Choosing or Changing Your Business Entity

The entrepreneur has many choices when choosing a business entity.  For most business owners, the relevant categories to choose from are a sole proprietorship, a general partnership, a limited liability company (LLC), and then two versions of the Corporation—the S-Corp and the C-Corp. There are 4 main questions to consider when choosing between these entities:
  1. How much formality can you tolerate?
  2. How much personal liability can you risk?
  3. Which entity will minimize your taxes the most?
  4. Where will you get the money to fund this business?
How much formality can you tolerate? First, let’s deal with the question of formality, or how much do you want the government to place legal requirements on the business?   Sole proprietorships and partnerships have few (if any) government requirements to set them up or to carry on the business.  Limited liability companies are slightly more formal than sole proprietorships and partnerships.  Finally, S-Corps and C-Corps have the most government regulations for setting up the corporation, running the corporation, and terminating the corporation. One key question in determining the appropriate level of formality is, “How diverse is your ownership?”  If you or only a few people are involved in this business venture, you may feel more comfortable with an entity with less formality.  However, if there are many owners/investors with diverse backgrounds involved, more formality may be needed to ensure the business is run properly and fairly for all owners. How much personal liability can you risk? The second question to consider is, “How much personal liability can you risk?”  In other words, how willing are you to personally pay the bill for the business’s debts and obligations?  Under a sole proprietorship or partnership business structure, the liabilities of the business pass directly to the owner.  In other words, if there is not enough money in the business account to pay the business’s bills, the owner must pay the bills out of her own pocket.  Therefore, your personal liability under both a sole proprietorship and general partnership is high. By contrast, your personal liability under a LLC, S-Corp, or C-Corp is low.  These entity structures protect the owner from being personally liable for the debts and obligations of the business.  In other words, if the business bank account does not have enough money to pay its bills, the owners cannot be forced to pay those bills out of their own pocket.  However, if there is evidence of fraud, unfairness, or the business has not sufficiently observed the formalities that we just discussed previously, the court can break through this entity protection and still hold the owners of the business personally liable.  This court action is called “piercing the veil.” One key question in determining the amount of entity protection you need is whether buying insurance can mitigate the risk you will face in your business?  If you can purchase sufficient insurance to cover the risks in the business, you may be able to use a sole proprietorship or partnership structure.  If you cannot purchase sufficient insurance to mitigate your risk, you may have to choose a LLC, S-Corp, or C-corp structure so that you can take advantage of the additional protection that the entity itself provides. Which entity will minimize your taxes the most? The third question to consider is “Which entity will minimize your taxes the most?”  The sole proprietorship, partnership, LLC, and S-Corp are all “pass thru” entities.  In other words, these entities allow the income and loss of the business to “pass thru” the business and go straight to the owner. The owner then pays income tax to the government.  Therefore, the business income is only taxed once—at the owner level.  In addition, the owner can use the losses of the business to offset other income she may have from other sources.  Thus, she can lower the total amount tax she has to pay to the government. However, the taxes for a C-corp are handled differently.  When income comes into the C-corp, that income is taxed at the business level.  The income is then distributed to owners through dividends and is taxed again at the owner level.  Therefore, the income of the business is taxed twice—once at the corporate level and once at the owner level. Which tax option is best for you and your business?  It depends upon the specifics of your business.  I suggest you or your accountant crunch the numbers to see which entity will provide you with the most tax savings. Where will you get the money to fund this business? The last question to consider is, “Where will you get the money to fund this business?”  If you are going to fund the business yourself or you are going to ask for money from friends and family, then a sole proprietorship or a partnership is probably sufficient for your purposes.  However, if you want to obtain funds from institutional investors, such as venture capitalists or a private equity firms, those types of investors are typically more comfortable with an entity structure with more formalities.  These types of investors particularly like the C-corp because the government formalities provide more predictability and control over their investment. Conclusion It should be noted that more than one entity structure may be right for you.  In addition, you may have to change your entity structure as your business grows and develops.  If our firm can be of assistance to you in making these decisions, feel free to give us a call.  We wish you the best in your business!