Common Sense for Picking a Business Entity


KEEP IT SIMPLE:

COMMON SENSE FOR PICKING A BUSINESS ENTITY

Picking the best entity for your business should be fairly simple. Unfortunately, some business gurus offer advice on this subject that’s more confusing than helpful.

Maybe you’ve seen one of those fancy charts that promises to sort it all out for you. It lists seven or eight types of business entities - including rare birds like limited partnerships, for example. Then, for each type of entity, it gives you 20 or 30 legal and tax characteristics. Helpful? I don’t think so. I’d call it information overload.

Let’s see if we can cut through the fog and find a strategy that’s best for you.

First, probably 99% of small and mid-sized business will be well served by one of just four basic business entities:

  • Sole Proprietorship
  • General Partnership
  • Limited Liability Company
  • Corporation

But how do you choose from among the Big Four? By focusing on a few liability and tax issues. Obviously, it will pay to get some input from your lawyer and CPA - but the key concepts are easy to grasp.  

Sole Proprietorships and General Partnerships

We’ll group sole proprietorships and general partnerships together. They share important liability and tax characteristics. Let’s begin with legal liability. As a sole proprietor, you bear the full legal liability for business debts and for any legal judgments against your business. Similarly, in a general partnership, each partner is personally liable for all monetary obligations.

Suppose you form a general partnership with two other people. What if one of your partners fires an employee who then sues the partnership for wrongful discharge? And what if the jury returns a verdict for $100,000 for the employee? You and your two partners will each be personally responsible for paying the full $100,000.

To satisfy the six-figure verdict, the fired employee can go after your personal assets as well as partnership assets. Your home, your personal bank accounts and your car are all at risk. As we’ll see, by doing business through a corporation or limited liability company (LLC), you can reduce this risk.

There’s another characteristic shared by sole proprietorships and general partnerships: neither offers any flexibility when it comes to federal income taxes. The profits from the business are reported on your personal tax return if you’re a sole proprietor. With a partnership, you report your share of the partnership profits on your own tax return.

In each case, you have “pass-through” taxation. Your business doesn’t pay income tax on the profits but you do.

For some businesses - especially for some small businesses just starting out - being exposed to unlimited personal liability and being responsible for taxes is no big deal. Maybe you have no employees, don’t anticipate any business debts and feel you can handle all the risks of lawsuits by buying liability insurance. Fine. A sole proprietorship or general partnership may work for you.

Ditto if you plan to withdraw the profits as earned and you don’t exptect to leave profits in the business for future expansion. Doing business as a sole proprietorship or general partnership will keep your paperwork and legal and accounting expenses to the bare minimum.

But most businesses can benefit from one of the other two business types. That’s so even though the paperwork requirements are a bit more complex and the costs a little higher.

LLCs and Corporations

We’ll pair LLCs with corporations since they share important liability and tax characteristics.

Again, let’s begin with liability. For liability purposes, the law treats an LLC or a corporation as separate from the owners. (In an LLC, an owner is called a member. In a corporation, an owner is called a shareholder.) For the most part, an owner stands to lose only what he or she has invested in the business. An owner normally isn’t liable for debts of an LLC or corporation. This means a creditor or judgment-holder can’t seize an owner’s personal assets.

Let’s return to the earlier example, but with an important variation. Suppose you and two other people form an LLC rather than a partnership. Now let’s assume that one of the other owners fires an employee who then sues the LLC for wrongful discharge. This time, if the jury returns a verdict for $100,000 for the employee, you won’t be personally liable for paying the money.

Be aware, however, that the owner who fired the employee will be personally liable - along with the LLC - if the fired employee gets a verdict against the owner as well as the business.

So the protection you gain by forming an LLC or a corporation doesn’t give you a 100% safety net. You can still face personal liability if you’re the person who causes harm to someone - like firing an employee improperly or injuring a customer. That’s also true if you personally guarantee a business obligation like a bank loan. You’ll be personally liable if your LLC or corporation lacks funds to pay back the loan.

But even though an LLC or a corporation won’t protect you completely from liability, the protection these business types do provide is an attractive benefit.

On the tax side, by forming either an LLC or a corporation, you gain tax flexibility. You can choose to have pass-through taxation for your business like a sole proprietorship or general partnership has. On the other hand, you can decide to have the business taxed as a separate entity. Because an LLC or a corporation may be in a lower tax bracket than you are, you may prefer this separate taxation if you’re going to leave profits in the business. Ask your CPA for details.

If you create an LLC and take no tax action, the profits will be passed through to the owners. To have the business itself taxed, you must file an election form with the IRS. With a corporation, a different rule applies. The corporation will be taxed unless you file a form declaring S Corporation status. Once you file that form, corporate profits will be passed through to the owners who will pay income tax on those profits.

Making Your Choice

All right - we’ve narrowed down the choices for most businesses to the LLC and the corporation. How do you choose between them? In most cases, the LLC has a slight edge. It usually involves less paperwork than a corporation to set up and maintain. In addition, the set-up and maintenance costs are usually a bit less.

The LLC gives you maximum flexibility in how you structure your business. For example, you don’t need a board of directors or traditional corporate officers like a president and secretary - although you can have them if you want to.

In a few situations, however, the corporation may have an edge over the LLC. This might be the case if you have outside investors who’d like to have corporate stock certificates to show for their investments. Or if you’re planning to offer ownership options to employees, the availability of corporate stock certificates may make the process easier.

If you’re already set up as an LLC or a corporation, stick with it. There’s no legal or tax reason to switch to the other format. If, however, you’re just starting out or you’ve already formed a sole proprietorship or general partnership, now’s a good time to think about whether to become an LLC or corporation.

This article was authored by Fred S. Steingold, a member of the Michigan Bar, who is with the Law Firm of Fred S. Steingold, with an office at 320 N. Main in Ann Arbor, MI 48104, Phone (734) 665-0635. Copyright by Fred S. Steingold, 1999.