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Which Business Entity Is Best for You?

February 02, 2011

Jim Bailey, CPA, MST, CFP
Partner
BlumShapiro

As you are probably well aware, there are several different types of business entities. Which type best suits your current needs? The following is a summary of the main points:

Sole proprietorships
This structure may be used for a firm owned and operated by a single person. Because you have no other partners or shareholders, you maintain complete control of the business. Basically, you reap all the rewards, but you also run all the risks.

A major disadvantage is that you have unlimited personal liability. However, you can reduce the risk by purchasing adequate insurance coverage. It also may be more difficult than a partnership or corporation to obtain financing.

Partnerships
Each general partner faces unlimited personal liability for all partnership debts. All partners must agree before an interest can be transferred, and any one partner can cause a dissolution.

The death of one of the partners may cause the business to dissolve. However, a partnership agreement can provide for a new partnership to spring into existence upon the death of a partner. In essence, the surviving partners "buy out" the deceased partner's interest. This buyout is usually funded through life insurance. Important: The partnership agreement should include a method for valuing a partner's interest.

As far as taxes are concerned, the partnership's profits or losses are reported on each partner's individual tax return.

Corporations
A corporation is a separate legal entity. This type of structure limits your liability to the amount of your investment. A corporation has a guaranteed continuity of life, shares can be freely sold or transferred and it has the ability to raise capital through the sale of stock.

However, a traditional C corporation triggers double taxation: once at the corporate level and once when dividends are distributed to the shareholders. One solution is to distribute income in ways other than taxable dividends, such as salaries, debt repayment, etc. Of course, the IRS limits deductions for wages to "reasonable" amounts for services actually rendered.

Note: Shareholders may be held personally liable in some cases. This is known as "piercing the corporate veil." Generally, this occurs when a court finds commingling of assets, a lack of corporate formalities or extreme undercapitalization.

There are several different categories of corporations, including the following:

  • Close corporations:  All the shareholders must consent to a transfer of stock. In this respect, it is similar to a partnership. Usually, the number of shareholders in a close corporation is limited.
     
  • S corporations:  Generally, this status provides insulation from liability while affording tax benefits. Reason: An S corporation is not subject to double taxation. In brief, the shareholders are taxed like partners in a partnership. State law may have an impact.
     
  • Limited liability companies:  This entity blends corporate and partnership characteristics. Generally, a limited liability company (LLC) is taxed like a partnership. At the same time, owners of interests in the company (called members) receive the protection of limited liability. Caution:  Once again, state law may affect your decision.

Each situation should be analyzed on its own merits. Make an informed decision with professional assistance.

 

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