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How do I choose or change a business entity?

Whether you have been in business for years or you are launching a start-up, choosing or changing your business’s entity is an important part of its financial and overall future.

A business’s entity determines the rules that govern its formation, operation, taxation, and dissolution. Its entity also establishes the degree to which the business and its investors are liable for the acts of an agent of the business. The entity you choose for your business will affect future financial business decisions, like the need for additional insurance to protect yourself against liability or the decision to sell ownership interests.

When choosing an entity for your business, you will want to consider the attributes of each type of entity and which best fits your vision for the business. There are seven primary entity attributes:

There are certain requirements and procedures involved in forming and maintaining the entity. The fewer formalities of existence, the simpler and less expensive the entity. So, if you want to avoid spending a lot of money forming or maintaining your business, consider an entity that has few formalities of existence.

An entity offers limited liability if an owner can lose nothing more than his or her investment. In other words, the owner’s personal assets are insulated and cannot be used to satisfy the entity’s liabilities (debts). If you do not wish to put all of your personal assets at risk, think about an entity that offers limited liability.

In a pass-through entity, only the owners are taxed, not the entity. A separate taxpaying entity, on the other hand, may be taxed on the same profits twice; the entity is taxed on its profits, and then the shareholders are taxed when (or if ) these profits are distributed to them as dividends. This is known as double taxation, and its existence is the main reason business owners choose a pass-through entity. If you plan to have the profits of the business distributed as soon as they are earned, or if you want a business that will permit you to deduct business losses from your personal income, consider a pass-through entity.

An entity has centralized management if a person or a relatively small group of people is responsible for management decisions. If you only plan to give a few people decision-making power, which usually results in quicker decisions, choose an entity with centralized management.

Some entities are more flexible than others in sharing profits and control with their owners. Depending on the flexibility, an entity can sell its stock to any willing buyer, issue classes of stock with differing rights regarding the distribution of corporate profits to shareholders, or issue stock with different voting rights. If you want to have control over how profits are distributed and who has control over the corporation, you should choose an entity that allows you this control.

Some entities can exist forever. This is called continuity of life. An entity does not possess this attribute if the death, bankruptcy, retirement, insanity, or resignation of an owner can cause it to end (dissolve). Continuation of the business can be planned for, so while this isn’t necessarily a real problem, it is something you should be aware of and consider.

You should consider the ease with which ownership interests may be transferred. Free transferability of interests exists when owners are permitted to sell their ownership interests to others without restriction.

What are the primary types of entities from which you can choose?

Sole proprietorship.

The most straightforward way to structure your business entity, a sole proprietorship is easy to set up—no separate entity must be formed. The business is simply an extension of the sole proprietor.

Sole Proprietorship

Entity is extension of single owner

Formalities of existence

Few formalities of existence; very simple and easy to form.

Liability

Owner is liable for all financial obligations the business incurs; personal assets can be subject to claims of the business’s creditors.

Taxation (pass-through or double)

A pass-through entity; allbusiness income, gains, deductions, or losses are reported on the owner’s personal income tax return.

Centralized management

Has centralized management; owner maintains complete control over the business.

Flexibility in sharing profits and control

Sole owner receives all profits and maintains complete control.

Transferability of interests

Business can be sold without restriction.


Partnerships.

If two or more people own a business, then a partnership is a viable option to consider. Partnerships are organized in accordance with state statutes. Certain arrangements, however, like joint ventures, may be treated as partnerships for federal income tax purposes, even if they do not comply with state law requirements.

General Partnership

Two or more people who share in the profits or losses of the business, all of whom can act on behalf of one another.

Formalities of existence

Generally inexpensive and simple to create and maintain;no formal documents need be filed with the state.

Liability

Each partner is personally liable for any acts of the others, and all partners are personally responsible for the debts and liabilities of the business.

Taxation (pass-through or double)

Generally not subject to federal income taxes. Income, gains, deductions, and losses are generally reported on the partners’ individual federal income tax returns.

Centralized management

Unless specified otherwise in the partnership agreement, all partners have the ability to enter contracts and make business decisions.

Flexibility in sharing profits and control

Flexible in sharing profits and control; can create ownership interests that would provide preferential treatment with regard to profits and/or management participation.

Transferability of interests

Typically, a partner cannot sell his or her partnership interest unless this right is specified in the agreement or every partner consents to the transfer. Sale of interests dissolves the partnership for nontax purposes.

Limited Partnership

Combines limited liability and centralized management; has more than one class of partners: general and limited

Formalities of existence

Relatively inexpensive and simple. Requires more effort thana general partnership; governed by state law and a partnership agreement.

Liability

Limited partners receive liability protection as long as they do not participate in the management of the business; general partners remain personally liable.

