How To Choose the Best Type of Business Entity
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Like all aspiring business owners, Nic Faitos had to decide whether to classify his company as a sole proprietorship, partnership, corporation or other type of legal entity.
Faitos registered his small floral business in 1994 as a Subchapter S corporation. In retrospect, Faitos, president of Starbright Floral Design in New York City, said deciding on the right kind of business formation wasn’t difficult at all.
But not all decision-making processes are alike, says Mark Jaffe, president and chief executive of the Greater New York Chamber of Commerce. Some are quick. Others take more time.
You should assess the types based on your available time, commitment and resources, and consider long-term goals for your business, he said.
Although you can change your ownership type at any time, you should decide carefully, experts agree, because the form of business you choose will affect the way you file paperwork, face personal liability, pay taxes and, if necessary, file for bankruptcy protection.
“It’s such a personal choice when you’re picking a business,” said Lisa Rigler, executive director of the Gilbert (Ariz.) Small Business Alliance. Below, experts weigh in on each type, and Business.gov provides the advantages and disadvantages of, and tax requirements, for each ownership method.
One person owns and manages a sole proprietorship, which means you are responsible for all debts incurred.
“Sole proprietorships work really well for the new entrepreneurs because they’re easy to start,” Jaffe said. “And these unincorporated businesses can always change into an incorporated business later on.”
Advantages: Easy. Inexpensive. Complete control of operating decisions. Generated income goes to owner to keep or reinvest. Easy to dissolve if the business does not go as planned.
Disadvantages: Unlimited liability. Funding difficulties. Less attractive to prospective employees.
Tax requirements: You report your business income and expenses on a Form 1040 Schedule C .
Bradford Randolph, a New York City attorney who helps people with taxation law and other business law matters, said the Internal Revenue Service recently has put more focus onsole proprietors because they tend to underreport their income.
The IRS estimates self-employed filers underreported $68 billion in 2001 on their tax returns.
“There’s nothing wrong with a Schedule C,” Randolph said. “It’s just a very significant action of the IRS to make sure those forms are prepared properly now.”
Shareholders own a corporation, but this independent entity is liable for its debts and actions.
A corporation has complex legal and tax requirements, Randolph said.
Advantages: Limited liability. Shareholders’ personal assets are protected. Ability to generate capital through the sale of stock. Corporate tax treatment. Attractive to potential employees because of competitive benefits and potential for partial ownership through stock options.
Disadvantages: Time-consuming. Costly. Double taxing in some cases. Additional paperwork and record-keeping because of regulations.
Tax requirements: You pay federal, state and sometimes local taxes and report revenue to the IRS using a Form 1120 or 1120-A tax return.
If you own a corporation, you can elect to receive Subchapter S recognition from the IRS to become an S corporation.
With an S corporation, you have some of the protections that some big corporations have and you can raise capital without going public, said Dow Rigler, a board member of the Gilbert Small Business Alliance.
The nice thing about the S corporation "is that it doesn’t pay separate taxes like a regular corporation, but you still can protect your personal assets,” he added.
Advantages: Tax savings. Business-expense tax credits. Independent life separate from shareholders.
Disadvantages: Stricter operational processes. Shareholder compensation requirements.
Tax requirements: You would file a Form 2553 to elect “S” status. States tax S corporations differently. New York, for example, taxes profits and the shareholder's proportional shares of the profits.
Two or more people own this type of incorporated entity. In partnerships, each owner shares responsibilities, profits and losses.
“It’s important to discuss a wide variety of issues upfront and develop a legal partnership agreement,” according to Business.gov. “This agreement should document how future business decisions will be made, including how the partners will divide profits, resolve disputes, change ownership (bring in new partners or buy out current partners), even how to dissolve the partnership.
“Although partnership agreements are not legally required, they are strongly recommended and it is considered extremely risky to operate without one.”
Advantages: Easy. Inexpensive. Shared financial commitment. Complementary skills of each partner. Partnership incentives for potential employees.
Disadvantages: Joint and individual liability. Disagreements among partners. Shared profits.
Tax requirements: You would file an annual information return to report the income, deductions, gains and losses. The business does not pay income tax and “passes through” profits or losses to its partners. Partners include that amount on personal tax returns.
Limited liability corporations
This entity combines aspects of a corporation and a partnership. Owners of an LLC are called members.
“The sexy thing to do is an LLC because that takes the liability off the personal owners,” Gilbert's Rigler said.
Advantages: Limited liability. Less record-keeping and paperwork. Fewer restrictions on profit-sharing.
Disadvantages: Limited life. Self-employment taxes.
Tax requirements: You would file a Form 8832. You also would file as a corporation, partnership or sole proprietorship and fill out corresponding tax forms.
A group of people owns this limited liability entity, which can be for-profit or not-for-profit.
“Starting up requires finding and forming a group of potential members who agree on a common need and a strategy on how to meet that need,” according to Business.gov. “An organizing committee will then conduct exploratory meetings, surveys, and cost and feasibility analyses before every member agrees with the business plan.”
Advantages: Less taxation. Funding opportunities. Reduced costs and improved products and services. Perpetual existence. Democratic organization.
Disadvantages: Obtaining capital through investors. Possible shortage of membership and participation.
Tax requirements: Cooperatives do not pay federal income taxes as a business entity. Members, not the cooperative, pay federal taxes when they file their personal income tax. You would follow the Subchapter T Cooperatives tax code.