Incorporating: Pro’s and Con’s of Business Entities - Part I
To Incorporate or Not to Incorporate:
The Pros and Cons of Different Business Entities (Part One of Two)
Have you ever wondered if being a sole proprietor is your best business option? Maybe you should create an LLC (limited liability company), an LP (limited partnership), or an S-Corporation. There’s no one right or wrong answer when matching your business to just the right business entity. And the business entity you choose depends largely on your personal situation and circumstances. But we don’t want to imply that your decision isn’t a weighty one; the type of business entity you choose will affect your liability, your creditors’ access to your assets, and your tax obligations. So it is a decision that requires pertinent information and considerable thought. Sometimes just a little knowledge can ensure that you make the best choice for you.
Sole Proprietorship
A sole proprietorship is a business owned and operated by one person. This is the most popular business type for new, small business owners, especially if they work from home. Perhaps you already decided that a sole proprietorship is the perfect match for your business right now. While there are many benefits in having a sole proprietorship, the one drawback is that you have unlimited liability for any debts or obligations incurred by the business. The business is not an entity separate from its owner, and if the business is sued, all of the business owner’s personal assets are at risk. If the business becomes insolvent, the sole proprietor must declare personal bankruptcy to avoid business debts.
However, that may not a problem you expect to encounter.Cons If you work from your home office, you’re probably not incurring much business debt. But if you’ve grown your business enough that it requires a rental property with staff that you manage, then you might want to look at other options.
Limited Liability
The business entity you choose can greatly affect your personal liability. When shareholders or owners of a business are not personally liable for any business debts or obligations, they enjoy “limited liability.” The last thing you want to do is create a business where the negligence of a partner, or even an employee, puts your personal assets at risk. This week we’ll discuss the limited liability of C-Corporations and S-Corporations.
Corporation. Owners of a corporation are issued shares of stock and are thus called shareholders. A corporation exists independent of its shareholders, and is viewed as a separate entity, which can generate income, incur debt, and be sued. Corporations are commonly classified according to their taxation status as either C-corporations or S-corporations. Unless the corporation elects otherwise, its income will be taxed at the corporate level at corporate rates.
C-Corporations
Following are some of the pros and cons of C-Corporations:
Pros
- Limited liability
- Shareholders are not required to manage the corporation.
- Continues to exist after a shareholder’s death, retirement, or bankruptcy.
Cons
- Filing a corporation can be expensive.
- Corporate formalities are required (shareholders and directors meetings, corporate minutes book, employer identification number (EIN), etc.)
- Because the corporation’s income is taxed, and the shareholder’s income is taxed, corporations experience “double taxation.”
S-Corporation
If a corporation meets certain requirements, it can elect to be taxed as an S-corporation, with the profits and losses passing through to the shareholders to be taxed at the shareholders’ rates. Unlike a C corporation, the S corporation itself is not taxed, although an informational return (IRS Form 1120S) must be filed with the IRS. And S-corporations are limited to one class of stock and cannot have more than 75 shareholders. An S-corporation enjoys the same limited liability as a C-corporation and has some of the following pros and cons:
Pros
- Limited liability.
- Shareholders are not required to manage the corporation.
- Continues to exist after a shareholder’s death.
- Only shareholder’s income is taxed.
Cons
- Filing a corporation can be expensive.
- Corporate formalities are required (shareholders and directors meetings, corporate minutes book, employer identification number (EIN), etc.)
Many believe that businesses require a large number of shareholders in order to incorporate. But in most states you only need one shareholder and one director to form a corporation, and that shareholder and director can be the same person. And while that may be something you aspire to in the future, you may not feel either of these entities is the best match for your current business. But there are two more limited liability entities that may work for you: limited partnerships (LP’s), family limited partnerships (FLP’s), and limited liability companies (LLC’s). Come back next week and learn more.
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