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The Importance of Choosing the Right Business Entity

Among the first decisions a business owner or practicing professional must make is the best business entity for their organization. This is a crucial decision when starting business because it has far-reaching legal and tax consequences. So you must have a vision for your company for the long term as you decide what entity to use.

Some advisors will suggest that your business be a sole proprietorship is fine if you’re the only owner and plan to report your taxes on your own 1040. Although a sole proprietorship is the simplest way to run your business, doing so has disadvantages that can be very significant. Any of the available limited liability business entity types will give much better protection to the business’s owners than a sole proprietorship.

Here are the key factors to consider when choosing your company’s form:

Liability protection. Each of the available entity types offers a particular degree of protection for their personal assets from their business activities. Sole proprietorships and the general partners of partnerships have personal liability for the activities of their entities.

Taxation. A corporation can be taxed as a completely separate entity from the owners (AKA a “C Corporation”), or elect to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code (AKA an “S Corporation”).

A major disadvantage of a C-corporation is its double-tax treatment (“double taxation”), meaning that the corporation’s income is taxed and then any distributions paid to shareholders are also taxed. By making an S election, a corporation’s income passes through the entity to its owners, who report that income on their personal tax returns much like a sole proprietorship or partnership. Therefore, a S-corporation eliminates double taxation.

LLCs can be taxed in four different ways, so please consult with an attorney and a CPA before deciding how your LLC will be taxed.

Income Tax for Employee-Owners. Consider how you will be receiving the benefit of your work. Will you be taking distributions of profit? Will you be taking a salary? Distributions of profit aren’t subject to payroll taxes, but they are subject to regular income tax.

Salaried employees pay half of their own payroll taxes, allowing the company to pay the other half. You must know how you are going to be compensated under each structure to reduce your income and payroll taxes as much as legally possible.

Shares and Voting Rights. Each entity has different mechanisms for ownership and control/management. Don’t overlook your management vision when deciding which form to use. Who will be active in the business? Who will be passive investors? Who will have a vote in the affairs of the business? Do you want to “go public”? Do you want to have an employee stock ownership plan in the future? Are you going to want to give your children some part of your business but don’t want them to have any role in management until they’re ready?

Future Sale. Another key issue is the future sale of the company in light of the business’ potential growth. If the company is a holding company for growth investments and real estate, a partnership structure may be more advantageous at later sale to avoid a tax on possible “phantom gain” or gain that you have to pay tax on, but for which you never really received the income.

Answering these questions will help determine which form is best for the present and the future.

Whether you choose a corporation, a partnership, a limited liability company, or some other entity, take the time to consider each of these factors fully. Once in place, changing entities is possible but can be difficult.

If you’re a small business or mid-size business owner, call us today at 888-597-9685 to schedule your comprehensive LIFT (legal, insurance, financial and tax) Foundation Audit. Normally, this session is $1,250, but if you mention this article and we still have room on our calendar this month, we will waive that fee.

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