It is a common recommendation for new business owners to think closely about the type of business entity that is most appropriate for their new enterprises. The various business entities have different applicable rules and there is no one business form that is appropriate for everyone.
Major Concerns of Business Owners
When deciding on a business entity type, the main concerns that most business owners have concern:
- Protection from liability;
- Paying as little in taxes as possible;
- Keeping control of the business; and
- Ease of setup.
Most people who start a business are mainly concerned with the start-up costs, marketing, gaining business, setting up normal procedures, etc., and not about what happens in case of incapacity or a death. This perspective is quite logical because most businesses start out having very little value or even have a negative value.
However, the longer the business stays afloat and the bigger the business becomes, there comes a point where ignoring the estate planning consequences of the selected entity can create very significant problems for the owner’s spouse and family if something tragic happens. For example, what if anyone of the following is involved in the owner’s personal life:
- The owner has no children interested in taking over the business;
- Some of the owner’s children are interested in running the business and others are not;
- The owner has a second spouse and children from the first marriage;
- The owner’s children are “idiots”, and key employees don’t want to cater to them until they become smart;
- Et cetera, et cetera, et cetera.
There are certainly effective strategies for each of these possibilities, but first, we must provide some basics. The chart below covers the main characteristics of the most common business entities. Immediately thereafter, we’ll further elaborate on a few of the terms used therein.
The Most Common Business Entities
ENTITY Liability Taxation Control Formality of Setup
SOLE PROPRIETORSHIP Unlimited Flows through to owner Sole owner controls Easiest
GENERAL PARTNERSHIP Unlimited Flows through to owners Mainly in equal shares for each partner Easy, but filing with state is usually recommended
LIMITED PARTNERSHIP Unlimited for general partner, and limited for limited partner Flows through to owners General partner controls, regardless of percentage ownership Must file with state, usually need formal partnership agreement to do so
C CORPORATION Limited Double taxation Majority of shareholders control Many specific requirements
S CORPORATION Limited Flows through to owner(s) Majority of shareholders control Same as C Corp, plus organization must meet additional requirements to be able to elect S Corp status
LIMITED LIABILITY CORPORATION Limited Flows through to owner(s) unless elected otherwise Manager-members control, regardless of percentage ownership Much less than for C and S corporations
Further Clarifications of Chart Terms
- Limited: Owners that have limited liability are only liable for business obligations up to the level of their individual investment.
- Unlimited: Owners with unlimited liability are also liable for all of the obligations of the business.
- Flows Through to Owner(s): Any profit or loss in the business is declared on the owners’ individual tax returns. The entity itself owes no taxes.
- Double Taxation: The business profits are taxed at the corporate rate. Then, any remaining income paid to owners (usually in the form of dividends) is taxed at their individual rates.
- Flows Through Unless Elected Otherwise: The LLC owners may choose how they are to be taxed.
- Regardless of Percentage Ownership: Control is based on the position held rather than how much of the business is owned. For example, in limited partnerships, a general partner can own 1% of the business and still control it.
- Majority of Shareholders Control: When voting occurs, each share is voted. The majority of the shares wins. Owners holding a majority of the shares will automatically control the business.
In our next post, we will provide an example of a small business enterprise and give some rationale behind why it might select each of the six listed entities at various times.
- Learn About Business Ownership Structures (www.thompson.law.pro)
- How to Choose Your Business Organization (alexbajwa.com)
- Choice of Entity — Part 2: Taxation (blog.deplawfirm.com)
- Business Succession Planning: Gifting and Discounting Basics (estateplanninginfoblog.com)