In choosing the business form for a new enterprise, one has a variety of business entities available. We will address small businesses and closely held companies rather than publicly held companies which are beyond the scope of this website. For small businesses there are a unique set of tax, legal and management considerations which should be addressed when choosing the type of business entity best suited for you.
The following types of entities are most often utilized in a new business venture. They are sole proprietorships, “C” corporations, “S” corporations, limited liability companies, general partnerships, and limited partnerships.
A proprietorship is the simplest form of business. When a single business owner decides to start a new business, and does not create a separate legal entity, then the business is classified as a proprietorship. A proprietorship is simple to form and there are very few federal or state requirements. A separate income tax form is not required for proprietorship. The proprietor simply includes his income on Schedule C of his annual Form 1040. Unless the proprietor is using a name other than his own name, he need not even register the business name with the Secretary of State in Columbus, Ohio.
More proprietorships are formed than any other type of business. From a legal standpoint, a proprietor is personally liable for all the debts and liabilities of his business. Personal liability can be a significant issue in any business which involves financial risks.
ENTITIES OTHER THAN PROPRIETORSHIPS
Tax considerations are extremely important in selecting a form of business entity. There is no entity level income taxation for sub-chapter “S” corporations, partnerships, or for limited liability companies. This means that while a business will file a tax return, there is generally no income tax imposed on income at the entity level – rather income taxation flows through to individual owners of the business.
Entity level taxation does exist, on the other hand, for “C” corporations. Because of “double taxation”, “C” corporations are rarely chosen by business owners in forming a new business.
In addition to income tax issues, self employment taxation/payroll tax considerations are significantly different for the different types of entities. While this is a complicated area, it can be generally stated that partnerships and limited liability companies have more favorable tax treatment for business owners than corporations. Tax issues regarding self employment taxation, payroll taxation and business sales and liquidations favor partnerships (and limited liability companies) over corporations. Simply stated, limited liability companies and partnerships are more tax efficient than either “S” or “C” corporations.
PERSONAL LIABILITY OF BUSINESS OWNERS
A sole proprietor is personally liable for all the debts and liabilities of the proprietorship. The same holds true for general partnerships – all partners are personally liable for all debts and liabilities of the partnership business.
Other entities offer business owners creditor protection for their personal assets. Asset protection is defined as protection of the business owner’s personal assets from business creditors. If an entity is “asset protected” only the assets of the business are subject to creditors’ rights and not the owner’s personal assets. There are special rules for professionals however. Professionals such as medical doctors and attorneys are personally liable for malpractice and for the malpractice of those professionals under their control regardless of the type of business entity chosen. For this reason, virtually all professionals maintain malpractice insurance even though they may have chosen to operate as a corporation, a limited liability company, or a partnership.
Asset protection can be achieved utilizing a “C” corporation, an “S” corporation, a limited liability company or a limited partnership (caveat: the limited partnership, however, must have at least one partner who is a general partner who must be personally liable for all debts and liabilities of the partnership business – only limited partners are not personally liable for partnership debts and liabilities).
Corporate shareholders, limited partners and members of limited liability companies (they are called members rather than shareholders) are generally at risk only for their capital contributions and any debts which they have personally guaranteed. There are a variety of additional situations in which personal liability issues can arise but which are not within the scope of this website – e.g. non-payment of payroll taxes, state sales taxes and those instances where owners have ignored the structure of the corporation or limited liability company in their business dealings.
Here is a summary of the characteristics for those entities offering asset protection for the owners:
“C” CORPORATIONS: The “C” corporation is a separate taxable entity apart from its shareholders. The “C” corporation pays tax on its taxable income and capital gains. Ordinary losses do not flow through to shareholders. Shareholders in “C” corporations are usually employees receiving compensation through a corporate payroll system. Additionally, distributions to shareholders of current income or previously accumulated profits are treated as taxable dividends to individual shareholders.
“S” CORPORATIONS: An “S” corporation is a pass-through entity for tax purposes. An “S” corporation does not normally pay income tax on profits or capital gains. Individual shareholders pay tax on their prorata share of the corporation’s income and capital gain based on their percentage ownership. “S” corporations, like “C” corporations, however, can have a tax at the entity level (corporate level) with a corporate liquidation and/or sale and for “built-in gains taxes”. These issues are beyond the scope of this website but can result in an adverse corporate tax consequences.
LIMITED LIABILITY COMPANIES: Limited liability companies are covered in more depth on another page in this website. Limited liability companies have become very popular in the past few years because of their tax efficiency as well as their flexibility in terms of ownership structure. For example, while “S” corporations require prorata ownership of profits, losses, capital gains, distributions and proceeds from liquidations and business sales – limited liability companies can be structured so as to establish that limited liability owners (members) share differently in profits, losses, capital gains and in distributions resulting from liquidations and sale of businesses. Therefore, limited liability companies are more flexible in terms of structuring a business to favor some owners over other owners. Additionally, as discussed above, limited liability companies are more tax efficient because of advantages over corporations in self employment taxes for owners, payroll taxes and a lack of a built-in gains tax as well as tax-free liquidations.