Selecting a Small Business Entity

One-Person Businesses  
The obvious and classic one-person organization is a sole proprietorship without any corporation or limited liability protection. The principle advantages are that there are few if any organizational expenses, and,

for income tax purposes, the profits and losses of the business are those of the owner and are taxable or deductible to the owner in the year in which they incurred, and business profits are not taxed twice (as they would be in a corporation). The principal disadvantages of this form of proprietorship are that:

1) the owner is personally liable for all debts and obligations of the business and

2) the availability to the owner of employee benefit plans is somewhat limited.

A one-person business can also be organized in a corporate form as either an S corporation or C corporation. In both types of corporations, the business owner is shielded from personal liability for business debts other than those personally guaranteed. In the S corporation the profits and losses of the business are passed through to the owner as if it was a sole proprietorship. In addition, other owners or shareholders can be later added up to 75 in number without changing the business entity.

The disadvantages of an S corporation are that management and organizational flexibility are somewhat limited by the requirements of the Internal Revenue Code, organizational expenses are greater than in a sole proprietorship and the availability to the owner of employee benefit plans is limited. A C corporation also shields the owner from personal liability for business debts, and allows the addition of new owners without changing the business entity. Unlike the S corporation or sole proprietorship, it permits earnings to be retained by the corporation for future capital needs (up to certain amounts) without being taxable to the business owner and it is easier for the owner to participate in employee benefit plans of the business. The disadvantages of a C corporation are that because a C corporation is a separate taxable entity, there is a danger of a double tax on both the corporation and the shareholder level being imposed because there is no-pass through tax treatment as in an S corporation.

A sole proprietor may also elect to form a limited liability company. This business form provides the same shield from personal liabilities as a corporation, and has the added advantage of pass-through taxation as if the business were a sole proprietorship. Furthermore, additional owners or partners may be added without changing the business entity. There is great flexibility in the organizational structure and management requirements. The disadvantages of such a business format include: as in a corporation, significant organizational expense; the impossibility of retaining earnings for future capital needs without them being reportable as income; and the availability to the owner of employee benefit plans for the business is limited.

Multi-Person New Businesses
If there is more than one owner, they can also elect the S corporation, C corporation, or limited liability company formats. In addition, a multi-person business can select a general or limited partnership. The main advantages of a general partnership include: flexibility of management and organization, and pass-through taxation, whereby the profits and losses of the business are attributed directly to the partners. (The partnership does not pay a separate tax). The disadvantages of a general partnership are that each partner is personally liable, without limitation, for all partnership debts and liabilities, including those incurred by other partners in the course of partnership business; interests in the partnership are not readily transferable; it is impossible to retain earnings in the business for future capital needs without being reportable as income by the owners; and the availability to the owners of employee benefit plants is limited.

A limited liability company has the same tax effect as a general partnership with respect to income and expenses. The advantages and disadvantages are mostly the same as those listed for general partnerships, except that a member of a limited liability company is shielded from personal liability for the LLC's debts and obligations, with some notable exceptions for limited liability companies formed by professionals, such as lawyers, accountants, etc.

A limited partnership gets all of the tax advantages of the general partnership and the limited liability company. In addition, only the limited partners, and not the general partner or partners, have personal liability protection. A limited partnership is managed and controlled by the general partner, while the limited partners are similar to stockholders who do not participate in the control of the partnership business.

In selecting a business entity, there are no infallible general rules that are applicable to every business. Each situation is unique and must be dealt with separately. The advice of both a competent attorney and an accountant should be sought and the selection made with the various factors mentioned above in mind. A knowledgeable professional can discuss in greater detail with a new business owner all of the advantages and disadvantages of the various types of business entities.

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The information expressed above should not be construed as legal advice but merely information on the law that may be of interest to you.  Remember, individual legal problems require individual solutions. Please contact Miller, Miller & Tucker, P.A. if we can help.