How to Choose an Appropriate Form For Your Business

The following is a guest post from attorney Jeffrey Katz. Guest post guidelines can be found here.

When starting a new business, one of the first considerations an entrepreneur should anticipate is the specific type of structure that is appropriate for their business.

The business forms include sole proprietorship, partnership, limited partnership or a limited liability company, C Corporation, and S Corporation. These entities sometimes go by different names in different states.

Let’s closely analyze each structure and determine the appropriate form for your business.

What Is a Sole Proprietorship?

A sole proprietorship is the easiest form of business to start. It is most appropriate for workers such as freelance photographers, writers, craftsmen, or independent contractors.

These are professions that work on a contract basis, meaning that they are sole-proprietorships in themselves. Although, in order to establish legitimacy, you must comply with local registration, permit laws, and licenses.

In addition, a sole proprietorship is not a legal separate entity from the owner, thus the business is one and the same. This means you must pay a self-employment tax (Social Security and Medicare) in addition to income taxes for the year.

Essentially, if you want to run the show yourself and feel you have a grasp for what your target audience desires, a sole proprietorship is for you.

Advantages: flexible form of business, the operating costs are minimal; you are the individual owner; file income tax returns through the owner’s individual tax returns.

Disadvantages: the life of the business can only be as long as the owner’s life (no family members, friends, or others can be concurrent owners of the business); the owner is subjected to unlimited personal liability which means if a business loses money or owes any tax liabilities, the owner is subject to pay all of the expenses.

Should I Form a Partnership?

Partnerships differ from sole proprietorships because it involves two or more people running the business.

However, like a sole proprietorship, there is no need for local or state filings, other than tax returns.
An example of a partnership could be two or more people owning a food truck. There are two owners, one could be the principal driver and the other could be the principal chef.

They both share profits and liabilities according to the partnership agreement, yet they are unregistered with local government. General partnerships are most applicable with small businesses like food trucks or vendors.

Advantages: under federal tax law, a partnership is not taxed as a separate entity; tax liabilities are allocated towards partners in proportion to the partner’s percentage interest in the partnership; partners can withdraw cash and assets from the partnership without federal income tax consequences.

Disadvantages: a partner is personally liable to any debts or other obligations due after partnership agreement is signed; partnership taxation can be complex and may require a great deal of planning; there might be quarrels between how the business should be run between the partners.

How About a Limited Partnership (LP)?

A limited partnership is a partnership, but with limited and general partners.

Limited partners merely invest in the company and stay out of the business operations. There must be at least one or more general partners who invest in the company and manage the day-to-day operations with personal liabilities to any of the company’s debts.

Limited partners are only liable to what they invest in the company, meaning if the company goes bankrupt, a limited partner would not be forced to pay outstanding debts with personal assets.

An LP is appropriate for law firms, accounting firms, film companies, finance firms and real estate projects. Private equity companies almost always use general or limited partnerships for investment funds.

What Is A Limited Liability Partnership (LLP)?

LLPs are a form of partnership that allows for limited personal liability among all the partners.

This means that one partner is not financially responsible for debts against the firm if another partner owes liabilities due to misconduct.

LLPs are generally utilized by professionals in accounting, architecture, law, medicine, or dentistry. Industries like these are subject to frequent lawsuits and malpractice claims, thus limited liability is essential to prevent a partner from going bankrupt.

Advantages: same advantages as partnership, except a partner is not liable for obligations or debts of the LLP

Disadvantages: same as partnership, except not all states have adopted LLP status, so it may not be recognized in certain jurisdictions.

Is a Limited Liability Company (LLC) Right For Me?

LLCs are flexible forms of business that combine elements of a partnership and corporation.

Owners, who are called “members,” have limited liability for the company’s debts like shareholders of a corporation and they also have pass-through taxation like a partnership or S Corporation.

This business entity is created by filing a document with the state, usually called the “Articles of Organization.”

An LLC has a similar tax structure as an S corporation, so what exactly differs the two? Well, LLC has a good deal of flexibility and operational comfort, while an S Corporation can save on employment tax. Also, LLCs allow for an unlimited amount of members while an S corporation only allows for up to 100 shareholders.

Advantages: protects members from personal liability for the debts and obligations of the LLC; freedom from limitations on the funds from which dividends may be paid; elect to choose whether it be taxed as a partnership or corporation.

What Is a “C Corporation”?

A C Corporation is a separate legal entity that is viewed as a “human being” regarding tax laws.

The corporation can engage in business contracts, file lawsuits, and even be sued. However, the dividends issued to shareholders is taxed with the shareholder’s income as well, causing a situation called “double taxation.”

C Corporations provide more flexibility than an S Corporation because of the number of owners a C Corporation can have. Both types of corporations are restricted to state laws, meaning they must file for articles of incorporation, hold and document annual meetings of directors and shareholders, and update the bylaws frequently.

If you have a company that is expected to grow and flourish, a C Corporation is right for you.

Advantages: shareholders have limited personal liability towards business debts; the ability to deduct the cost of benefits as a business expense; unlimited number of stockholders; issue different types of stock (preferred or common); ability to spread profits between shareholders and the corporation to lower tax rate; offer employee incentive stock programs.

Disadvantages: “double taxation” → in addition to paying corporate income taxes, any dividends distributed to shareholders are taxed again; expensive to start; harder to maintain than a sole proprietorship or partnership.

Should I Form A “S Corporation”?

An S Corporation differs from a C Corporation because the company is not a taxable entity.

Instead, the corporate income and losses are “passed-through” to the shareholders for federal tax purposes. Small businesses generally take advantage of this type of corporation because it offers legal advantages, like employee benefits of a corporate structure, in addition to tax advantages of a partnership.

The limitation of 100 shareholders prevents much growth, but this entity can be a viable option for small franchises or small-chain stores.

Advantages: pass-through taxation → partners or shareholders of the corporation would be taxed at an individual level, meaning no tax is due through the corporate entity; income splitting → S corps give ability for shareholders to split their income among family members as “gifts” of stock; protection of limited personal liability.

Disadvantages: limited to 100 shareholders; fewer tax-free benefits for employees; estate planning can be complicated for employees; employee stock ownership plans are not plausible; tax rates to the individual may be higher than a C Corporation’s employee.

JDKatz, P.C. is a full-service law firms specializing in real-estate law, tax law, elder law, business law and estate planning in the Washington, D.C. metro area. If you wish to learn more please visit www.jdkatz.com or contact us at 301-913-2948. You can read more about submitting a guest post to California Law Report here.