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Business Formation – Choosing a Business Entity

In the process of going through your Business Plan, you will need to begin thinking through how you want your business set up and what business entity you will be using. This post is designed to give you an overview of choosing a business entity that is right for your business. This is not specific advice that I recommend you going forward with without first consulting an accountant, lawyer, or professional businessman who is knowledgeable in these matters as the ramifications of this decision are significant and each business is unique. With that said, you do need to understand these concepts in order to make a well-educated decision, so I would like to provide an overview of what you need to know about business entities before making that decision.

Types of Business Entities

With a few exceptions, the main business entities that you can form for your business are: Sole Proprietorship, Partnership, Limited Liability Company, S Corporation, and C Corporation. The following are brief descriptions of each entity adapted from: Smith, Harmelink, Hasselback. 2012 CCH Federal Taxation: Comprehensive Topic. CCH, 03/2011.

Sole Proprietorship - a form of business where one person owns all of the business’ assets and is fully responsible for all of the business’ liabilities. The business is tied to the individual and is not a separate legal entity even though it is treated as such for accounting purposes. All income and expenses flow through to the owner and is reported for tax purposes on Schedule C of Form 1040. Most small businesses are sole proprietorships as it is the easiest to set up with the fewest legal requirements and pass-through benefits, but also has the greatest amount of liability for the owner, higher self-employment taxes, and a harder time raising capital for the business as the owner typically contributes all of the funds.

Partnership – a form of business where two or more persons own all of the business’ assets and are fully responsible for all of the business’ liabilities. Like the sole proprietorship, the partnership is not a separate legal entity but is tied to the partners; however, for tax and accounting purposes it is treated as a separate entity. A partnership must file a Form 1065 for tax purposes and details the income and expenses that pass through to the owners on a Schedule K-1, which is filed with each individual’s 1040. Partnerships are also a popular entity due to the ease of setup, control, management, pass-through benefits, and legal requirements; however, the drawbacks come in the partners holding full liability, higher self-employment taxes, it is harder to raise capital, and a clear partnership agreement is needed as conflicts are common between owners.

Limited Liability Companies (LLC) – the LLC is the most recent form of business entity (as of 1977) and has corporate and partnership characteristics with flexible structure and operations. Legislation for LLCs is not similar across all 50 states, but LLCs are considered conduit entities and do provide limited liabilities to owners for debts and obligations (exception: unless debt is secured with personal assets of one or more members). LLCs pass net income through to its owner(s) similar to a partnership but can also be taxed as an S Corporation if an election is made. LLCs are popular in that they provide limited liability, pass-through benefits, and flexibility, but are a bit more complicated to set up as you are required to file formation documents with the state along with annual reports and have higher self-employment taxes (unless S-election is made).

S Corporation – this form of business is a separate legal entity that is distinct from its owners with up to 75 shareholders. Shareholders are not liable for debts and obligations, but officers can be held liable for fraud or severe misconduct. An S Corporation is a separate legal entity, but not a separate tax entity and files Form 1120S with a Schedule K-1 to pass through income, expenses, gains, losses, and credits through to each shareholder similar to a sole proprietor or partnership. S Corporations have the benefits of being able to raise capital through selling stock and owners can take advantage of more a favorable employment status for tax purposes. The main disadvantages are that management is more official as this entity is closer to a C Corporation, annual meeting documentation is required, and more complex filing documents are required.

C Corporation – this form of business is similar to an S Corporation in that it is a separate legal entity with unlimited shareholders. Shareholders are not liable for debts, obligations, or taxes based on the corporation’s income. Corporations are taxpaying entities that file Form 1120 to report all income and expenses. Corporations are primarily for larger businesses due to the advantages of limited liability, ease of transferring ownership through selling stock, and the ability to raise significant capital through selling stock. Disadvantages include complex filings and management structures, and double-taxation through shareholders being taxed on dividends from the corporation.

I would recommend the following PDF for a chart that compares these entities against each other for closer review and comparison to make your decision (I can vouch for the accuracy of this information, but I am not familiar with the company): http://www.suncorpfilings.com/documents/Entity%20Comparison%20chart.pdf

What Business Entity is Right for Your Business? 

So down to choosing your business entity, what one is right for your business? Again, I will say that this question is best worked out between you and your accountant. However, here are some thoughts. The audience I am reaching out to with this blog are mostly small to medium sized businesses centered around a skill-set, talent, and passion of an individual or small group of people. With this in mind, most business of this type start out small and simple. The simplest form of business setup is as a sole proprietorship or partnership, but these business entities leave the owner(s) liable for business debts and obligations. The answer for many is an LLC that provides the structure of a sole proprietorship or partnership, but the limited liability of a corporation.

If, after determining the right business entity for your business, you find that an LLC is best for you, you can either work with an accountant to get the documents set up correctly, or you can go to your state’s Secretary of State website to fill out the appropriate documents. For Colorado, you can visit this site to file documents for a new business entity.

So I had way too many thoughts to fit in one post here, so I have taken half of what I originally wrote here and put it into a new post. Check back next week for some thoughts on protecting limited liability between your company and your personal assets.

Keep Reaching!

Mark

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