Business Entity Selection for Small Business Owners 

Mary Grace Graniero, CPA, CFP®, Financial Planner

One of the most important decisions that small business owners face is selecting the right type of business entity. There are many options available, such as sole proprietorships, partnerships, limited liability companies (LLC), and corporations. The type of entity you select will affect everything from your day-to-day operations to the amount of liability you are exposing yourself to. This article will evaluate the pros and cons of each option in order to help you determine which structure would suit you and your business the best.

Paint chips in whites, reds, and oranges

Sole Proprietorship 

A sole proprietorship is the simplest and most straightforward way of opening and running a business. Unless you register as another form of business, you automatically operate as a sole proprietorship. Unlike other entity types, this form of business does not require a separate tax return. Individuals simply file a Schedule C with their 1040 at tax time. Because of their simplicity and low operating costs, sole proprietorships are often a popular choice for businesses just starting out. However, it is important to understand the drawbacks associated with this particular business structure. Because there is no legal separation between the business and the individual, it exposes the individual to extensive liability. The individual and business are considered to be one in terms of assets and liabilities, which means any lawsuit brought against the business could affect the individual’s personal assets and vice versa. Another limitation of sole proprietorships is that it is very difficult to raise capital to expand the business because you cannot sell stock or ownership interests and it can be very difficult to obtain commercial loans. If you operate a business that is low-risk and expect minimal expansion over the life of the business, then operating as a sole proprietorship may be the right choice for you. Otherwise, it is worthwhile to learn more about partnerships, LLCs and corporations. 

Partnership 

If you are embarking on a business idea with one or more partners, then the partnership entity type is the first structure you would want to consider. This would be the simplest option and would come in the form of a limited partnership (LP) or a limited liability partnership (LLP). 

Limited Partnership 

If one partner is more involved than the others, then it could make sense to form a limited partnership. In this business entity, one individual is assigned as the general partner and assumes unlimited liability, allowing them to retain exclusive management of the business. All other partners would assume limited liability and would not be involved with the day-to-day operations of the business. Examples of companies that are often formed as LPs include hedge funds and real estate investment trusts. Details surrounding liability exposure, ownership percentages, profit distributions, and more would be documented in a partnership agreement at the start of the venture, and amended when there are any changes in ownership (Choose a Business Structure). In a limited partnership, profits are passed through to each partner’s personal tax return, and the general partner will incur self-employment tax on their share. 

Limited Liability Partnerships  

In a limited liability partnership, all partners have limited liability, meaning their personal assets are generally protected from the debts and obligations of the partnership and the actions of other partners. Under this structure, all partners in an LLP can participate in the management of the business without risking their limited liability status. LLPs are often used by professional service firms such as law firms, accounting firms, and consulting firms. 

Limited Liability Company (LLC) 

A limited liability company is a unique hybrid of the partnership and corporation business structures. Under an LLC you are protected from personal liability in most instances, meaning your personal assets such as your vehicle, house, and savings accounts will not be affected if the LLC faces bankruptcy or lawsuits. The profits of the business will be passed through to the members’ personal tax returns and they will not have to pay corporate tax. They will, however, have to pay self-employment tax on their earnings. The rules for maintaining an LLC vary from state to state, so it’s best to consult a tax advisor when choosing to pursue this option. 

Single-Member LLC (SMLLC or Disregarded Entity) 

If you are the only owner of the business and would like the liability protection offered by LLCs, you can also choose to form a single-member LLC. In order to take advantage of the same protections offered to an LLC, you will be subject to the same requirements. Single-member LLCs are popular because they offer the liability protection of a traditional LLC while maintaining simplicity in management and operations. By default, a single-member LLC is treated as a disregarded entity for tax purposes by the IRS. This means that the LLC itself does not pay taxes at the business level. Instead, the LLC’s income, losses, deductions, and credits are reported on the owner’s personal tax return (Form 1040), usually on Schedule C (for sole proprietorships) or Schedule E (for rental real estate or royalty income) and taxed at the owner’s individual tax rate. While single-member LLCs are typically managed by their sole owner, they can still choose to be managed by a designated manager if desired. This flexibility allows the owner to structure the management of the LLC according to their preferences and needs. 

