective way to control the liability of owners. However, at least one of the partners must be a general partner that is, at least theoretically, exposed to unlimited liability. In addition, limited partners cannot be too actively involved in running the business without losing their liability protection. These factors, along with the complexities of partnership taxation, may make the use of a C Corporation, S Corporation, or limited liability company (LLC) a more attractive choice.
LLCs are available in every state. In theory, LLCs are attractive because they combine the best attributes of corporations and partnerships by offering limited liability to all owners (like S Corporations), flexible ownerships structures (like partnerships), and avoidance of double taxation (like both S Corporations and partnerships).
Furthermore, unlike limited partnerships, all owners can fully participate in the management of the business without the threat of losing their limited liability protection. The major drawbacks of LLCs are that the true degree of liability protection offered is somewhat uncertain since the laws are evolving, and members of LLCs that conduct an active business will generally be subject to self-employment taxes. Accordingly, corporations still offer more time-tested assurance that the benefits of limited liability will be realized. State franchise tax cost must also be considered.