One of the most important and impactful decisions every business owner must make concerns the entity selection for his or her company. There are many different entity types, different entity types, including sole proprietorships, general partnerships, limited liability companies (“LLCs”), and corporations, just to name a few. Each has its own unique risks and rewards, as well as tax, legal, and operational implications, which makes selecting the right entity of significant importance. In selecting the entity that best meets the needs and objectives of your business, consider the following:
- Liability Protection. The primary reason business owners choose to incorporate or organize an LLC as opposed to operating as a sole proprietorship or general partnership is to protect their personal assets from the liabilities of the business. Corporation and LLC owners cannot be held personally liable for debts, liabilities, and legal judgments against the company based on ownership alone. Sole proprietors and general partners in a partnership can be held personally liable for these liabilities because sole proprietorships and partnerships are not considered separate entities from their owners.
- Tax Treatment. Double taxation is an unfortunate reality for many business owners. A corporation formed under state law that does not make an additional tax election is taxed under Subchapter C of the Internal Revenue Code (“IRC”), and is therefore commonly known as a C corporation. C corporations pay income taxes on their business income, and any distributions made to the entity’s shareholders are taxed again at the individual level.
- Unincorporated entities, such as partnerships and limited liability companies, avoid this double taxation because these entities do not pay their own income taxes, but rather the owners of the entity pay tax on their share of the entity’s taxable income. Similarly, eligible entities that select to be taxed under Subchapter S of the IRC, sometimes called S corporations, can also avoid double taxation. S corporations are also attractive to small business owners from a self-employment tax perspective.
- Ability to Raise Capital. When it comes to equity financing, C corporations offer the greatest flexibility in raising capital because they can easily issue stock to attract new investors and are more suitable for undertaking a public stock offering. S corporations are more limited in this regard, because there are restrictions on the number of shareholders and the classes of stock S corporations can offer. Partnerships and LLCs typically rely on owner contributions and debt financing to raise capital, because although they can also raise capital through equity financing, it can be a more cumbersome process than simply issuing new shares of stock. Still, in the right application, partnerships and LLCs can be useful in private equity offerings.
- Ease of Formation and Maintenance. The greatest feature of sole proprietorships and partnerships is their simplicity in formation and maintenance, but as discussed above, they offer few other benefits. Other entities incorporated or organized in Virginia must be registered and maintained through the Virginia State Corporation Commission (“SCC”) and adhere to recordkeeping rules to retain liability protections. Maintaining these records and ensuring the entity remains in good standing with the SCC can be costly and time consuming, but well worth the liability protections offered.
- Governance and Operations. Corporations are governed by bylaws adopted by the corporation’s board of directors. Corporate governance is generally more formal, which can be beneficial when the corporation is held by many owners. The corporation’s board of directors, which is elected by the corporation’s shareholders to make decisions on major company issues, appoints the officers of the corporation, which handle the company’s day-to-day operations.
Partnerships and LLCs are typically governed by a written agreement between the entity’s owners. Owners of LLCs and partnerships have great flexibility in drafting their governing documents and structuring the organization of the entity. General partnerships are governed and managed directly by the partners. LLC owners, also called members, can structure their entity as “member-managed” (managed by all members) or “manager-managed” (managed by managers designated by the members). The managers or managing members are responsible for the daily operations of the LLC.
In choosing the entity that best fits you and your business, a careful assessment of these and other considerations is necessary. It is not a “one size fits all” analysis, and even after the business owners decide on the appropriate entity, there are further tax, governance, and operational decisions that must be made. The attorneys at PLDR are well equipped to guide you through the entity selection maze and assist in organizing and structuring the entity that best fits the objectives of your business.