Once coupled to a development idea, every entrepreneur faces the challenge of deciding which business entity would best suit his or her needs. While one would think that there is one right answer to this dilemma, in fact, the answer depends on a number of factors that are unique to each business, resulting in many different entities being the "right" choice, depending on the circumstances.
Factors affecting entity choice include:
- Liability Protection
- Owner Relations
- Income Tax Consequnces
- Other Tax Consequences
- What Others are Doing
- Cost
Considering these factors, the owner has the following choices:
- Corporation (S-corp or C-corp)
- Partnership
- Sole Proprietorship
- Limited Liability Company (LLC)
- Limited Partnership (LP)
- Limited Liability Partnership (LLP)
- Others, such as Joint Venture, etc.
Perhaps the best way to compare all these choices is through a table which sets forth some of the most common advantages and disadvantages of each type of entity in comparison to the above factors:
|
Issue |
LLC |
LP |
S Corp |
C Corp |
Sole Proprie- |
General Partner- |
LLP |
|
Limited Liability |
Yes, for members even if participated in management |
Yes, but only for limited partners who do not take too active of a role in mgt. General partner has unlimited liability |
Yes, for shareholders, even if participate in mgmt. |
Yes, for shareholders, even if participate in mgmt. |
No |
No |
Yes, however, certain limitations |
|
Formation Requirements |
File Articles of Organization with State with fee; pay annual fee and file annual report. |
File Certificate of Limited Partnership with State with fee; pay annual fee and file annual report |
File Articles of Incorporation with State with fee; pay annual fee and file annual report |
File Articles of Incorporation with State with fee; pay annual fee and file annual report |
None |
None |
File Certificate |
|
Operational Formalities |
After filing organizational papers with state, and paying annual fee and doing annual report there are few, but should have a written operating agreement. |
After registering with State, just paying annual fee and filing annual report |
Corporate Formalities must be observed (i.e. annual minutes, annual meetings, etc.). Should have written Shareholder Agreement. |
Corporate Formalities must be observed (i.e. annual minutes, annual meetings, etc.). Should have written Shareholder Agreement. |
None |
None, but should have written partnership Agreement in place |
After registering with State, just paying annual fee and filing annual report |
|
Management |
By all members unless manager appointed |
By general partner; limited partners need to make sure not to be too involved or lose liability protection |
By board of directors (who may be and often are shareholders) |
By board of directors (who may be and often are shareholders) |
By individual owner |
By all partners |
By all partners |
|
Taxability of Income |
No tax at entity level, if it qualifies as a nonpublicly traded partnership |
No tax at entity level if it qualifies as a nonpublicly traded partnership |
No tax at entity level, except on certain passive income, capital gains and built-in gains |
Entity level tax imposed |
Tax on owner |
No entity level tax, tax on individual owners |
No entity level tax |
|
Levels of Federal Taxation |
One |
One |
Generally One. However, if a former C Corp, may have built in gains or passive income issues causing additional taxation |
Two |
One |
One |
One |
|
Number of Owners |
Most states require only one. (if publicly traded may be considered a corp for tax purposes) |
At least two. (if publicly traded may be considered a corp for tax purposes) |
One to 100 with further rules; |
No restrictions |
One |
At least two |
At least two ((if publicly traded may be considered a corp for tax purposes) |
|
Types of Owners |
Any type |
Any type |
Only U.S. citizens, residents and certain U.S. trusts. No corps, LLCs or partnerships can be shareholders except for certain tax exempt charitable foundations, certain trusts, ESOPs and qualified S Corp subisidiaries |
Any type |
n/a |
Any type |
Any type |
|
Classes of Ownership |
Multiple classes allowed |
Multiple classes allowed |
Only one class of stock permitted, but can have different voting rights |
Multiple classes allowed |
One class |
Multiple classes allowed |
Multiple classes allowed |
|
Taxation of Contributions of property to entity |
Nontaxable unless a disguised sale; the LLC would be an investment company if incorporated, or if the member is relieved from debt |
Nontaxable unless a disguised sale; the LLC would be an investment company if incorporated, or if the member is relieved from debt |
Taxable, unless the investor meets the 80% control test of IRC Section 351 whereby the transfer would be nontaxable at that time unless for relief of debt |
Taxable, unless the investor meets the 80% control test of IRC Section 351 whereby the transfer would be nontaxable at that time unless for relief of debt |
Nontaxable |
Nontaxable unless a disguised sale; the LLC would be an investment company if incorporated, or if the member is relieved from debt |
Nontaxable unless a disguised sale; the LLC would be an investment company if incorporated, or if the member is relieved from debt |
|
Special Allocations of Taxable Income or Loss |
Yes |
Yes |
No |
N/A |
N/A |
Yes |
Yes |
|
Deductibility of Losses |
Member can deduct his/her share of LLC losses, but only to extend of his/her basis in the LLC ownership interest, including his/her share of the debt of LLC |
Member can deduct his/her share of P’ship losses, but only to extend of his/her basis in the P’ship ownership interest, including his/her share of the debt of P’ship |
Shareholders can deduct allocoable share of corp’s losses only to the extent of (i) the shareholder’s tax basis in the stock, which does not include any portion of the corp’s debt; or (ii) the amount of any shareholder loan to the corporation, subject to certain limitations. |
Shareholders can not deduct any of corp’s losses, unless shareholder is another corporation filing a consolidated return |
Generally no restrictions |
Member can deduct his/her share of P’ship losses, but only to extend of his/her basis in the P’ship ownership interest, including his/her share of the debt of P’ship |
Member can deduct his/her share of P’ship losses, but only to extend of his/her basis in the P’ship ownership interest, including his/her share of the debt of P’ship |
|
Continuity of Life |
Yes |
Generally, NO, but continuity can be achieved by majority vote of general partners after an event of dissolution. |
Yes |
Yes. |
N/A |
Generally, NO. Any partner can trigger dissolution by withdrawal. Can create by vote of partners. |
Generally, NO, but continuity can be achieved by majority vote of general partners after an event of dissolution. |
|
Self Employment Tax on Distributive share of Income |
Yes as to active members and any manager, No, as to non-active members or return of capital |
Yes as to general partner; NO as to limited partners |
No |
N/A |
Yes |
Yes |
Yes |
|
Health Insurance Deduction |
100% |
100% |
100% |
100% if company reimburses taxpayer or their dependents for medical care expenses, even if discriminatory; not income to shareholder. |
100% |
100% |
100% |
|
Reasonable Compensation Issue |
No |
No |
No, but can be challenged if comp is unreasonably low to avoid employment taxes |
Yes |
No |
No |
No |
These are not all of the factors that should be taken into account and you should consult your legal and accounting advisors when making this decision. Sometimes factors conflict, and a good advisory team can help point out which entity would do best in the long run.