Incorporation 101: What Type Of Legal Entity Should I Choose?

Which Business Entity Is Right For Me?

Once decided to become involved in a new business venture, how would you know which legal entity is the right for you? The choice of entity would influence many aspects of the life of your business, from taxation to liability limitation and more.

Let's start by reviewing the most common types of entities, available for people doing business in the United States.

Sole Proprietorship

A sole proprietorship is a type of business entity which is owned and run by one individual and where there is no legal distinction between the owner and the business. All profits and all losses accrue to the owner (subject to taxation). All assets of the business are owned by the proprietor and all debts of the business are his debts and he must pay them from his personal resources, meaning that the owner has unlimited liability.

A sole proprietor may do business with a trade name other than his or her legal name. This also allows the proprietor to open a business account with banking institutions. It is a "sole" proprietorship in the sense that the owner has no partners. 

Establishing a sole proprietorship is cheap and relatively uncomplicated. You don't have to file any papers to set it up - you create a sole proprietorship just by going into business. In other words, if you'll be the only owner of the business you're starting; your business will automatically be a sole proprietorship, unless you incorporate it or organize it as an LLC. Of course, you do have to get the same business licenses and permits as any other company that goes into the same business. It is also advised to register a DBA ("Doing Business As") name with the state for your business.

Advantages of Sole Proprietorship:

• One takes all the profits of the business - no corporative taxes on the profits made,
• No double taxation,
• Easy to start up,
• Relatively fewer regulation,
• Full control over the business,
• Easy to discontinue,
• Quick decision process and no opposition when taking a decision.

Disadvantages of Sole Proprietorship:

• Unlimited liability - owner of the business is responsible for the business's debts,
• If business becomes successful, the risks accompanying the business tend to grow,
• Hard time raising capital - owner has to make up for all the business's funds,
• Sole proprietor is responsible for his or her own health insurance.

C-Corporation

C-Corporation is a type of business entity that is organized under specific provisions of the General Corporation Law. A Corporation must have corporate officers and bylaws, and must be registered with the State. In addition, the corporation will be taxed at the State and Federal level on its earnings.

A corporation offers the protection from personal liability for the owners. This "corporate veil" of protection does not offer protection from liability in the case of fraud, failure to pay taxes, under capitalization of the corporation, or commingling of personal and corporate funds.

Most major companies (and many smaller companies) are treated as C-Corporations for Federal income tax purposes.

Advantages of C-Corporation:

• Limited Liability - owners of the business are not personally responsible for the business's debts,
• A corporation may qualify as a C-Corporation without regard to any limit on the number of shareholders, foreign or domestic.

Disadvantages of C-Corporation:

• Double taxation - C-Corporations are subject to corporate taxes, therefore creating the effect of double taxation (first on corporative level, and then on shareholders' personal level).

S-Corporation

Similar to the C-Corporation, S-Corporation offers all the benefits of a corporation, but with a different tax structure. S-Corporations pay no Federal income tax, but pay state level tax. S-Corporation's shareholders report the company's income or losses on their personal tax returns.

Despite the obvious tax benefits, S-Corporation comes with several restrictions. Major restrictions are:

• Can't have more then 100 shareholders,
• All shareholders must be physical entities - or simply put, real persons, not corporations, partnerships, etc (there are few exceptions for non-profits),
• All shareholders must be U.S. citizens or residents,
• Must have only one class of stock.

Limited Liability Company (LLC)

LLC combines the limited liability protection of a corporation (hence the name) with the flexibility and pass through taxation of a partnership/sole proprietorship. Like the shareholders of a corporation, the owners (members) of an LLC are not personally responsible for the debts or liabilities of the LLC.

The LLC has no limitations on who may be involved, and it can be managed by its members or by managers. It is often more flexible than a corporation and it is well-suited for companies with a single owner.

Advantages of LLC:

• Limited Liability - owners of the business are not personally responsible for the business's debts,
• No double taxation,
• No limits on number of members.

Disadvantages of LLC:

• Usually more expensive to form and/or renew.

So Which Type of Entity Is Right For Me?

The answer to this question depends strictly on your specific needs and circumstances. We always recommend our clients to discuss those specifics with a professional CPA or business attorney, however, it is equally important to educate yourself prior to scheduling appointments. After all, it is your business.