How To Select The Right Entity Structure

Selecting an entity structure is one of the most important decisions you’ll make for your company. The decision will impact how much you pay in taxes, the amount of paperwork you’re required to do, the personal legal liability you face, your share of the money, how big you can grow, and your ability to raise money. Choosing the right entity structure is critical to your success.

There are five main entity types for small businesses:

  • Sole proprietorship
  • Partnership
  • C corporation
  • S corporation
  • Limited liability company

The one you choose really depends on your short and long-term goals, your current and planned financial responsibilities, and your leadership style. When we work with clients in selecting the right structure, we start with some basic questions that give us a good sense of where they want to go and who they are as leaders. Examples of these questions are:

  • Will you be a solo leader with a few employees, or will you be taking on partners and collaborating with investors?
  • Do you want to be the sole decision-maker in your business, or would you rather collaborate with partners, board members, and investors?
  • How large do you want your business to grow?
  • How will you raise capital for your venture?
  • Will you be bringing in shareholders and issuing stock to them? If not, is that something you’re open to in the future?
  • Do you plan on running your business for the long haul?
  • In the near term will the business earnings be reinvested in the business or paid to the owners as dividends?

The answers to these questions will ultimately determine our recommendation.

Finding your match:

As you read through the entity types described below, see where’s there’s alignment between your plans and the described business structures. Note: This is not meant to be a “DIY tool” that substitutes for professional consultation with your CPA or attorney. It’s merely a guide to get you thinking about the different entity types and their benefits. Be sure to check out BGW’s chart on entity selection at the end of this article.

Sole proprietorship

If you want to run a smaller operation, with few employees, the sole prop route is probably best for you.

People who are successful in this role are comfortable making 100%  of the business decisions while also being accountable for any costs, debts, and legal responsibilities.

Sole proprietorships are the easiest and most affordable entity structure to set up. There’s no legal paperwork involved apart from local licenses and permits. Many small businesses start out as sole proprietorships—from mom and pop grocery stores, to art studios, to clothing boutiques — and later change once their income hits a certain amount.

On the downside, sole proprietors are taxed as an individual, which means letting go of a significantly larger percentage of profits than you’d pay as a corporation. You’re also 100% liable for the company’s finances. If your business hits hard times, you are personally responsible for any debts and you could lose your personal assets. It’s also much harder to get financing or raise capital as a sole proprietor—banks and investors see it as a riskier endeavor. If you have plans to grow quickly, this may not be the route for you.

Partnerships

A partnership lets two or more individuals share the workload and at least some of the risks and contributions. This type of organization relies on the collective resources, talents, and efforts of each partner. Examples of partnerships include law firms, bars, restaurants, creative agencies, and family businesses.

There are three types of partnerships to consider:

  1. If you and your collaborators plan on equally splitting all your contributions, profits and losses, then you’re looking at a general partnership.
  2. If one or two partners will be doing most of the heavy lifting, but one or more partners will have limited management say and limited liability, then you should be considering a limited partnership.
  3. Finally, if you want to test out a new business idea with some friends or family for a set period of time, you’ll be looking at a joint venture. If you decide to keep the train going after its expiration date, you must then commit to a general partnership. 

C corporations

C corporations are the most common form of corporation in the U.S. Unlike partnerships or sole proprietorships, legal liability for debts and claims is taken off individuals because the C corp is its own legal entity. As a result, the corporation itself can retain profits and incur losses, and it is taxed separately from its owners.

The main upside to a C corp is legal liability protection for owners—not needing to worry about your personal assets being affected by debts, losses, or lawsuits against the company. You also have the option to sell stock or bring on investors to propel growth.

The downside? Establishing a corporation is complex and expensive and arguably even more so after tax reform. Regulations on C corps at the state, federal, and local levels can result in hefty legal bills. Plus, ongoing maintenance fees are also much higher for C corporations. Finally, the corporation is taxed twice—once as a separate legal entity, and possibly secondly when distributions are made to the shareholders. That all doesn’t make it a wrong choice per se. It’s just something to factor in.

C corps are run by shareholders, a board of directors, and management—owners of the business usually hold one or more of these positions. It’s a great option for companies expecting high growth and expansion.

 

S corporation

A corporation is a C Corp until an election is made to become an S Corporation. When a business applies to become an S corp, it remains a separate legal entity, provides legal liability protection to its owners, and is supervised by a board of directors, shareholders, and management. 

What’s the benefit of becoming an S Corp? Major tax savings.

Unlike C corps, S corps opt for the business’ income, losses, deductions, and credits to be passed onto its shareholders who report these in their personal income tax returns. The company is not subject to federal income tax because it is not claiming any profit. That can be a major tax advantage if the corporation has achieved enough success to permit substantial distributions of earnings to its owners. For corporations that need to reinvest their earnings to finance internal growth will likely find remaining as a C corporation is preferable to the S corporation. 

On the flip side, there are certain limits on S corporations — some that can be pretty restrictive to growth. For example, S corps can only have a maximum of 100 shareholders (all of whom must be US citizens or residents) and only one class of stock. Again, this isn’t an automatic disqualifier but something you need to consider especially if rapid growth is in your future.

Also, know that the IRS keeps a close eye on the payrolls of S corps. Because of the significant tax advantages of an S corp, the IRS constantly monitors the wages of shareholders who are employees to make sure they are being compensated according to market and industry standards and paying their fair share of taxes. In other words, you can’t select an S corp to benefit yourself personally.

One final note: Only U.S. citizens can form an S corporation and only individuals may be shareholders. 

 

Limited liability company (LLC)

A limited liability company (LLC) can be best described as a hybrid business entity. Owners can choose how they are taxed— as a corporation or opting for the business profits, losses, credits, or deductions to be passed through to their individual tax returns, as a sole proprietorship, partnerships, or S corporations.

An LLC is relatively easy to set up, and it gives your venture some flexibility. Like a C or S corporation, an LLC gives owners and shareholders legal liability protection, so their personal assets are never at stake if the company is faced with any losses, debts, or lawsuits.

Unlike S or C corporations that require earnings and dividends to be paid in proportion to share ownership, an LLC has some flexibility to allocate both earnings and distributions in different ratios than capital ownership. This arrangement can be attractive if an owner is investing “sweat equity” while other owners provide the cash.

Unless you have a clear exit strategy in mind, make sure you choose partners or shareholders who are in it for the long run when starting an LLC. An LLC must be dissolved if there is only one partner remaining.

 

Changing your business entity

Businesses evolve just as people do, and it’s very possible that, at some point, you’ll need to change your business entity. We had a lot of questions about this after tax reform, in fact. 

You do have the freedom to change your entity type in the future, but it’s not a decision you should make yourself. Your CPA and attorney will be invaluable to you here regarding the tax and legal implications of your decision.

At a glance

Utilize the following chart for an “at a glance” view of the differences between entity types. You can also download it here: [download id=”5453″]

 

 

 

 

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