Choosing a Legal Entity for Your Business

August 8, 2011

Just starting your business?  Have you selected the right entity?  Choice of entity is a crucial first step for business formation. The right decision can pave the way for success. The wrong decision may cause you unnecessary accounting challenges. It can also contribute to diminished returns or even your business’s failure.  In fact, choosing the right type of entity is similar to buying a new home. You need to meet your current needs, but plan for the future at the same time.  The right business entity should protect your personal assets against legal liability, but provide flexibility as your business grows.

Sole Proprietorship
If you are the only owner of your business, sole proprietorship may be the way to go. The tax advantages are usually better than with a corporation or LLC and allow you to avoid the cost and complexity of establishing and maintaining a separate entity.  You also avoid the taxes owed for the privilege of having an LLC or corporation.  Although a sole proprietorship does not protect you personally from litigation, sufficient protection can usually be provided through insurance.

A general partnership is a form of business organized by two or more individuals who do not want to set up a corporation or other type of company.  The individuals are responsible for any debts and liabilities in proportion to their stake in share capital of the partnership.   The same proportions are used for the distribution of profits.  In the case of a general partnership, only the income of the members is subject to taxes.

The C-corporation is the most commonly used type of corporation. C-corporations can have any number of shareholders.  Shareholder’s assets protected from the creditors of the corporation since the liability of the shareholders is limited to the amount contributed by them to the capital of the corporation. One disadvantage of C-Corporations is double taxation as profits are taxed first as income to the corporation, then as income to the shareholder when distributed as dividends or profit sharing.  

Corporations with fewer than 75 shareholders can obtain S-corporation status. If a corporation has S-corporation status, the corporations are not separately taxable entities, so the income and loss are “passed-through” to the shareholders.  This is probably on one of the biggest advantages of an S-corp.

Limited Liability Company (LLC)
A n LLC combines the corporate advantages of limited liability with the partnership advantage of pass-through taxation. Members of an LLC can be managers of the company, allowing them to shield their personal assets from risks.  Like partnerships, LLC’s are taxed on the level of its members.  Profit and loss distribution does not have to be allocated according to the ownership percentage, but rather, according to an operational agreement.   The main difference between an LLC and an S-corporation is that all profits, liabilities, losses and deductions of S-corporation are divided between the owners in proportion to the number of shares held by them.   An LLC allows for more flexibility for the division of these items between the owners.

While this overview should provide you some direction for your business, it doesn’t present all the options and benefits available.  Be sure to consult with your tax professional from Beverly Hills, Malibu and the Los Angeles area to understand what is best for your business.