BUSINESS LAW: Selecting an entity for your business

When starting a business, and again during periods of change, a question arises as to the best type of entity for your business. While the decision is best made with advice from your team of accountants, attorneys and insurance professionals, it’s important to understand the entities available and advantages and disadvantages to each.

Sole Proprietorship

The simplest form of business, this entity is often chosen when a business is starting and there is only one owner. This is the least expensive to form and operate.

If you plan on conducting business under a trade name, rather than under your own name, you will need to file an Assumed Name certificate with the county clerk’s office. As a sole proprietor, all income and losses are yours for income tax purposes and you will report all of the income and deductions on your own return.

One disadvantage with this form is the personal liability you have for the business’ obligations. Another is that while you can take advantage of some tax-sheltered retirement and deferred income plans, you can’t deduct all of your family’s health insurance premiums as a business deduction.

Partnerships

If more than one person is involved, a partnership may be the answer. It’s similar to a sole proprietorship, as income and losses are passed through the entity to the individual partners. There is only one level of taxation, at the individual partner level. The partnership will file an informational tax return, but will not pay tax itself.

In forming a partnership, it is important to set forth the manner of operation and all the rights, duties and obligations of the participants in a Partnership Agreement. While you can have a partnership without a written agreement, it would be unwise.

Liability for the individual partner is personal and unlimited. Additionally, any partner can bind the partnership entity. Thus, one individual could sign a contract for which the other partners could ultimately be liable. The liability does not extend simply to the assets that the partners placed in the partnership, but to their personal assets as well.

Corporations

Incorporating can solve many problems, but can create a few others. First, a small, closely-held corporation can consist of one shareholder or a few. It’s a separate entity from the individual shareholders who own it, which insulates them from personal liability arising from the corporation. While you can lose your investment in the corporation, your home and personal bank account will be safe from creditors (provided there are no issues of fraud).

The start up of a corporation is more complex than the other forms and, therefore, more costly. Articles of Incorporation must be filed. You must select a board of directors, elect officers, adopt bylaws and issue stock.

It is necessary to hold meetings of the directors and officers. Finally, it will be important to choose whether the corporation should elect “S” corporation tax status.

“S” Corporation

This election permits the corporation to pass its income and losses to the shareholders. Owners can use corporate loss to offset income from other sources. The corporation retains the benefit of insulating the shareholders from personal liability.

The “S” corporation files an informational tax return, but doesn’t pay tax itself. The informational return defines each shareholder’s portion of the corporate income. In an “S” corporation, income must be allocated to the owners according to their ownership interest in the corporation.

Regular or “C” Corporation

This is the traditional corporate form and there is insulation for the shareholders from personal liability.

The corporation pays income tax at the corporate level as a separate, taxable entity. This can result in some instances of double taxation, as salaries and distributions to shareholders each have tax consequences, as well.

A benefit with this form is that fringe benefits can be deducted as a business expense.

Limited Liability Companies

A relatively new form of entity, this shares many attributes associated with the “S” corporation. There is limited personal liability for the individual owners (called “members”), even if they participate in management. They may, but do not have to, pass through income and losses to the individual owners.

When passing income and loss to the owners, an LLC need not allocate these in proportion to ownership interests as with an “S” corporation. This can provide a flexibility in operation for owners with differing goals, financial participation and management in the corporation.

As with any of the corporate forms, an LLC is more costly and complex to create and operate than a sole proprietorship or partnership. You will need to file Articles of Organization and will need an LLC Operating Agreement, which is similar to the bylaws of a corporation as it spells out the duties and obligations of the members.

While most states recognize LLCs, not all do.

If you’re planning on doing business in other states, it’s important to determine whether they recognize this corporate form, especially as it applies to limited liability for the participant owners.

Conclusion

The variety of entities to select from provides a good option for every type of business situation. The key is to select the form best for your business at this time. As you grow, your business may progress in a way that requires a new entity selection. With every decision, it’s important to consider all of the factors, such as liability, complexity and cost of formation, complexity of operation and tax consequences.

Linda Wasielewski, a Traverse City-based attorney, focuses on estate and business planning and probate matters. BIZNEWS

Comments

comments