The Accounting Blog

Most companies have a tough time figuring out the right type of business entity for their business. Partnership? Corporation? LLC? Following is a brief overview of the different entity types along with some basic advice. (For those who like to cut to the chase, refer to the "Rules of Thumb" at the bottom of this post.)

Sole Proprietorship
A sole proprietorship is the simplest business entity to form. No paperwork needs to be filed- a sole proprietorship generally comes into being when an individual begins conducting a new business (unless you form another legal entity, such as a corporation or LLC). The business may be conducted under an assumed name, which is commonly referred to as a DBA ("doing business as"). Note: there can be only one owner of a sole proprietorship (any more and you'll need to form a partnership, corporation or LLC).

General Partnership
A partnership is a business with two or more owners that has not formed another type of entity (i.e. corporation or LLC). No paperwork needs to be filed to create a partnership, although drafting a partnership agreement at the outset is recommended. There are two types of partnerships: general partnerships and limited partnerships. Typically speaking, general partnerships are relatively simple to set up and run. Income and expenses pass through to partners and all partners are treated equally. The main drawback of partnerships is that the partners bear personal liability for the debts and obligations of the partnership. As a result, partnerships are not suitable for businesses that engage in inherently risky activities (construction, machinery, food service, environmental risks, etc.).

Limited partnership
Limited partnerships are more complex to create and maintain than general partnerships. There are two types of partners in a limited partnership: the general partner (who controls day-to-day operations and is liable for business debts) and limited partners (who are not responsible for business debts or claims). The most common example of a limited partnership is a real estate partnership in which one individual (the general partner) solicits investments from other individuals (the limited partners) in order to purchase property. The general partner then manages the business while the limited partners serve as passive investors. Limited partnerships generally involve the preparation of a written partnership agreement, which can be complex because some partners may be treated differently than others. In particular, limited partnerships provide the ability to allocate income/gains/losses/etc. differently among different partners (called "special allocations").

C Corporation
A corporation is a business entity that carries its own legal status, separate and distinct from its owners. As a result, the primary advantage of corporations provide owners with limited liability against business claims (often referred to as the "corporate shield"). There are two types of corporations: C corporations (often called "regular" corporations) and S corporations. The primary disadvantage of C corporations is what's known as double taxation: profits are taxed first at corporate tax rates (around 35% for federal and 9% for California) and then again at the individual level (i.e. when owners receive profits from the corporation in the form of dividends, that income is fully taxable on their personal tax return- hence, double taxation). C corporations are formed by filing articles of incorporation with the Secretary of State.

S Corporation
An S corporation is a regular corporation that has special tax status (under Subchapter S of the IRS code- hence the name). The main advantage of S corporations is that they do not pay federal income tax. Instead, income and/or losses from S corporations pass through to shareholders in the same manner as partnerships (that's why partnerships and S corporations are both referred to as "pass-through entities."). In other words, S corporations avoid double taxation. Note: S corporations have certain restrictions that do not apply to C corporations (i.e. maximum of 100 shareholders, all shareholders must be U.S. citizens, and only one class of stock is allowed). S corporations are formed the same way as C corporations- by filing articles of incorporation with the Secretary of State. Important note: to elect S corporation status, you must file Form 2553 with the IRS within approximately two months of your incorporation date- check with your lawyer or CPA for the details.

LLC (Limited Liability Company)
Over the past few years, LLCs have replaced S corporations as the most popular form of business organization for new companies. The reason? LLCs combine the best attributes of corporations and partnerships: limited liability, pass-through taxation, and flexibility in allocating profits and losses. Furthermore, LLCs aren't subject to many of the same restrictions as S corporations. The biggest drawback of LLCs is that their legal treatment varies by state, making them a questionable choice for businesses that operate (or plan to operate) in multiple states. Much like limited partnerships, LLCs are formed by filing Articles of Organization with the state and governed by an operating agreement that looks a lot like a partnership agreement.

LLP (Limited Liability Partnership)
LLPs are a special type of partnership designed to provide individual partners with protection against malpractice by other partners in the business. LLPs are primarily designed for professions such as doctors, lawyers and accountants. As a result, they're not really applicable to anybody else.

Rules of Thumb
1) Legal protection. No doubt about it- the need for limited liability is the single most important factor in choosing a business entity for most companies. Rule of thumb: businesses that engage in risky activities should be conducted through a limited liability entity- a corporation, LLC or (to a much lesser extent) limited partnership.
2) Tax issues. When it comes to taxes, sole proprietorships, partnerships and LLCs come out about even (they're all pass-through entities). As far as corporations are concerned, S corporations have a distinct advantage over C corporations because they avoid double taxation. Rule of thumb: S corporations are the preferred choice for most smaller companies (in particular, start-ups that expect to lose money for the first few years- because the losses can then be passed through to shareholders' personal tax returns).
3) Cost and administration. Sole proprietorships and partnerships are the easiest to form and least expensive to maintain. Corporations and LLCs are almost always more expensive to create and difficult to maintain. Rule of thumb: if your business does not need limited liability protection and you want to "keep it simple," consider sticking with a sole proprietorship or partnership.
4) If you're considering forming an S corporation: take a look at an LLC instead (for all of the advantages mentioned above).
5) When to choose an S corporation over an LLC: if your company plans to issue stock or stock options, or if your company plans to operate in multiple states.
6) When to choose a C corporation over an S corporation: if the corporation has more than 100 shareholders, has shareholders who are not U.S. citizens, or intends to file a public offering in the future.
7) Be wary of changing from one entity type to another. A lot of people think they can simply convert to a different entity in the future. While it is possible to do so, it's never easy and can cause considerable headaches. In particular, trying to convert a C corporation or S corporation to an LLC can trigger some very unpleasant tax consequences.
8) Last but not least: never put appreciating assets (such as real estate or liquid investments) into a C corporation. When you sell them, you'll pay double taxes. Go with a partnership instead.

(Sources: Nolo, Micromash, Quickfinder)

Posted by Will K at 04:07 AM October 3, 2005