The StartUp Blog at PartnerUp

Tax differences, liability issues, government filings, shareholder regulations…Zzz Zzz…No wonder so many business owners feel perplexed when choosing a business entity, my job is to write about business and there are words in there that I don’t even understand. But for most business owners the confusion stems from comprehending the implications of each type of entity. Who’s liable in a limited partnership? How are S corporations taxed differently than C corporations? What legal formalities are in place for creating a sole proprietorship?

Well, let’s first take a look at the business-entity landscape. The two most commonly utilized business entities are Limited Liability Companies (LLC’s) and S corporations. These two types of entities provide protection from personal liability, which is one of the biggest advantages of each. Business owners aren’t too keen about the idea of putting their personal assets on the line. Some other common entities are sole proprietorships, general partnerships, limited partnerships and C corporations. Proprietorships and partnerships allow for a great deal of freedom but can be risky. C corporations also protect from personal liability, but they have more complicated tax issues.

If you are thoroughly confused, relax. I’ve highlighted the most important aspects of the six most common entities and given you the pros and cons of each.

Business Entity: Sole Proprietorship

What is it: A sole proprietorship is the default business form for an individual. It consists of one person with total control and liability. Sole proprietorships don’t need to be registered with the state and are the simplest of all business structures. As a sole proprietor your business is automatically your name (e.g. Robert Jones), but you can also choose to operate under a trade name like “Bob’s Hardware,” so long as you make a fictitious name registration with the secretary of state’s office.

The Pros: The convenient thing about a sole proprietorship is that government regulation is kept to a minimum. There are no legal formalities to creating or dissolving the business, basically your business begins and ends when you start and stop doing business. Of course you do still have to get a business license and permit, so don’t think that you are completely regulation-free. Sole proprietors are also exempt from paying a double tax, which means that they pay income taxes on the profits made as an individual, but are not also forced to pay that same tax as a corporation. 

The Cons: Some business owners shy away from sole proprietorships because of liability issues. Under a sole proprietorship, the owner and the business are legally inseparable, so all debts and liability issues lay on the shoulders of the owner. It is a risky situation and the principle reason that many business owners opt to go incorporated instead. Sole proprietors are also not allowed to have outside equity investors.

Business Entity: General Partnership

What is it: A general partnership is an arrangement in which two or more individuals or entities (can be an individual and a corporation) conduct business “jointly and severally.” “Jointly and severally” means that each partner can be liable for the entire partnership debt. The basic difference between a general partnership and a sole proprietorship is the number of owners. General partnerships do not formally organize their business into a separate business entity and may or may not have a written partnership agreement that spells out the rights and duties of the partners.

The Pros: In a general partnership partners do not have to pay wages to the other partners, and they do not have to pay payroll taxes unless they’ve hired employees beneath them. This results in less paperwork and less expense. Like sole proprietorships, general partnerships have little government regulations during the formation and duration of the business. General partnerships are also not forced to create a partnership agreement, but creating one could potentially help you avoid major headaches in the future.

The Cons: Because of the risk involved with liability issues, general partnerships call for a great deal of trust in your partner. All partners are individually liable for all wrongs committed by the partnership or by specific partners. If creditors or the courts come down against the partnership, they may go after each partner’s personal assets (house, vehicle, etc.) in addition to the partnership’s assets, even if only one partner is at fault.

Business Entity: Limited Partnership

What is it: A limited partnership is similar to a general partnership with one major difference. A limited partnership consists of one or more general partners and a number of limited partners. The general partners are the main players, while the limited partners are nothing more than investors. A limited partnership must also formally file with the state.

The Pros: Limited partnerships enjoy many of the same advantages that general partnerships do. They do not have to pay wages or payroll taxes and have less paperwork and expense. Limited partners are also only liable to the extent of their investment, so they don’t have to fear personal liability.

The Cons: General partners in a limited partnership, however, are still fully liable for all wrongs committed by the partnership or by specific partners. Unlimited liability for general partners once again creates risk.

Business Entity: Limited Liability Company (LLC)

What is it: A Limited Liability Company (LLC) is a business structure that combines aspects from corporation structures and partnership structures, but is neither a corporation nor a partnership. LLCs can have an unlimited number of members (in an LLC owners are called members not partners), and provides personal liability protection for all members.  An LLC is formed through the filing of articles of organization with the secretary of state’s office.

The Pros: The biggest draw for LLCs is the protection from personal liability. Because an LLC is seen as a separate entity in the eyes of the state, creditors cannot go after the personal assets of members.  They can, however, still go after the assets of the business. LLCs also have the choice of filing tax returns as either a partnership or a corporation, though most choose to file as a partnership.

The Cons: While corporations can live forever, LLCs die when a member dies or undergoes bankruptcy. There is also a great deal more paperwork and government regulation with an LLC versus a partnership or a proprietorship.

Business Entity: S Corporation

What is it: Generally, S corporations don’t pay income taxes. The corporation’s income is instead divided among its shareholders, who then report the income on their individual income tax returns. There are certain requirements to becoming an S corporation. Your business cannot have more than 100 shareholders, shareholders must be U.S. citizens, your business must have only one class of stock and profits must be divided proportionally among shareholders. S corporations are formed through the filing of articles of incorporation with the state. There is no distinction between S and C corporations at the initial filing stage. But to become an S corporation you must file Form 2553 with the IRS by a certain date. If you fail to meet the deadline, your business automatically becomes a C corporation.

The Pros: S corporations are taxed on income similarly to partnerships, meaning that there is no entity level taxation. This prevents them from having to pay a double tax, which is a tax at both the entity level and owner level. S corporations can pass-through net business losses to their shareholders, which will reduce shareholder’s taxes. Shareholders are also not held personally liable for the debts of the S corporation. 

The Cons: The disadvantage of having S corporations is that they must pay reasonable salaries to shareholder-employees, which doesn’t sound like a bad idea. But salary and wages paid to shareholder-employees is the number one audit risk for S corporations.  Also, when you have appreciating assets inside of your S corporation, you can have a difficult time retrieving them without heavy taxation.

Business Entity: C Corporation

What is it: C corporations are considered separate entities from those who own or operate them. They have their own names and identities, and all assets and liabilities belong to the corporation.  They have bylaws, corporate minutes and have articles of incorporation filed with the state. Structurally they are the same as S corporations, the difference, however, lies in taxation and corporate ownership.

The Pros: Unlike S corporations, C corporations can have an unlimited number of shareholders, and shareholders can be non-U.S. citizens. C corporations can also have multiple classes of stock.

The Cons: C corporations could potentially pay double taxes at both entity level and owner level. They always pay taxes at the entity level, but if profits are distributed to shareholders in the form of dividends, shareholders must report them as personal income and pay taxes on them at the individual level as well.

Be careful not to make any hasty decisions when it comes to choosing your business entity. You’ll want to make sure that you choose one that is not only a good fit for you now, but is also likely to be a good fit for the future of your business. With so much of your time and money riding on the success of your small business, it’s important to take the time to carefully consider each of these options.