The Importance of Choosing the Right Business Entity

This is a crucial decision because it has far-reaching legal and tax consequences. So you must have a vision for your company for the long term as you decide which entity to use.

Some advisors will suggest that your business be a sole proprietorship, which is fine if you’re the only owner and plan to report your taxes on your own 1040. But nothing could be less helpful than a sole proprietorship. Any of the available entity types will give much better liability protection than a sole proprietorship.

Here are the key factors to consider when choosing your company’s form:

Liability protection. Each of the available entity types offers a particular degree of protection for their personal assets from their business activities. Sole proprietorships and the general partners of partnerships have personal liability for the activities of their entities.

Taxation. A corporation is a tax-paying entity. A corporation is either a C-Corporation, which is taxed as a completely separate entity from the owners, or an S-Corporation, which is a pass-through entity taxed like a partnership.

The major disadvantage of a C-Corp, with respect to tax considerations, is that both profits and distributions to shareholders are taxed—known as “double taxation”. An S-Corp election allows corporations to be taxed as pass-through entities, on their owners’ tax returns, like a partnership. Therefore, an S-Corp eliminates double taxation.

LLCs can be taxed in four different ways, so please consult with an attorney and a CPA before deciding how your LLC will be taxed.

Income Tax for Employee-Owners. Consider how you will be receiving the benefit of your work. Will you be taking distributions of profit? Will you be taking a salary? Distributions of profit aren’t subject to payroll taxes, but they are subject to regular income tax. Salaried employees pay half of their own payroll taxes, allowing the company to pay the other half. You must know how you are going to be compensated under each structure to reduce your income and payroll taxes as much as legally possible.

Future Sale. Another key issue is the future sale of the company in light of the business’ potential growth. If the company is a holding company for growth investments and real estate, a partnership structure may be more advantageous at later sale to avoid a tax on possible “phantom gain” or gain that you have to pay tax on, but for which you never really receive the income.

Shares and Voting Rights. Each entity has different mechanisms for ownership and control/management. Don’t overlook your management vision when deciding which form to use. Who will be active in the business? Who will be passive investors? Who will have a vote in the affairs of the business? Do you want to “go public”? Do you want to have an employee stock ownership plan in the future? Are you going to want to give your children some part of your business but don’t want them to have any role in management until they’re ready? Answering these questions will help determine which form is best for the present and the future.

Whether you choose a corporation, a partnership, a limited liability company, or some other entity, take the time to consider each of these factors fully. Once in place, changing entities can be difficult.