Types of Business Entities (#296)
/In this podcast episode, we discuss the various types of business entities. Key points made are noted below.
The Sole Proprietorship
Let’s start with the sole proprietorship. It’s not incorporated. In fact, it’s really just an extension of the person who owns it. This means that the owner is entitled to the entire net worth of the business, and is also personally liable for all of its debts. It has no legal existence without the owner.
A sole proprietorship is a pass-through entity, which means that its financial results go straight through to the personal tax return of the owner. It’s generally OK to use any losses from the business to offset any other income the owner might have earned, unless the IRS decides that the business is not being run to earn a profit. In this case, the business is considered a hobby, so the owner can only deduct hobby losses up to the amount of any hobby income.
You generally want to stay away from a sole proprietorship because of the unlimited personal liability issue, and because you can’t sell shares in the business to get more funding. And that’s because there aren’t any shares.
The Partnership Entity
Next up is the partnership entity. In this case, the partners share in the profits and losses, and are also personally liable for its liabilities. Once again, it’s a pass-through entity, so its profits and losses are reported on the partners’ tax returns. There’s usually a partnership agreement that states the ownership percentages and how profits and losses are split among the owners. As was the case with a sole proprietorship, using a partnership is not always the best idea, because of that personal liability issue. Another problem is that the partners are taxed on the income of the partnership, even when the income hasn’t yet been distributed to them – which can cause some cash flow issues for the partners when the taxes are due for payment.
However, you can keep adding partners, which makes it a better vehicle than a sole proprietorship for raising money.
You can get around the unlimited liability issue by setting up a limited partnership. Under this arrangement, limited partners are only liable up to the amount of their investment. The party who actually runs the limited partnership is called the general partner, and he, she or it still has unlimited liability – but at least that’s just one of the partners, not all of them. Unfortunately, this feature comes with a downside, which is that the limited partners have no control over the business.
The C Corporation
Next up is the C corporation. This is an entirely separate entity, so it’s taxed on its own income – it doesn’t flow through to the shareholders. Instead, the corporation files its own tax return and pays its own taxes. However, the shareholders are sill subject to something called double taxation, which occurs when the company pays them dividends. In this case, the company has already paid taxes on its own income, and then the shareholders have to pay taxes on any dividends received – so the same income is taxed twice.
Despite the double taxation issue, C corporations are great for raising money. They can sell shares to investors, and raise lots of cash. Also, if the shares are registered, shareholders can fairly easily sell their shares to other investors. And on top of that, the corporation acts as a liability shield, so the shareholders are not liable for the debts of the business. This is why most really large businesses are C corporations.
The S Corporation
A variation on the C corporation is the S corporation. It’s basically the same thing, expect that its profits and losses flow straight through to its shareholders. If you don’t have many shareholders, it can make sense to convert a C corporation into an S corporation, to avoid the double taxation issue. And it still provides shareholders with protection from the liabilities of the business, so it’s generally better than a C corporation. The main problem with an S corporation is that it has to transfer most of its excess cash to the shareholders, so that they can pay their tax bills. This can be a problem when the business also needs the cash.
The Limited Liability Corporation
And finally, we have the limited liability corporation. It gives its members protection from the liabilities of the business, and passes through its earnings to them – sort of like an S corporation. An LLC is created by state statute, so its characteristics vary a bit, depending on the state. But generally, it’s treated like a partnership for tax reporting purposes. A key difference between an LLC and an S corporation is that an LLC has no cap on the number of members, while an S corporation is capped at 100.
How to Select a Business Entity
These entities are much more complex than the summary I’ve just given. There’re also issues with things like the self-employment tax, ownership basis, and the number of classes of shares you can offer, but I think I’ve touched upon the essential characteristics of each entity type.
So when would you use each one? It depends on your specific circumstances, but I’ll provide a few examples. Let’s say you have a small family-owned business, so there aren’t many shareholders. In this case, an S corporation would be a good choice, since it provides liability protection.
If you’re running a business that’s growing really fast, then a good choice is a C corporation – because you can sell shares to lots of investors, to raise money. And finally, if you’re investing in real estate, it can make sense to form a limited partnership, since that format gives the limited partners some protection from creditors.