Choosing an entity type in the United States
23 January 2017
Different U.S. entity types such as corporations, partnerships and LLCs have pros and cons. Read this article on the most commonly used entity choices
This article, authored by Fred Farkouh of NY accounting firm Farkouh, Furman & Faccio, is the second article in our series on setting up a business in the United States and provides a basic overview of the different types of entity on offer when doing business in the U.S. The choice taken by a business owner must take into account the business' needs as they relate to the tax and non-tax advantages and disadvantages.
Five entity types
Whether you’re dealing with a start-up or a business already in existence, choosing the right entity type is important. It will determine the liability exposure of the company’s owners and the taxability of the company under federal and state laws, as well as the ability to raise funds and the continuity of the business. Deciding on an entity type is challenging as there are advantages and disadvantages to each. The five most commonly utilized entity choices are Corporations, S corporations, Partnerships, Limited Liability Companies, and Sole Proprietorships. Each has various laws that govern their operations and tax filing obligations—these will often be complex.
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Corporations are usually organized through the filing of a corporate State charter. Once the corporation is organized under State law, it is typically accepted as a corporation for Federal income tax purposes. An election may also be made (“check-the-box election”) to treat certain entity types as corporations for Federal income tax purposes.
The most well-known characteristic of Corporations is that they are taxed at the entity level separate from their owners. The owners contribute money or other property to the corporation in exchange for its stock, there are no restrictions on the number of shareholders, and changes in ownership do not affect the continuity of the business. The owners’ liability in the Corporation is limited to their investment in the Corporation. Corporations also have the flexibility to raise capital by issuing stock or debt.
One disadvantage of organizing as a Corporation is that corporate earnings, which have already been taxed at the corporate level, are taxed to the shareholders when they are distributed as dividends.
A Partnership is defined as “an association of two or more persons who carry on as co-owners in a business for profit.” Like S corporations, Partnerships are taxed as flow-through entities for Federal income tax purposes. It is usually recommended that Partnerships have a written partnership agreement that encompasses the partners’ understanding of the business venture.
Partnerships can be further classified as either general or limited. In a General Partnership, all the partners conduct business jointly and have unlimited liability—putting their personal assets at risk to satisfy partnership obligations. On the other hand, the Limited Partnership has a general partner and a limited partner. The general partner manages the business and has unlimited liability, while the limited partner has limited liability up to the amount invested in the partnership and cannot participate in partnership management.
S corporations have a similar organizational structure to C corporations, however to qualify as an S corporation, the business must make an election to be taxed under Subchapter S of the tax code. This election continues for the lifetime of the entity, unless it is terminated.
Once an election to be taxed under Subchapter S is made, the entity is treated as a pass-through entity for Federal income tax purposes; this means that its income is only taxed once at the shareholder level, thus avoiding the double taxation issue that exists with Corporations. S corporations are limited to only one class of stock and are subject to restrictions on the number and types of shareholders (no more than 100 shareholders). These limits on the number of shareholders and classes of stock are often seen as disadvantages of the S corporation structure. Other disadvantages include less flexibility in allocating income and losses, and the fact that certain states may not recognize the S-corporation election.
Limited liability companies (LLCs)
In the last few years, Limited Liability Companies (LLCs) have become one of the most commonly utlized entity types. An LLC and its operations are formed and governed under state law. By default, an LLC with one member is taxed as an entity disregarded as separate from its owner, and an LLC with two members is taxed as a partnership. LLCs can make the “check-the box” election to be taxed as a corporation; this flexibility is one of the main advantages of an LLC.
An LLC is similar to a corporation in that its members have limited liability and there is no requirement for any member to have unlimited liability as in the case of a general partner, however it is like a partnership in that it is treated as a flow-through entity (unless an election to tax it as a corporation has been made).
A Sole Proprietorship is the least formal type of entity - generally there are no legal forms to be filed during formation. All business or management decisions are made by the sole proprietor, but the sole proprietor may hire employees to assist with the business' operation. This type of structure is normally used for small businesses.
The main drawback of a Sole Proprietorship is that the proprietor is personally liable for all business expenses—therefore, there is no liability protection for the sole proprietor’s assets. Furthermore, since the business is typically operated by a single individual, in many cases the business will not not have a successor.