There are many considerations an entrepreneur needs to consider before starting their business. The idea, funding, and an opportunity cost analysis may all rest heavily on your shoulders in the early stages. Sadly, the choice of entity type is too often overlooked. While it can be changed later, it is better to avoid the added costs and headaches of such a major change. Your entity choice should instead be informed and deliberate. This article will first explain the two main considerations when making the decision: taxation and liability. After, we will discuss most common entity types and where they stand within this framework.  Hopefully after reading this, you can make a decision that is right for you.

Taxation

Under Double taxation, the entity AND the individuals (including owners, shareholders, or investors) must pay taxes on profits. For example, a C corporation makes a profit and pays dividends to its shareholders. The C Corporation must pay income tax on the profit, and the shareholders must each pay tax on their dividends.

On the other hand, pass-through entities are NOT subject to this double taxation. Instead, only the individuals are responsible for the tax on profits. Pass-through entities should be preferred for anyone who wants to maximize their reward for taking the risk of starting a business.

Liability

Liability is the state of being responsible for something. Personal liability is the type of liability that means if your entity is sued or goes bankrupt, YOU are personally responsible for paying if the entity alone cannot cover the amount.

Limited liability is safer and therefore the preferred status. You cannot prevent the entity from incurring liabilities, but at least your house, cars, and other assets remain safe behind this liability shield, also called the corporate veil. Despite the misleading name, this concept applies to any entity that provides limited liability to its owners.

It is important to note that the corporate veil is NOT absolute. If one can prove that you treat the entity and yourself as one. Actions that may cause this include but are not limited to comingling business and personal assets, undercapitalization, and ignoring necessary formalities. It is important to learn what would piece the veil for your chosen entity for your specific state.

The Forms

Sole proprietorships are only for single owners and will be your default structure if none is chosen. It is easy and benefits from pass-through taxation. This comes at the cost of unlimited liability. For this reason alone, it is recommended you avoid this type if possible.

The general partnership requires two or more owners and will be the default structure in that situation. They also benefit from pass-through taxation and struggle from unlimited liability. This includes the action of your partner. The limited partnerships (LP) include general partners with unlimited liability and full management power, and also limited partners with limited liability but limited decision power. Lastly, there is limited liability partnerships (LLP). Individual partners in the LLP are fully responsible for their own actions, but not their partners.

The LP and LLP are therefore preferred over a general partnership as they retain the pass-through taxation while limiting the liability to some extent or for certain members. If your work is suited for a partnership style form such as professionals, these two would be preferred over the general partnership, but there are still better options so each owner can receive full limited liability.

Corporations have several types of forms but are all recognized mainly for granting full limited liability to the owners, or as they are called here, shareholders. C corporations are the style most would recognize as it is common for the large entities we interact with on a daily basis. C corporation’s main benefit other than liability protection is the ease of funding through the sale of stock. This form also scales strongly compared to others forms. Other than the burden of greater formalities, C corporations do suffer from double taxation. This major limitation is a strong enough reason to look for other options.

Non-profit corporations are very unique and recommended to ONLY those who meet the specific criteria. This must be formed in support of specific causes and is subject to heightened scrutiny by the IRS. With that said, for those who wish to work for a purpose other than profit, there is no better way as liability is limited, taxation isn’t an issue, and funding is encouraged as a potential tax write off for doners.

S corporations benefit from pass through entity status, but are subject to many requirements such as limitations on how many and who may be a shareholder. This means the S corporation does not benefit the same way as the C corporation does from ease of funding. The S corporation is also subject to a much stricter degree of paperwork and general scrutiny from agencies like the IRS. Despite this, if this form is available in your state, it is a strong choice as it still avoids double taxation while keeping limited liability.

The limited liability corporation (LLC) is generally the best entity form for a small business and the one the Elon Law Small Business Clinic usually recommends to our clients. This is because it is easy to form, is a pass-through entity, and gives the owners limited liability. An LLC by default is member managed, which means the owners run the daily operations. For small businesses, this may be preferred as this is a much easier and a lower cost version that will feel closer to a sole proprietorship or general partnership. This does not scale as well since all members are equal in decision making. For owners who wish to operate closer to a c corporation, they may elect to form a manager-managed LLC. Here, members are closer to investors and must hire managers to make the daily decisions. This could ultimately be best, but the added overhead may be too much to bear when starting off.

Your Next Step

If you are interested in shifting your idea into reality don’t hesitate to contact the Elon Law Small Business Clinic. We are available to assist you in the formation of an entity, among many other legal services typical for a new small business. We hope to see you soon.

For help with your entity choice concerns, please contact the clinic at businessclinic@elon.edu.

 

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