How to Choose the Right Business Entity for Your Venture
Choosing the right business entity is an important decision for any entrepreneur. It can influence everything from liability protection to taxation and growth potential. Many business owners start their journey informally, often as sole proprietors or default partnerships, but, as the business grows, seeking expert advice to establish a formal entity becomes essential to protect assets and optimize operations. Here, we break down some key considerations and entity types to help you make an informed choice.
The Initial Considerations
Before forming a business entity or restructuring your entity structure, it is important to address the optimal structure from multiple lenses because what makes most sense for business operations may not be very tax advantageous or vice versa. While these decisions can be revisited later, careful planning at the outset can save significant expenses, taxes, and complications down the line.
The Tax Cuts and Jobs Act (TCJA) introduced significant changes to how businesses are taxed, emphasizing the need to periodically revisit entity choices. Even if a formal analysis was done in the past, revisiting entity selection can uncover opportunities for tax savings under new regulations.
Overview of Entity Types
Sole Proprietorships
A sole proprietorship is not technically a formal entity. It is simply what is formed when an individual begins operating a business without filing entity-formation documents with the state. While simple and cost-effective, sole proprietors bear unlimited liability for the business’s debts and obligations. Sole proprietors can operate under their own name or a “doing business as” (DBA) name, which may require state registration.
Partnerships
A partnership is created when two or more individuals operate a business together. While general partnerships often require no formal filing, other forms, such as limited partnerships (LPs) and limited liability partnerships (LLPs), require state filings. Key distinctions include:
General Partnerships: All partners share management duties and bear unlimited liability.
Limited Partnerships: Require at least one general partner with unlimited liability, while limited partners have liability limited to their investment.
Limited Liability Partnerships: Offer all partners limited liability protection, with no general partner required.
The terms of the partnership are typically outlined in a partnership agreement, though state law provides default rules if no agreement exists.
Corporations
A corporation is formed by filing articles of incorporation with the state. It offers limited liability protection to shareholders and officers, meaning losses are generally limited to their investment. Corporations are managed by a board of directors and governed by bylaws and shareholder agreements. State laws set default rules if these documents are absent or silent on specific issues.
C-Corporations: State-law corporations will default to being taxed as a C-corporation for federal tax purposes, but LLCs can elect to be taxed as a C-corporation by filing with the IRS. C-corporations are subject to “double taxation,” meaning the corporation will pay income taxes on its income, and shareholders will also need to pay income taxes on dividends they receive from the C-corporation. The corporate tax rate may be lower than the individual tax rate, and whether this entity structure makes sense depends on a lot of factors.
S-Corporations: An S-Corporation is a tax classification that allows state-law corporations or LLCs to avoid double taxation by passing income through to shareholders, who are taxed individually. To qualify, the entity must meet several requirements: no more than 100 shareholders, all shareholders must be U.S. citizens or residents, only individuals and certain trusts or estates can be shareholders, there must be only one class of stock, profits and losses must be allocated proportionally, and the entity cannot be an ineligible corporation. If these rules are violated, the S election is revoked, and the entity reverts to C-Corporation taxation. Unlike partnerships, S-Corporations must allocate tax attributes proportionally but offer flexibility in treating payments as wages or distributions, reducing self-employment tax obligations.
Limited Liability Companies (LLCs)
LLCs offer the liability protection of corporations while maintaining the flexibility of partnerships.. Owners, called members, can choose to manage the LLC themselves or appoint managers. LLCs are governed by operating agreements and offer flexibility in taxation, as they can elect to be taxed as sole proprietorships, partnerships, or corporations. However, state formation and annual fees are often higher than other entities.
Series LLCs
Some states, including Utah and Nevada allow for an entity structure known as a Series LLC. It allows the owner to have one tax return across a series of Series LLCs that each have their own liability protection as if they were separate LLCs. This is especially helpful for real estate investors that want to keep their rental properties separate, but don’t want all the red tape of a separate legal entity for each of their properties, for example.
Tax Classifications
The tax classification of your entity significantly impacts your financial outcomes. Key options include:
Disregarded Entity
Applies to sole proprietorships and single-member LLCs by default.
