Choosing an Entity Type for Your Business: Answers to your Frequently Asked Questions (FAQs)
June 24, 2021|
what entity should i choose for my business?
The type of business entity you choose during incorporation will directly impact the amount of money your business owes in taxes, how much personal liability the owner or owners will have, and the types of administrative requirements that your business will have. When choosing a legal structure, business owners should consider their needs along with federal and local laws. The decision is not final, however. Many owners change their business structure as their business grows and its needs evolve.
The most common business entity types are sole proprietorships, partnerships, corporations, and limited liability companies (LLCs). Business owners should consult with a trusted attorney to ensure they select the best entity for their business.
Sole Proprietorship: A sole proprietorship is an unincorporated business entity, meaning there is no document filing with the state. With this type of business entity, there is no separation between the business itself and the owner, so the owner is entitled to all profits but is also personally liable for all debts and liabilities. Sole proprietorships do not offer protection for the owner’s personal assets, and so they are generally a better fit for smaller businesses. As your business grows and requires more liability protection, it may be wise to switch to another entity type.
Sole proprietorships are pass-through entities, which allows them to pay taxes on business profits and losses through their individual tax returns, instead of at a business level.
Partnership: A partnership is a business entity owned by two or more people. No documentation must be filed with the state to form a partnership. A partnership is by default a general partnership unless a written partnership agreement is created.
Under a general partnership, all partners have equal control over the business and the authority to make legal decisions. Partners also share liabilities and profits equally. The business is not separate from its owners for liability purposes, which means that each partner is totally liable for the business’s debts. If one partner does not have the money to cover their share of the debts, the other partner will be personally responsible for the remainder.
To form a limited partnership, a partnership agreement must be filed with the local secretary of state or appropriate state agency. A limited partnership has both general and limited partners. Limited partners do not have total responsibility for the partnership’s debts, which means they can only lose a maximum of their total investment in the business. In return, limited partners do not have the authority to operate the business. Every limited partnership must have at least one general partner, who is responsible for business management and is personally liable for all the debts of the business.
Like sole proprietorships, partnerships are also pass-through entities, where partners are taxed on business profits and losses on their individual tax returns. Partnerships are not taxed at the business level.
Corporation: Corporations are separate legal entities from their owners and provide significant liability protection. This means that corporations are liable for their actions and debts separately from their owners, and owners have limited liability. Other advantages of corporations are that owners can raise money for the business by selling shares, and these businesses receive corporate tax treatment.
Compared to other business entity types, it is relatively time-consuming and costly to form a corporation and keep up with legal administrative requirements, which include:
- Filing articles of incorporation with the incorporating state.
- Filing initial reports and statements within a few months after incorporation is complete (applicable in certain states only).
- Issuing stock to shareholders.
- Record all stock transfers.
- Allowing its shareholders to elect a board of directors.
- Conducting annual director and shareholder meetings.
- Publishing financial statements.
- Developing and maintaining bylaws.
- Filing an annual report along with a filing fee (applicable in most states).
If a corporation does not meet these administrative requirements, it could lose liability protection for its owner(s) in the event of a lawsuit, or it could lose “good standing” with its state of incorporation and owe late fees and interest payments.
Within the corporation designation, businesses can be incorporated as an S corporation or a C corporation. The biggest difference between these two entity types is how they are taxed. C corporations are subject to double taxation because profits are taxed at the corporate tax return, and shareholders also pay tax on their personal income or dividends earned through the business. S corporations do not pay tax at the business level. Instead, any profits or losses are passed through to the shareholders, who are taxed on their personal earnings.
S corporations face restrictions in the number of shareholders they can have, classes of stock they can offer, and more. C corporations do not face any of these restrictions, which makes this entity type a better choice for larger businesses.
Limited liability company (LLC): An LLC is a business entity that shields owners from personal liability and has some tax advantages. Like a corporation, LLC owners are not personally liable for a business’s debts or legal troubles. LLCs can elect to be taxed as pass-through entities, like partnerships and S corporations, where profits and losses are passed through to members’ tax returns and are taxed as personal income.
Forming an LLC is more straightforward than a corporation. LLCs require articles of organization to be filed with the state. Owners must also create an operating agreement for an LLC, which sets out roles and responsibilities of its members.
This business structure is popular with owner-managed businesses, as it offers flexibility without corporate formality. Companies that seek outside investment may prefer a corporation structure.
Does the immigration status of a director or shareholder matter when choosing an entity type?
Foreign nationals can own US businesses, even if they are not US citizens or green card holders.
However, being a company officer with active duties may not be permitted for certain foreign nationals, such as H-1B visa holders. Additionally, foreign nationals who are not US citizens or permanent residents cannot be shareholders of S corporations. For this reason, many foreign nationals choose to incorporate their business as either an LLC or a C corporation.
For help choosing an entity, incorporating your business, and maintaining ongoing compliance with legal requirements, contact your Chugh, LLP legal professional.
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