Entity Selection

The appropriate business entity for any individual(s) will depend on their particular facts and circumstances. They must consider the current objectives with an eye towards future potential objectives to determine what type of entity best suits these goals. Some choices are based on the particular business while others are primarily focused on long-term estate planning objectives.

Simply, we can divide the entities into two categories, corporations and partnerships. Between these two categories is a gray area where the entities take on characteristics of each other. Deciding on which category to form the entity will depend upon the individuals forming the entity, how the profits are to be shared, the extent of liability exposure, and the tax consequences.

Sole Proprietorship: If an individual chooses to operate a business without selecting an entity that business will, by default, operate as a sole proprietorship. This is a business that is not incorporated and is owned by one person. A sole proprietorship is not a separate legal entity and therefore there is no legal distinction between the sole proprietor and the business. This makes a sole proprietor financially responsible for all liabilities the business incurs - all of that individual’s personal assets are subject to seizure or lien by creditors. From a tax standpoint all of the profit or loss from the business will be reported on the individual’s personal tax return and will be subject to self-employment tax in addition to forfeiting certain tax advantages available to corporations.

Corporations: This type of entity is formed upon filing articles of incorporation with the appropriate State. The owners of the Corporation are the shareholders, but unlike the sole proprietorship the shareholders do not have personal liability for those liabilities arising in the ordinary course of business. The entity automatically becomes a C Corporation unless the shareholders elect and timely file with the IRS a subchapter S selection.

The major difference between these two entities is that a C Corporation has a corporate level income tax on its profits whereas the S Corporation is a pass-through (or flow-through) entity, which does not have a corporate level income tax. A pass-through entity has a pro rata portion of the annual profit or loss reported to each shareholder, which is in turn reported on that individual's personal tax return and taxed at that individual's income tax rate.

If a C Corporation is profitable and pays a dividend to it shareholders there's a potential for double taxation. This can be avoided by increasing the compensation paid to its shareholder-employees as this will provide a deduction to the Corporation as a business expense thereby reducing the annual profit. The C Corporation is also permitted to take other deductions for tax purposes that an S Corporation may not take.

S-Corporation shareholders holding more then 2% of the stock in the corporation are also limited in availing themselves of corporate fringe benefits. There is also a limitation on the number of shareholders in an S Corporation and the types of shareholders permitted, for example not all trusts can be shareholders of an S Corporation.

Partnerships: A general partnership is a business entity that has not incorporated and is owned by two or more individuals. Profits will be shared amongst the individuals equally unless there's a partnership agreement in place providing for some other manner to the profits and losses. The taxation of those profits or losses is similar to an S Corporation as a partnership is a pass-through entity. Each partner of this entity will be personally liable for all debts and liabilities of the partnership. This liability also extends to the actions of the other partners either for debts incurred by one of the partners or through one of the partner's wrongdoings.

In order to minimize the liability exposure it might be advisable for the individuals looking to establish a partnership to consider either a limited partnership or a limited liability partnership (only available to accountants and attorneys). A limited partnership operates with one or more general partners managing the entity, while limited partners share in the profits and contribute capital they take no part in running the entity. The general partners are personally liable for partnership debts while the limited partners have no liability with regards to partnership obligations beyond their capital contributions as in a Corporation.

Limited Liability Company: an LLC falls within that gray area between a Corporation and a partnership. This type of entity has the pass-through characteristics of a partnership with the limited liability afforded corporate shareholders. The profits and losses in an LLC unlike a corporation may be divided in any manner the members decide as per their membership agreement. A 25% member does not necessarily need to receive 25% of the profits as in a corporation. The main benefit for an LLC is the remedy available to creditors attacking a member of the LLC personally. That remedy is called a charging order and provides the creditor only with the actual profits paid out to the member. It does not allow the creditor to take the individual members interest in the entity. The creditor cannot liquidate the LLC or compel the LLC to sell any of its assets to pay the claim against an individual member.