When an entrepreneur starts a new business operation, one of the first questions (s)he deals with is the form of business existence. There are a multitude of entities that the law allows. This article describes the four main types and the decision making model that an entrepreneur should follow in determining the best for the business.
Each state is different in what is allowed within the code, but the four most common types of operations are Sole Proprietorship, a Limited Liability Company, a partnership, and the Corporation. The following explains the attributes of each and how it is viewed by the Internal Revenue Service.
Sole Proprietorship (Self-Employed)
By far the simplest of all business entities to create, simply put use your name. In general, this type of operation does not have to be established with the State Corporation Commission because it is legally not separated from the individual operating the business. Documentation is low or practically nonexistent; you simply obtain your business license at your local Commissioner of the Revenue and you may begin operations. For the IRS, you can go online to http://www.irs.gov/pub/irs-pdf/fss4.pdf and prepare the document to establish a Federal Employer Identification Number (EIN or FEIN). This number allows you to hire employees and begin operations. The best reasons to operate in this format follow:
• You plan to operate/manage the business as a one person operation
• You have very little if any wealth to protect
• Little and easy documentation of business operations
• Low risk factors as it relates to your customers (little to no physical interaction with customers such as on-line selling, writing, office support, etc)
• Easy to file the taxes, only the Schedule C and SE are required as an attachment to your Form 1040 (you use the EIN obtained from above on your Schedule C)
• Less overall annual costs (around $600 to $1,000/year savings) due to no annual filing requirements with the State Corporation Commission and no separate tax return required
For more information about the sole proprietorship, read the following article: Basics of Sole Proprietorships.
Limited Liability Company
You are first required to establish this entity with your State Corporation Commission. It requires a few documents and of course, a fee of $100 or so depending on the state. What this does is to allow you to operate as a recognized entity and, therefore, protect you from lawsuits and certain types of civil issues. You have to obtain an EIN from the IRS as discussed above. The IRS requires you to file a separate tax return depending on your elections. For most folks, specifically those operating as one man operations, it is only necessary to file a Schedule C along with the associated SE to your personal Form 1040. However, if there are two or more individuals involved, you may either file as a partnership (only in the eyes of the IRS) Form 1065, or as a corporation via Form 1120(S).
This type of entity protects you from losing much of your acquired wealth. However, please take caution, most banking institutions or lending vehicles require you to provide your personal assets as collateral in loan negotiations. It only really protects you from the customer or vendor aspect of business operations.
The drawbacks include the annual filing fee, and the additional costs of preparing a tax return beyond the traditional Form 1040 documents. In effect, the average annual costs for this form of entity status is between $1,000 and $2,000, depending on the nature of your business.
I would encourage anyone hiring staff to have this as the minimum level of entity status no matter what your wealth circumstances may be. For some strange reason, employees have a tendency to get into or cause trouble and the owner is the one that pays.
Very similar in nature to the Limited Liability Company but has some unique advantages. It does allow for greater flexibility in the relationship between the parties as negotiated in the documents (partnership agreement). In general, most states do not require this form of entity to file a report with the State Corporation Commission. However, the IRS still requires a separate EIN and a tax return each year – Form 1065.
Oftentimes, folks create partnerships when they don’t even realize that they have. We do it every day in our interactions with others “If you’ll go to the restaurant with me, I’ll buy the food”. In effect, a partnership deal was generated, but no real outside activity is performed to earn money. But the key is that a relationship was established to carry out an end goal. It’s similar to a formalized contractual arrangement between two or more individuals.
You don’t see this type of entity status too often in our modern day litigious society. However, this is an effective tool in real estate deals where no renovations are required, thereby very little risk of lawsuit from outside entities (contractors, suppliers, tenants). Partnerships are generally more successful between family members due to greater trust between the partners in short term, low risk tasks.
For more information about partnerships, please read the following article: Principles of Partnerships .
This is the most common business entity created. It requires an annual filing with the State Corporation Commission and a separate tax return. As identified above, the IRS requires a separate EIN and the respective tax returns.
This is the best option if dealing with customers, vendors, and employees on a daily basis. Furthermore, it is the best option if hiring staff and negotiating agreements with banks or other types of lending institutions. It has the following advantages:
• A lot of case law history to protect the shareholders
• Plenty of IRS statues to provide guidance in operations
• Excellent tool for retirement plans, especially for the shareholders that are employed by the business
• For small business operations, a very low to no taxation if business is conducted with the guidance of a CPA
• A lot of flexibility for benefits accruing to shareholders
• An excellent tool for family businesses, especially in succession plans
There are some drawbacks, including significant yearly costs associated with the accounting aspect and legal requirements. In general, this type of entity works well for families with significant wealth and/or complex family issues (disabled members, many family members and divorce issues).
For more information about corporations, please read the following article: Why Incorporate?
When choosing the best entity for your situation, document the elements identified above and then, consult with your attorney and a CPA. Then talk with another CPA, and ask questions related to what you have learned thus far. The best entity status most likely has already come to light in your mind after reviewing the elements above, but it is necessary for professional confirmation to reaffirm your decision. Act on Knowledge.