Income and expenses are reported on the owner’s personal tax return (Schedule C).
Partnership Taxation
Applies to multi-member LLCs and partnerships.
Tax attributes flow through to the partners’ personal tax returns via Schedule K-1.
Allows flexible allocation of income, losses, and deductions.
C-Corporation Taxation
Corporations are taxed separately from their shareholders.
Subject to double taxation but benefit from lower corporate tax rates.
S-Corporation Taxation
Applies to corporations and LLCs
Offers pass-through taxation like partnerships but with stricter eligibility requirements.
Avoids self-employment taxes on certain distributions but mandates reasonable shareholder wages.
Six Key Factors to Consider
Ultimately how to determine the optimal entity depends on the extent to which the attributes of the entity form align most closely with the owners’ desires. There are six main characteristics to examine in determining optimal fit with the owners’ plans discussed below:
Continuity of Existence
Corporations are formed by filing the necessary paperwork with the state and typically have perpetual existence unless dissolved. Dissolution requires approval from both the board of directors and shareholders, making corporations particularly suitable for publicly held businesses. In contrast, partnerships often lack formalized agreements or state filings, making their existence less concrete. Partnerships allow for easy exit by dissatisfied minority partners, who can potentially force the liquidation of the business.Centralized Management
Corporations operate with centralized management, governed by formal rules and led by a board of directors. This structure ensures defined roles and processes for decision-making. Conversely, partnerships are managed by the general partners and often operate informally.
Corporations determine profit distributions through the board of directors or management, prioritizing payments to preferred shareholders before others, with distributions based on ownership percentages. Partnerships, however, can distribute profits according to the partnership agreement, offering more flexibility in how earnings are shared.Limited Liability
Liability protection is a major distinction between corporations, partnerships, and sole proprietorships. Corporations and LLCs offer limited liability, protecting shareholders’ and members’ personal assets, with losses limited to their investment. Partnerships and sole proprietorships, on the other hand, offer no such protection—partners are personally liable for the debts and obligations of the business, even if they were uninvolved in creating those liabilities.
However, variations like limited liability partnerships (LLPs) and LLCs provide liability protection while retaining some characteristics of partnerships, though their availability and rules depend on state law.Transferability of Ownership Interests
Corporations allow the board or management to issue new shares without shareholder approval, and shares can be easily transferred. This makes raising capital simpler and offers various exit strategies, such as employee stock ownership plans, gifting shares, or gradual sales. Partnerships, while generally allowing partners to transfer their interest as personal property, require unanimous approval for admitting new partners, restricting flexibility in ownership transfer.Tax Implications
Corporations are taxed in a way that can lead to double taxation. To minimize this, some owners pay out all profits as wages to shareholders, though the IRS may reclassify unreasonable wages as dividends. Partnerships, LLPs, and LLCs taxed as partnerships avoid double taxation by using pass-through taxation, where income flows through to partners’ personal tax returns. However, partners who actively participate in the business must pay self-employment taxes on net income.
An S-Corporation provides an alternative, combining pass-through taxation with a corporate structure, avoiding double taxation while offering limited liability. Choosing the right entity requires weighing both tax and operational factors to meet business goals.Capital
Capital planning is crucial when choosing a business entity. Business owners may fund their ventures through personal investments, partners, loans, or external sources like venture capital, crowdfunding, or family contributions. Corporations can access additional advantages, such as issuing shares and benefiting from tax-free distributions or special tax advantages, like the qualified small business stock exclusion. Partnerships offer flexibility in special allocations and include third-party debt in the capital structure.
Making the Final Decision
Choosing the optimal entity requires aligning the entity’s attributes with the owners’ goals. By working with a trusted expert and systematically evaluating the six factors, you can identify the entity type that best supports your business’s success. In some cases, a combination of entities may offer the greatest advantages through income shifting and intercompany activities.
Final Thoughts
Entity selection is not a one-size-fits-all decision. It’s a strategic process that takes into account legal protections, tax consequences, and long-term business goals. Revisiting your entity choice periodically ensures it remains aligned with your evolving business needs and regulatory changes, ultimately setting your venture up for lasting success.
