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When starting or operating a business, one of the most important decisions that you will make is what type of business entity you should choose. There are four main types of business entities: the sole proprietorship, a partnership, the limited liability company (LLC) and the corporation. Each type has advantages and disadvantages depending on the circumstances. When choosing a business entity, your ability to anticipate liability, taxes, ownership, management, exit strategies and other factors all play into the decision on which type is best suited for your business. It’s often advisable to contact a business lawyer to ensure the proper consideration and understanding of the pros and cons of each type of entity.
► Sole proprietorships: Most small companies in America are sole proprietorships. It is the most basic way in which to conduct business. There are no formalities to follow and all taxes are reported on the owner’s individual income tax.
Using a sole proprietorship really means you are just conducting business yourself. There is no separation of your personal or business assets and liabilities, which means that if the business has a liability, then you do as well. There is no liability protection. Your house, car and any personal assets can be used to satisfy any liability that arises in your business. If you operate a business that has the potential to create any liabilities, then you probably will want to consider one of the other types of business entities so you can protect your personal assets from the business assets.
► Partnerships: A partnership is a type of business entity that has various forms. There are general partnerships, limited partnerships and other, less common variations. A general partnership is like a sole proprietorship except that there are two or more partners conducting business together. A general partnership is not recommended typically because it doesn’t provide liability protection (like the sole proprietorship). A limited partnership can provide some liability protection, but it would have to be structured properly.
In all cases, the partners should have a written agreement that sets forth who is doing what, management items, financing and operational items, and who else can be involved as partners or owners. Partnerships are taxed as a “flow-through” entity because the income is taxed at the individual owner level. Partnerships are not as common these days due to the advent of the limited liability company.
► Limited liability companies: A limited liability company (LLC) is a very popular choice of entity for many small businesses. It has a lot of flexibility to allow the owners (members) to decide how they want to operate the business. It provides liability protection for all the owners and is taxed as a “flow-through” entity. A written agreement called an “operating agreement” would be strongly recommended if there are two or more owners. You can use an LLC even if you are a sole owner, thus giving you liability protection that the sole proprietorship doesn’t. It is the combination of liability protection and tax benefits that makes this type of entity very popular with small businesses.
► Corporations: Corporations come in two main types: the “S corporation” and the “C corporation.” The difference is in how they are taxed and who can be shareholders (or owners). All corporations protect their shareholders from liability incurred by the business.
The C corporation is taxed on its profits (a corporate tax), and when it distributes dividends to its shareholders, the shareholders are taxed on those distributions. This results in what is commonly known as “double taxation.” S corporations can achieve a “flow-through” tax (avoiding double taxation), but there are limits on the number of shareholders, type of shareholders, and stock types.
Corporations have to follow state laws and have more formalities than other business types. Many investors, however, will only invest in corporations, and getting your employees or consultants stock options or equity incentives is often more easily achieved with a corporation.
Because of the various complexities and pros and cons associated with each type of entity, careful consideration and foresight into your business is a must. The good news is that you can change from one entity type to another if your circumstances change. Find a professional who is well versed in this area, grab your crystal ball, and together the right entity choice will be determined.
In next month’s column, we’ll explore sources of financing.
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Fritz Battcher is a partner at Holland & Hart LLP (www.hollandhart.com/reno) where he helps clients navigate the complex strategies of mergers and acquisitions, public and private securities offerings and other corporate matters.
NCET (www.NCET.org) is a member-supported nonprofit organization that helps people explore business and technology.