by Christopher Branson, Partner
Are you ready to start your business, or maybe you already have a business, and wondering which entity is right for your business? With most businesses, you will have a few alternatives, and each option will present advantages and disadvantages. Your challenge is to sort through the advantages and disadvantages of each to figure out which option is the best fit for your needs. Below is a brief description of the different business entities generally available. Familiarizing yourself with the choices will make it easier to discuss your options with your lawyer, accountant, and business partners.
Sole Proprietor: For some small and start-up businesses, the best choice is no entity at all. This is a “sole proprietor.” By definition, a sole proprietor is a business owned and operated by a single individual. If two or more individuals own and operate the business, then it is no longer a sole proprietorship. A sole proprietorship is typically used by individuals who provide services. Examples include a contractor, plumber, bookkeeper, yoga instructor, or freelance writer.
No formal steps are required to create a sole proprietorship, but a sole proprietor may elect to take certain steps including registering their trade name, getting an EIN (Employer ID Number), purchasing business insurance and/or establishing a business bank account. A sole proprietorship files taxes by attaching Schedule C to the sole proprietor’s individual 1040 tax return and it is taxed only on earnings (revenues in excess of expenses).
In theory, a business can operate as a sole proprietorship for the life of the proprietor. As a practical matter, either of two developments typically causes individuals to end their sole proprietorship and move to one of the entities discussed below: the addition of another owner; or, the addition of one or more employees. With the addition of another owner, a sole proprietorship is no longer an option. With the addition of employees, the advantages of limited liability (which shields owners from the actions of the business’s employees) usually is enough incentive to trigger a move to one of the limited liability entities discussed below.
LLC: A Limited Liability Company, or LLC, is one of the more popular forms of business entity these days. The two key characteristics of an LLC are: it provides “limited liability” to its owners; and, it typically is taxed as a “partnership” which enjoys “flow-through” tax treatment (unless there is only a single owner).
People who elect to use an LLC generally want to take advantage of some of the features of partnership taxation that are not available to S-Corps and C-Corps. A typical use of an LLC is to hold commercial estate. But more and more LLCs are being used for businesses such as software and technology companies, construction companies, manufacturing companies and professional practices. One of the challenges of using an LLC is that the partnership tax rules do not allow the owners of an LLC to be “employees,” and this typically means that the owners (“Members”) are forced to file quarterly estimated taxes.
An LLC is formed by filing organizational papers (and a fee) with the Secretary of State, and it is maintained by making annual filings with the Secretary of State (together with an annual fee). Businesses will sometimes start as an LLC and later convert to an S-Corp or C-Corp. The reverse is less common – the tax code often creates penalties for converting from a corporation to an LLC, so that happens less frequently. An LLC does not pay its own income taxes. Instead, the taxes “flow through” to the members/owners who each pay a portion of the taxes attributable to the LLC activities.
S-Corporation: A Small Business Corporation, or “S-Corporation,” is a special class of corporation recognized under the federal tax code. Two key characteristics of an S-Corporation are: it provides limited liability to the owners/shareholders; and, it enjoys flow-through tax treatment similar to, but not identical to, partnerships and LLCs. S-Corporations offer some small tax advantages in the employment realm including that owners pay slightly fewer self-employment taxes and owners can be W-2 employees who (in contrast to owners of LLCs) do not have to file quarterly estimated taxes.
S-corporations present some challenges for businesses who have or are looking for investors. By law, an S-Corp can have no more than 100 owners/shareholders and all shareholders must be individuals (i.e., no shareholder may be a corporation, LLC or other business entity). An S-Corporation is formed by first filing organizational papers and a fee with the Secretary of State, and then filing with the IRS an election to be taxed as an S-Corporation. An S-Corporation is maintained by holding annual meetings to elect directors and officers and by making annual filings with the Secretary of State along with an annual fee. An S-Corporation does not pay its own income taxes. Instead, the taxes “flow through” to the shareholders/owners who each pay their pro rata portion of the taxes attributable to the S-Corporation activities.
C-Corporation: A C-Corporation is a corporation that does not elect to be treated as an S-Corporation under the federal tax code. Two key characteristics of a C-Corporation are: it provides limited liability to the owners/shareholders; and, unlike an S-Corp, it is not a flow-through entity. Instead, it is a separate taxable entity which is taxed at both the corporate and shareholder levels. This tax treatment produces the “double taxation” which is often cited as a disadvantage of using a C-Corp.
Most publicly-traded companies are C-Corps, but C-Corps are becoming increasingly rare for privately-held businesses. C-Corps are sometimes used by service professionals (doctors, lawyers, accountants, architects, etc.) who avoid double taxation by paying out all cash reserves at year-end as “bonuses” so that the corporation realizes no taxable income at year-end. A C-Corporation is formed by filing organizational papers, and a fee, with the Secretary of State, and it is maintained by holding annual meetings to elect directors and officers and by making annual filings with the Secretary of State along with an annual fee.
Limited Partnership: A Limited Partnership is a form of entity similar in many respects to an LLC. Like an LLC, a Limited Partnership is taxed as a partnership and its limited partners enjoy limited liability. However, unlike an LLC, a Limited Partnership is operated by one or more General Partners, who by law, do not enjoy limited liability. This lack of limited liability for the General Partner(s) is one of the reasons that LLCs are now generally used where in the past a Limited Partnership may have been used. A common work around for this lack of limited liability for the General Partner was to form an S-Corp to serve as the General Partner, but this additional complexity is avoided by the use of an LLC.
New Limited Partnerships are rare these days and typically are limited to certain commercial real estate ventures where some investors prefer or require that a Limited Partnerships is used. A Limited Partnership is formed by filing organizational papers, and a fee, with the Secretary of State, and it is maintained by making annual filings with the Secretary of State along with an annual fee.