What Business Entity is Right for my Company?

Business Entity

You came up with a great idea for a business. You might even have drafted a business plan.

Before you can move forward, one of the key questions that you need to decide, especially if you need to raise start-up capital, is what business entity to choose. Before you set up a structure, you must decide, what business entity is right for your company. A good business transaction lawyer can assist you in determining the right business entity before you make a costly mistake. Before you take that step, take a look at the pros and cons of some of the most common business entities out there.

Types of Business Structures

There are five main types of business entities:

Sole proprietorship

If anyone else owns part of your business, it is not a sole proprietorship. Also, if you have incorporated your business, it is not a sole proprietorship. If you own a domestic limited liability company (LLC), are the sole member, and treat the company as a corporation, it is not a sole proprietorship. A corporation cannot be a sole proprietorship. A sole proprietorship can, however, have employees. Most businesses in America are sole proprietorships. It is the simplest form of business entity, and it costs nothing to set up.

You will likely have to file IRS forms 1040 (Individual Tax Return); Schedule C (1040), Profit or Loss from Business or Schedule C-EZ (Form 1040), Net Profit from Business. You will also need to pay self-employment tax (i.e. Social security and Medicare taxes as both employer and employee), and income tax withholding. If your business loses money, you can lose your personal assets to creditors. If someone successfully sues you, they can go after your personal assets as a judgment creditor. It can be difficult to raise investment capital if your business entity is a sole proprietorship.

Partnership

A partnership is a business entity in which two or more people are in business together but have not incorporated the business. Partners cannot be employees, so no one gets a Form W-2. You will report your income from the partnership using a Schedule K-1 (Form 1065). The partnership will have to file a tax return, and the partners must each report their income using Form 1040. There are general partnerships and limited partnerships. A limited partnership must have at least one general partner. General partners can lose their personal assets if the business fails, but limited partners can only lose their investment. It can be harder to raise investment capital for a partnership than for a corporation.

Corporation

The shareholders own a corporation. The IRS taxes corporate profits twice—both at the corporate level and then again when the profits are distributed to the shareholders as dividends. The corporation has to pay taxes on its profits and file a corporate tax return (using Form 1120, Corporation Income Tax Return), and the shareholders have to pay taxes on the profits the corporation distributes to them as dividends (using Form 1040). The shareholders have limited liability in the event the corporation loses money or someone wins a lawsuit against the corporation, which is one reason many companies elect to incorporate, despite the double taxation.

S Corporation

If they meet the strict guidelines, many business entities choose to be S-corporations, because these business structures get to avoid the double taxation of standard corporations. Also, the owners of these business structures enjoy liability protection.

Limited Liability Corporation (LLC)

The owners of an LLC are members, not shareholders. The IRS may tax the business as a partnership, a corporation, or an S-corporation, depending on how the members set up the entity. If set up as a partnership or S-corporation, the business will avoid double taxation. And just as the name suggests, the owners get to protect their personal assets because of the business’ limited liability.

The recently passed Tax Cut and Jobs Act makes your business entity choice more critical than ever. Generally, businesses (of all types) will be able to deduct 20% of their business income before calculating income tax. However, the 20% deduction is dependent upon the business owner’s taxable income and the business type. Special rules apply to limit the deduction for personal service businesses (doctors, lawyers, professional athletes, etc.). An S-corporation as an entity choice has suddenly become relatively more favorable in some circumstances as business income can be shifted to owner wages.

If you are setting up a new business or thinking of making changes to your existing business, schedule a consult with business transaction attorney Stephen Thienel today. Mr. Thienel has decades of experience assisting clients in business formation, transactions, and taxation. Thienel Law, LLC serves clients in Maryland, Virginia, and the District of Columbia.

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