Taxation (pass-through or double)

Pass-through entities; partners pay a tax on the profits. Partnership must file an “informational” return with the IRS.

Centralized management

General partners manage the partnership.

Flexibility in sharing profits and control

Flexible in sharing profits and control; can create ownership interests that would provide preferential treatment with regard to profits and/or management participation.

Transferability of interests

Generally, partners can transfer their interests without restriction. But they cannot sell their interest unless this right is specified in the agreement or every partner consents to the transfer. This sale dissolves the partnership for nontax purposes.

Limited Liability Partnership

Offers protection from personal liability;a good alternative to an LLC

Formalities of existence

Forming LLPs may be quite simple, but they have more formalities of existence than general partnerships.

Liability

Partners face personal liability for their own negligence and that of an employee they directly supervise.Please note: The scope of liability protection varies and is defined by state statute.

Taxation (pass-through or double)

Pass-through entity; profits are taxed only once, at the individual owner level.

Centralized management

General partners manage the partnership.

Flexibility in sharing profits and control

N/A

Transferability of interests

Transfer of LLP ownership interests can dissolve theLLP unless provisions in the agreement state otherwise.

Limited Liability Company

Combines pass-through taxation with limited liability; a hybrid of a partnership and a corporation

Formalities of existence

May be relatively inexpensive and simple to create and maintain. Requires more effort than a general partnership because it is a creature of state law.

Liability

Generally, the LLC, not the individual partners, is liable for business obligations.

Taxation (pass-through or double)

Can be taxed as either a corporation or a partnership. Usually taxed as a partnership, an LLC offers pass-through taxation.

Centralized management

Can have centralized management; all members can participate in management, or the members may elect a small committee of managers.

Flexibility in sharing profits and control

Flexible in sharing profits and control; can create ownership interests that would provide preferential treatment with regard to profits and/or management participation.

Transferability of interests

Members typically cannot sell their interest unless this right is specified in the agreement or every member consents to the transfer. Otherwise, the sale may dissolve the LLC for nontax purposes.

A partnership may not be the best choice of entity for a business that anticipates an initial public offering (IPO) in the near future. Although there are publicly traded partnerships, most IPO candidates are organized as corporations.


Corporations.

Corporations offer some advantages over sole proprietorships and partnerships, but they also come with drawbacks. The two most important advantages are that corporations provide the greatest shield from individual liability and are the easiest type of entity to use to raise capital and to transfer interests. (The majority stockholder can usually sell his or her stock without restrictions.) Corporations are generally subject to federal income tax, however, so the distributed earnings of your incorporated business may be subject to corporate income tax, as well as individual income tax.

C Corporation

A legal entity that assumes a separate legal and tax life from its shareholders

Formalities of existence

Very difficult and expensive entity to form and maintain. Subject to strict regulation by both local and federal government.

Liability

Limited liability; generally liability for corporate action is limited to the extent of the share holders investments in the corporation.

Taxation (pass-through or double)

Subject to double taxation; profits are taxable first at the corporate level and again at the individual level when and if they are distributed to the shareholders as dividends. Shareholders cannot deduct losses from their personal income.

Centralized management

Centralized management through a board of directors; shareholders indirectly participate in management by electing the board of directors and by voting on certain corporate issues.

Flexibility in sharing profits and control

Flexibility in sharing profits and control; can issue different classes of stock by which it can regulate who can exercise control over the corporation.

Transferability of interests

Interests can generally be transferred without restriction; shares of stock can generally be freely bought and sold without consequence to the entity structure.

S Corporation

Combines limited liability with pass-through taxation

Formalities of existence

All shareholders must consent to S corp election. Must satisfy several requirements to be eligible.

Liability

Limited liability; liability is generally limited to the extent of the shareholders’ investments in the corporation.

Taxation (pass-through or double)

Pass-through taxation; shareholders report the corporation’s income, gains, deductions, and losses on their individual federal income tax returns.

Centralized management

Centralized management; shareholders indirectly participate in management by electing the board of directors and by voting on certain corporate issues.

Flexibility in sharing profits and control

Limited to 100 shareholders; shareholders must meet certain eligibility criteria. Stock with different voting rights may be issued, but different classes such as preferred and common are not allowed.

Transferability of interests

N/A


Choosing the best form of ownership

There is no single best form of ownership for a business. Often, the limitations of a particular form of ownership can be compensated for through other means. For instance, insurance can reduce liability exposure if the chosen entity does not provide this kind of protection. Even after you have established your business as a particular entity, you may want to reevaluate your choice as the business evolves. We can work with an experienced attorney and tax advisor to help you decide which form of ownership is best for your business.

To choose or change business entities, contact MaPP at (330) 339-6413 or submit a form.

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