Starting a small business? No matter what size business you plan to have or what your plans are for its future, you need to decide what business entity to use. Entity selection may seem simple, but it can affect your finances, your risk, your future growth, and your taxes. Use this short guide to help you understand your choices.
Sole Proprietorship
The simplest business type is the sole proprietorship. A sole proprietorship is not actually a separate entity from the person who creates it. While you may operate under a business name, the business's assets are all owned by you individually. Similarly, the business’s liabilities are your personal responsibility. All of its income will be taxed to you personally and reported on your personal income tax return.
There are two major downsides to sole proprietorships. First, they afford you no liability protection. If someone sues your business, they will be suing you personally and all your assets will be available to the party suing you. Second, you cannot pass on the business to anyone else in its current form. To sell the business, you must sell its assets and the buyer must set up a new business.
General Partnership
If a business has two or more owners, a sole proprietorship is not a viable option. Instead, you have the option to form a partnership. There are two types of partnerships: general and limited. General partnerships are similar to sole proprietorships in that the partners are personally liable for the partnership’s debts. This means the partners can be sued personally to pay the partnership’s debts and each partner’s assets are exposed to potential liability.
Unlike a sole proprietorship, a partnership files its own income tax return, but each partner pays the taxes on a portion of the partnership’s income. However, it does differ from a sole proprietorship because it can survive if one or more partners leave the business (as long as there are at least two partners left).
General partnerships are relatively easy to form. Normally the partners sign a partnership agreement that describes how the partnership will operate and how much of the partnership each partner will own. If the partners neglect to write their own agreement, the terms of the Pennsylvania’s Uniform Partnership Act will define the important terms of the partners’ business relationship.
Partnership agreements offer a great deal of flexibility about how the business will run, who will perform what functions, how disputes will be resolved, how partners may come or go, and what triggers dissolution of the business.
Limited Partnership
Limited partnerships are very similar to general partnerships, but they have two different types of partners: general partners and limited partners. A limited partnership must have at least one general partner and at least one limited partner. General partners are personally liable for all the partnership’s debts and obligations. Limited partners are not. Limited partners are only liable to the extent of their investment in the partnership. They are called limited partners because their liability is limited. They also have no voice in how the partnership operates. Instead, all day to day decisions for the partnership are made solely by the general partner(s).
General partnerships and limited partnerships are taxed the same way. They really only differ in terms of the role and liability exposure of the general and limited partners. However, to form a limited partnership, you must file documentation with the Pennsylvania Department of State. Simply drawing up a partnership agreement will not be enough.
C Corporation
If you elect to form a corporation, you are creating a separate business entity to operate your business. Although there is only one type of business corporation, they can be taxed under two different subchapters of the Internal Revenue Code. One subchapter is called Subchapter C and corporations taxed under Subchapter C are called C corporations. The other subchapter is called Subchapter S. S corporations are described more fully below.
A C corporation is completely distinct from its owners – called shareholders. This means that its assets belong to the corporation and its legal obligations are paid exclusively using its assets and income. The shareholders are not personally liable for the corporation’s debts. Their liability is limited to their investment in the corporation.
C corporations file their own income tax returns and they pay taxes on the income they receive. If they have excess profits, they can distribute profits to shareholders in the form of dividends. In turn, the shareholders pay income tax on the dividends they receive from the C corporation.
Ownership in any corporation is represented by shares of stock. Thus, the shareholders are the owners of the business. They in turn vote to elect a board of directors to make major policy decisions for the corporation. The board of directors in turn appoints officers to handle day to day business operations. Thus, ownership and operational control are distinct in a corporation. The shareholders may also be officers and directors, but that does not have to be the case.
C corporations can have an unlimited number of shareholders and their shareholders can be people, trusts, other corporations or other kinds of business entities. They can have many different classes of stock. Stock is freely transferable to others unless the shareholders decide to put limits on their ability to transfer their shares. This allows for easy growth and expansion because you can add new owners or sell your interest in the corporation very easily. Moreover, the corporation survives the departure or death of any shareholder.
C corporations must follow formalities in how they operate. They must file formation documents with the Pennsylvania Department of State. They must adopt bylaws. They must elect officers and directors annually, have shareholder and director meetings, issue stock certificates, etc. If they do not, their owners’ risk being classified as general partners. That means they can become personally liable for all the corporation’s debts and obligations.
S Corporation
An S corporation is a business corporation taxed under Subchapter S of the Internal Revenue Code. Usually, it does not pay income taxes on its income. Instead, its shareholders pay the tax on the business income. In turn, an S corporation can distribute cash to its shareholders without triggering dividend income for the shareholders. In essence, the S corporation eliminates one of the two layers of income tax that C corporations and their shareholders pay.
S corporations offer the same liability protections and must follow all the same corporate formalities of C corporations. However, they can only have one class of stock and are limited to no more than 100 shareholders. Generally, those shareholders must be people or specific kinds of trusts.
Therefore, in some respects an S corporation is taxed similarly to a partnership but operates like a C corporation. It is this hybrid status that makes S corporations a popular business entity for many small business owners.
However, S corporations are subject to many rules that can limit their growth. As your company grows, it may outgrow the limits of an S corporation and need to adjust to a more traditional structure.
Nonprofit Corporations
Do not forget that you can create a business as a nonprofit corporation. The primary difference between nonprofit corporations and other businesses is that what is left over after expenses are paid is not distributed to owners. Instead, profits are kept within the company and used to further its business purpose.
Nonprofit corporations may be exempt from income taxes. In that case, they are subject to careful IRS oversight and reporting requirements to keep their special tax status. For example, they must specifically operate for an approved purpose and may not be allowed to engage in certain activities.
Nonprofit corporations offer the same liability protections as business corporations. They must follow the same formalities as business corporations, i.e. they must have a board of directors and they must elect officers. Some will have members, but others will not.
Simply forming a nonprofit corporation does not guarantee tax exempt status. First you form the corporation with the Pennsylvania Department of State, then you apply for tax exempt status from the IRS. It is important not to overlook the second part of this process.
Limited Liability Companies
A limited liability company (LLC) is a type of business entity that shares some similarities with corporations and others with partnerships and sole proprietorships. Like corporations and limited partnerships, they are formed by filing documents with the Pennsylvania Department of State. Like partnerships they have a governing document (called an “operating agreement”) that identifies the owners and describes how the company will be operated.
LLCs offer the same liability protections as corporations, but they are not required to follow all the operating formalities of corporations. If they have only one owner, they can be taxed like a sole proprietorship, a C corporation or an S corporation. You get to decide. If they have more than one owner, they can be taxed as a partnership, a C corporation or an S corporation. Again, the choice is yours.
They can issue ownership certificates (called “units”) that are very similar to shares of stock in a corporation, but they don’t have to. They can be run by a manager (akin to a general partner or the president of a corporation) or by the owners (called “members”).
In short, LLCs are very flexible and thus a common choice for new businesses. However, great care must be taken when choosing among all the options available for structuring your LLC.
Know Where to Start
The choice of business entity clearly has far-reaching impacts on business purpose, growth, reporting, taxes and risk. Choosing the right business structure is critical to your long-term success. Your best ally in this decision is an experienced business attorney. They are familiar with the pros and cons of each entity type and can help guide you to the right call. They can also help you prepare the documents needed to form the business entity you want.
Pennsylvania entrepreneurs have relied on The Law Firm of Leisawitz Heller to help them choose the best entity to achieve their business goals for over 50 years. Learn more about all your options by making an appointment with us today. We look forward to helping you start your business on the right foot to future success.