Corporation 

C Corp 

A C Corporation is a legal entity that is completely separate from its owners. The corporation itself will be taxed and held legally liable for its actions. This business type offers the strongest protection to its owners, but it is also the most expensive to operate. C Corporations have stricter guidelines relating to their record-keeping, operational processes, and reporting requirements. C Corps are the only entity type that faces “double taxation” because the business is taxed on its profits and the owners are taxed on their dividends. Because the corporation is a separate legal entity, it makes it very easy for business to continue when an owner sells their shares (Choose a Business Structure). Another advantage is that C corporations can raise capital through the sale of stock, allowing them to expand and attract new ownership. If you expect that your business will need to raise funds or “go public” at some point, this may be the entity type for you. 

S Corp 

S corps allow businesses to avoid the double taxation that C corps face. Profits generated by the business will be passed through to the owners and will not be taxed at corporate rates. Each state has its own rules on how S corps are treated for tax purposes. Some will only tax S corps above a certain limit and others will not recognize them at all and choose to tax them as a C corp. Because of this, the benefit will vary depending on your state’s rules, so it’s important to consult a tax advisor before pursuing this option. In addition to registering with the state, S corps must also register with the IRS and follow the same filing and operating requirements that apply to C corps. If you are considering incorporating your business, check the IRS guidelines to see if your business would meet the criteria to file as an S corp. 

If you choose one of the many business types that offers you limited liability protection, know that there is still a possibility that any lawsuit brought against your business could “pierce the corporate veil”. This term refers to owners of a business losing their liability protection due to their failure to take the necessary steps in order to preserve the protections afforded to them under their chosen entity type. It is the responsibility of the owners to take the necessary steps in order to preserve these protections, including but not limited to the following:  

  1. Maintaining strict formalities. 
    • Corporations must keep their bylaws up to date, hold annual meetings for directors and shareholders, complete any filings required by their state of incorporation and pay the fees associated with them, in addition to paying any taxes incurred.  
    • LLCs have similar requirements related to annual filings and fees, in addition to maintaining their operating agreement and making updates when necessary. 
  1. Keeping records of business actions.  
    • It is important to have documentation of major business decisions and meetings that are held. Formal documents such as contracts and meeting minutes should be kept for at least seven years. 
  1. Avoid commingling assets. 
    • Maintain separate checking accounts and credit cards for the business and its owners.  
  1. Clearly advertise the name of your business. 
    • Employing marketing tactics such as signage, business cards and more will make it clear that there is a distinction between yourself and the entity you are operating. This is also accomplished by sending clients invoices that list the name of your business. 

If your business faces a lawsuit, it will be up to a judge to make the determination of whether or not the corporate veil can be pierced (Piercing the Corporate Veil) . By having proof that the above steps were taken, it is far less likely that a judge would decide to treat your business as a sole proprietorship or general partnership. 

In addition to affecting the day-to-day operations of your business, the type of entity you choose will also have an impact on your personal and financial well-being. When establishing or changing your entity type, it is best to consult a corporate lawyer. Once the entity has been established, an accountant in your state of jurisdiction will be able to help you ensure that you are meeting the necessary filing requirements. If you have any additional questions, our team of advisors at Howe & Rusling are always willing to work with you to find the best solution. 

Sources:
How to avoid piercing the corporate veil by Nikki Nelson
Choose a business structure, U.S. Small Business Administration

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Mary Grace Graniero

Mary Grace is a Certified Public Accountant and CERTIFIED FINANCIAL PLANNER™, responsible for working with clients to achieve both short-term and long-term financial goals.

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