Entity Formation

Types of Entities and Why They Matter

A business starts with an idea which turns into a product or service which then produces income. Entrepreneurs are thinking about running with their ideas to make that income, and are generally not thinking about liability and tax strategy. Liability and tax structure, among other things, is determined by the type of business you have and the legal entity structure of your business. The three main type of legal entity structures are a sole proprietorship, limited liability company, and a corporation.

Sole Proprietorship

A sole proprietorship, or sole prop for short, is you operating a business in your own name or under a dba. There is typically no registration of your business with the state. You have full personal liability for the debts and risks of your business whether it is a product or a service and you pay taxes on the complete gross income of the business including self-employment tax.   

Two people operating a business in this way together is a partnership. A partnership can limit liability of each partner in a limited liability partnership by using a partnership agreement. We can help by assessing your situation to determine if a sole prop or partnership is the type of legal entity structure that best suits your tax strategy and appetite for risk. We can also help by drafting partnership agreements.

Limited Liability Company (LLC)

An LLC is a business structure that begins with state registration. It is a separate entity for liability purposes. This means that, in many cases, a person can only reach the assets of the LLC in a lawsuit. That means that your personal assets, such as your house, cannot be reached. Conversely, an LLC generally has pass through tax qualities. This means that you pay tax on the gross income of the LLC on your personal tax return equivalent to the percent interest you have in the LLC. The taxes include both income taxes and self-employment tax on the full amount of that gross income. We can help with the state registration of your LLC as well as the drafting of an operation agreement between the members to spell out how the company will be run.

Corporation (C Corp)

A C Corp is a legal structure that is registered with the state as a complete separate entity from shareholders. This means that there is generally no liability risk to shareholders. The tradeoff for the reduction of risk is double taxation. A C Corp is taxed on income first on the corporate level to the company at a corporate rate, then, when dividends are made to the shareholders.  The shareholders pay tax on that same income on their personal tax returns their individual rate. We help clients to form a C Corps on a limited basis. 

Subchapter S Corporation (S Corp)

An S Corp is an elected tax status. When you form your business as a C Corp or LLC you can elect to be taxed in this manner. An S Corp has pass through taxation, which means that a C Corp can escape double taxation by having shareholders pay taxes on their personal tax returns. In the case of an LLC, the members pay income tax on their respective share of the gross income to the business. However, self-employment tax is not paid on the money left to operate the business. In short, making an S Corp tax election can help reduce a business’s tax burden. We can help to explain how and S Corp tax election can benefit your business and assist in making that transition.

Disclaimer:  Do not rely on the above information as legal advice.  This information does not create an attorney-client relationship. This information is for informational purposes only and is not meant to be legal advice. You should seek legal counsel from an attorney when approaching a Small Business Law issue to be sure you have appropriate representation.  Past results do not guarantee future results.

Ready to Start Your Business?

Contact us for your free consultation if you are ready to start or structure your business and need further explanation of the benefits and pitfalls of the various legal entities.