Should you Incorporate? The good, bad and ugly about entity selection

Incorporate?  Form an LLC?   Be a sole proprietor?   Selecting the right entity structure is an important issue for every enterprise.    The best choice isn’t always obvious, and it can have a dramatic legal and financial impact on you.

Over 75% of business owners chose the path of least resistance; they operate as Sole Proprietors.  This can cost them their home, their savings, and other personal assets.  For this reason, it ranks high on our our list of The Seven Deadly Sins of Small Business. 

DEADLY SIN #3:   Lack of Entity Selection

There are several forms to choose from; sole proprietor, corporation, LLC, or partnership.  No single form of entity is appropriate for every type of business owner, so it’s wise to seek competent professional advice to help you choose the form best-suited to your particular situation.

That said, here’s a brief overview of the good, the bad, and the ugly for each entity choice:

SOLE PROPRIETOR

If you are the only owner in the business, and you take no action to form any of the other forms or entities listed below, then you–by default–are a sole proprietor.  For taxes and legal purposes, you and your business are indistinguishable.  The business net income (or loss) is reported on your personal 1040 tax return.  You are personally responsible for all the business debts, including all the taxes.

The Good: It’s simple. It’s free from most legal formalities and red tape. You can move monies out of your business account with few limitations.

The Bad:  There’s no legal shield to protect your boat, your bank accounts, or personal assets from business obligations. You’re limited in regard to tax breaks available to corporations (for life, health, and medical insurance , for example).

The Ugly:  You pay self-employment tax (15.3%) on every dollar of net income (ouch!).

CORPORATION

The word “corporation” brings to mind GM, AT&T, GE… businesses so big we know them by their initials!  But you don’t have to be huge to benefit from incorporating.  The question is… should you?

A corporation is a separate legal person from it’s owner(s), and comes into being when it’s organizers file articles of incorporation with their state. All corporations begin as C Corporations, but may elect S status with the IRS.

The Good:  Favorable tax treatment related to fringe benefits. Owners not held liable for corporate debt. Ownership freely transferable to other shareholders. Useful device for estate planning.

The Bad:  Initial costs to create, plus annual costs to operate.  More formalities and red tape.

The Ugly: C Corporations are subject to two levels of income taxes; once at the corporate level and again when the corporation makes distributions to shareholders.  The good news is S Corporations escape double taxation because they operate as pass through entities, though electing S Corp status foregoes some of the favorable tax treatment related to fringe benefits noted above.

LLC (LIMITED LIABILITY COMPANY)

An LLC is an increasingly popular way to organize a small business; it’s estimated that about one-third of all new businesses choose this form.  But unlike corporations, which have been around for hundreds of years, the first LLCs began forming  in the 1980s in Wyoming.   Given it’s a relatively newer form of business structure, there still remain some grey areas in the minds of some legal experts.

An LLC is a hybrid.  It’s treated like a corporation for legal liability purposes, but for tax purposes can choose to be taxed as either a corporation, a partnership, or a sole proprietorship.

The Good.  The LLC protects its owners personal assets from business creditors. Owners’ (called ‘members’) liability for LLC debt is limited to their ownership interest.  Owners can directly run the business without needing a Board of Directors. Transfer of ownership between members is easy to execute. Favorable for situations involving passive investors, non US investors, and joint ventures.

The Bad.   There’s one exception to rule that LLC member’s personal assets are protected from business creditors; the IRS (and probably your state tax authority, too) can collect delinquent LLC payroll taxes directly from members.

The Ugly. Let me get back to you on this.

PARTNERSHIP

By definition, this is an unincorporated entity with at least two partners, organized to carry on a trade or business. There is no formal registration required (no formal anything).  It comes into being as soon as two or more persons join together to conduct business.

The Good:   Two heads are better than one.  No red tape.  Losses can be deducted on partners personal tax returns.  No formal action required to terminate the business

The Bad: Potential deadlock if partners don’t agree on management of the business. Partnership interests not freely transferable.  Death, bankruptcy, or unilateral decision of one partner to withdraw from the partnership will result in dissolution.

The Ugly: Each partner is personally responsible for the partnership obligations incurred by other partners.  Read that sentence again and you’ll understand why one of my business professors always scowled that partnerships were only good for two things:  (1.) dancing, and  (2.) …. uh, let’s just say the second one’s not done in a business setting.

THE BOTTOM LINE

There’s no “one size fits all” best choice when it comes to entity selection for your business.  This overview is not intended to provide legal advice or recommend the solution that’s best suited to your particular situation.

ANCHOR ON THIS:   Choosing to do nothing when it comes to entity selection is not smart business.  Get competent advice to help you work your way through the choice-of-entity maze.  Doing so will minimize your taxes, and provide optimal legal protection.

 

 

 

 

 

 

 

 

 

 

 

 

 

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