One of the most important decisions new business owners make is the selection of the entity type to be that will be used for the business.
Summary of the advantages and disadvantages of each entity type:
1) Sole proprietorship:
- Advantages:
- Easy to form, simple to operate.
- Easy to sell business assets.
- Few administrative burdens.
- Income is generally passed through to the owner.
- Disadvantages:
- Generally, have limited sources of capital.
- Unlimited liability and no guarantee of continuity.
- Business income is subject to self-employment tax.
2) Partnership:
· Advantages:
- More sources of capital and more resources available than proprietorships.
- Fewer admin burdens than corporations.
- Income and losses are generally passed through to the partners.
- Disadvantages:
- Transfer of interests is more difficult than proprietorships.
- Unlimited liability for partners.
- Net income is subject to self-employment tax.
- Partners are entitled to few tax-free fringe benefits that are generally available to employees.
3) Limited Partnerships:
- Advantages:
- Pass-through partnership taxation status.
- Flexible ownership structure.
- Limited partners are not personally liable for the debts/obligations of the LP if they don’t engage in management.
- Disadvantages:
- Must file with the state to register.
- In most states, general partners are liable for debts/other obligations of the LP.
- Losses for limited partners are generally passive losses.
4) Limited Liability Partnerships:
- Advantages:
- Pass-through partnership taxation status available.
- Flexible ownership structure and partners can insulate themselves from the acts of other partners.
- Disadvantages:
- Required to file with the state.
- Unlimited liability for own acts of malpractice.
5) Family limited partnership:
- Is often used as an estate planning strategy for families above the federal estate tax exemption.
6) Limited Liability company (LLC)
- Advantages:
- Members have limited liability; number of members is unlimited.
- Members can be individuals, corporations, trusts, other LLCs, etc.
- Income is passed through to members.
- Double taxation is avoided if partnership tax status is elected.
- Members can participate in management and there are multiple classes of ownership.
- Distributions to members don’t have to be proportional to the members’ ownership interests as they do for S corporations.
- May elect to be taxed as a partnership, an S corp, or a C corp.
- Disadvantages:
- May have limited life.
- Transfer of interests is difficult and sometimes limited by operating agreement.
- Some industries may not be permitted to use LLC status.
- Laws vary by state and laws are relatively new for LLCs.
- For tax purposes, the partnership rules generally apply.
- Members not meeting exceptions are subject to self-employment tax on all earned income if partnership status is elected.
7) C corporation:
- Advantages:
- Ease of raising capital and generally more management resources.
- Limited liability of shareholders and ease of transfer of ownership interests.
- Unlimited life of entity.
- Individuals may receive all employer-provided tax-free fringe benefits.
- Disadvantages:
- Potential for double taxation due to entity level taxation.
- Administrative burdens.
- More difficult to form and dissolution can cause taxable gains.
- Borrowing may be difficult without stockholder personal guarantees, which negates part of the advantage of limited liability.
- Requires a registered agent and federal tax ID number.
8) S corporations:
- Advantages:
- Income is passed through to the shareholders and shareholder have limited liability.
- Income is taxed at the individual level (may be lower than corporate rate).
- Distributions are exempt from the payroll tax system, assuming the Corp provides adequate compensation to those shareholders who are employees of the Corp.
- Disadvantages:
- Limited to 100 shareholders and only one class of stock.
- Shareholders must be individuals.
- Shareholder employees owning more than 2% of the company must pay taxes on a range of employee fringe benefits that would be tax-free to a shareholder of a C corp.
- The tax rate of a shareholder may be higher than the corporate tax rate.
- Borrowing may be difficult without stockholder personal guarantees.
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