Legal Entities – When and What Kind?

**Disclaimer: This is not to be construed as legal advice.

If you own a small business and run it as a sole proprietorship filing your taxes on a 1040 and a Schedule C, you may have at one time or another asked yourself if you should incorporate or otherwise change the business structure. Maybe it is because you need to hire one or more employees and want to manage growth, take out a business loan, any number of other factors. Perhaps you want to protect yourself from lawsuits or other liability. The question most sole proprietors have is – when and what kind. Do I form a LLC (Limited Liability Company), a Partnership, or a Corporation? What are the benefits and drawbacks of each form of entity?  A type of entity that might be right for one company might not be for another company even if that company sells the same product or service and has the same amount of revenue.

Sole Proprietorship – It is just you the owner. From a paperwork standpoint it is simpler. Taxes – just a Schedule C on the 1040 you already file. Fewer government regulations in most cases. Profits? They belong to you. But so do the negatives – things like lawsuits. All yours baby.  It is also the most common – especially in small one person businesses.

Partnership ­­­­- When two or more people join forces and pool resources, both having an ownership interest. There are multiple kinds of partnerships – general, limited, joint ventures and limited liability partnerships. If you are a sole proprietorship you are ruling this one out early unless you are bringing another owner on board. Even then until you look at your specific needs you won’t know if this is the structure for you.  From a tax perspective, you will file two returns – a 1065 partnership return (which is an information return only – all taxes are paid at the individual level) and your 1040 and Schedule C just like before you were a partnership.

Corporations – A corporation takes longer and is more expensive to set up, but has certain advantages over many other forms of legal entity. They are their own legal entity, completely separate from its owners and shareholders. There are four different types of corporations, but I will concentrate on the two most common. The C Corporation (regular or business) and S Corporation which has some of the advantages of a partnership or sole proprietorship, with advantages that regular or C Corporations have – Limited Liability. From a tax perspective, an S Corp is a flow through entity like a partnership or sole proprietorship. It can be taxed as a corporation or as a partnership. If your company is growing rapidly and you think you might want to issue stock through an IPO you may want to consider a C Corporation. But you will also have to have regular meetings of the Board of Directors and pay corporate taxes. (Form 1120 or 1120S)

Limited Liability Company (LLC) – A Limited Liability Company (LLC) is a kind of a hybrid type of entity that is designed to do what its name implies-limit owners liability. Rather than shareholders or stockholders, owners are called members. LLC’s are taxed much like an S Corporation. Owners get to choose to be taxed as a corporation or a partnership.  If you choose to file as a corporation you will file Form 1120 or 1120S, as a partnership a 1065 – assuming there are two or more members. If you are a Single Member LLC – you can choose to be a disregarded entity for tax purposes. What that means is you file a 1040 and a Schedule C.

There are other factors to consider as well of course. Management, Ownership Transition and Capitalization are some in addition to Personal Liability and Tax considerations.  Do your homework, then talk to your tax advisor and an attorney to help you determine what type of entity is going to be right for you and get the documents drawn up.

In terms of when, well that depends on you the owner. For some, choosing one of the above entities is something that you want to do before you open your doors. Others will wait until they are at least generating some revenue or hire the first employee. Others will wait even longer. There is no one size fits all right answer.


4 Replies to “Legal Entities – When and What Kind?”

  1. Hi Brad. Your post is great and would help a lot of readers understand the basic distinctions of legal business entities. In Philippine settings, not all of the above applies.

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