Basically, three separate categories of entities exist: partnerships, corporations, and limited
liability companies. Each category has its own advantages, disadvantages,and special rules. It is also possible to operate your business as a sole proprietorship without organizing as a separate business entity. Now that you’ve decided to start a new business or buy an existing one, you need to consider the form of business entity that’s right for you.
A sole proprietorship is the most straightforward way to structure your business entity. Sole
proprietorships are easy to set up–no separate entity must be formed. A sole proprietor’s
business is simply an extension of the sole proprietor.
Sole proprietors are liable for all business debts and other obligations the business might incur.
This means that your personal assets (e.g., your family’s home) can be subject to the claims of
your business’s creditors. For federal income tax purposes, all business income, gains, deductions,
or losses are reported on Schedule C of your Form 1040. A sole proprietorship is not subject to
corporate income tax. However, some expenses that might be deductible by a corporate business may
not be deductible by a business structured as a sole proprietorship. For example, health insurance
premiums, as of this writing, are not fully deductible for a sole proprietor.
If two or more people are the owners of a business, then a partnership is a viable option to
consider. Partnerships are organized in accordance with state statutes. However, certain
arrangements, like joint ventures, may be treated as partnerships for federal income tax purposes,
even if they do not comply with state law requirements for a partnership.
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.
In a partnership, two or more people form a business for mutual profit. In a general partnership,
all partners have the capacity to act on behalf of one another in furtherance of business
objectives. This also means that 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.
It is not necessary that each partner contribute equally or that all partners share equally. The
partnership agreement controls how profits are to be divided. It is not uncommon for one partner to
contribute a majority of the capital while another contributes the business acumen or contacts, and
the two share the profits equally.
Partnerships are a recognized entity in the sense that the entity can obtain credit, file for
bankruptcy, transfer property, and so on. However, the partnership itself is generally not subject
to federal income taxes (it does, however, file a federal income tax return). Instead, the income,
gains, deductions, and losses of the partnership are generally reported on the partners’ individual
federal income tax returns. The allocation of these items among the partners is governed by the
partnership agreement, subject to certain limitations.
A limited partnership differs from a general partnership in that a limited partnership has more
than one class of partners. A limited partnership must have at least one general partner (who is
usually the managing partner), but it also has one or more limited partner. The limited partner(s)
does not participate in the day-to-day running of the business and has no personal liability beyond
the amount of his or her agreed cash or other capital investment in the partnership.
Limited liability partnership
Some states have enacted statutes that provide for a new type of
partnership, the limited liability partnership (LLP). An LLP is a general partnership that provides individual partners protection against personal liability for certain partnership obligations. Exactly what is shielded from personal liability depends on state law. Since state laws on LLPs vary, make sure you consult competent legal counsel to understand the ramifications in your jurisdiction.
Corporations offer some advantages over sole proprietorships and partnerships, along with several
important drawbacks. The two greatest advantages of incorporating 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 (the majority stockholder can usually sell his or her stock without
However, corporations are generally subject to federal income tax. So, the distributed earnings of
your incorporated business may be subject to corporate income tax as well as individual income tax.
A corporation that has not elected to be treated as an S corporation for federal
income tax purposes is typically known as a C corporation. Traditionally, most incorporated
businesses have been C corporations. C corporations are not subject to the same qualification rules as S corporations and thus typically offer more flexibility in terms of stock ownership and equity structure. Another advantage that a C corporation has over an S corporation is that a C corporation can fully deduct most reasonable employee benefit costs, while an S corporation may not be able to deduct the full cost of certain benefits provided to 2 percent shareholders. Virtually all large corporations are C corporations.
A corporation must satisfy several requirements to be eligible for treatment as an S corporation
for federal income tax purposes. However, qualification as an S corporation offers a potential tax
benefit unavailable to a C corporation. If a qualifying corporation elects to be treated as an
S corporation for federal income tax purposes, then the income, gains, deductions, and losses of
the corporation are generally passed through to the shareholders. Thus, shareholders report the
S corporation’s income, gains, deductions, and losses on their individual federal income tax
returns, eliminating the potential for double taxation of corporate earnings in most circumstances.
However, many employee benefit deductions are not available for benefits provided to 2 percent
shareholders of an S corporation. For example, an S corporation can provide a cafeteria plan to its
employees, but the 2 percent shareholders cannot participate and receive the tax advantages that
such a plan provides.
It is important to note that S corporation treatment is not available to all corporations. It is
available only to qualifying corporations that file an election with the IRS. Qualifying
corporations must satisfy several requirements, including limitations on the number and type of
shareholders and on who can own stock in the corporation.
Limited liability company
A limited liability company (LLC) is a type of entity that provides
limitation of liability for owners, like a corporation. However, state law generally provides much more flexibility in the structuring and governance of an LLC as opposed to a corporation. In addition, most LLCs are treated as partnerships for federal income tax purposes, thus providing LLC members with pass-through tax treatment. Moreover, LLCs are not subject to the same qualification requirements that apply to S corporations. However, it should be noted that a corporation may be a better choice of entity than an LLC if an IPO is anticipated.
Choosing the best form of ownership
There is no single best form of ownership for a business. That’s partly because the limitations of a particular form of ownership can often be compensated for. For instance, a sole proprietor can often buy insurance coverage to reduce liability exposure, rather than form a limited liability entity.
Even after you have established your business as a particular entity, you may need to re-evaluate
your choice of entity as the business evolves. An experienced attorney and tax adviser can help you decide which form of ownership is best for your business.