When you start a new business there are many decisions to be made, but one of the first and most important is what form of legal entity your business will take. The entity type you choose will have lasting effects including how you are protected under the law and affected by income tax regulations, so it is important to have clear reasons for your decision and think long-term when making your choice.

This decision is likely to be influenced by how you choose to organize your operations and whether you intend to work on your own or in conjunction with others, but this cannot and should not be the only deciding factor for your entity type. You should also be considering how you expect your business to run in the future and what changes you expect to make in the coming years.

There are five basic forms of business organizations, sole proprietorship, partnership, limited liability company (LLC) or partnership (LLP), C corporation, and S corporation.

A sole proprietorship is typically a business owned and operated by one individual or often, a married couple . It is a business that is unincorporated and not considered a legal entity but is instead an extension of the individual who owns it. The owner has possession of all business assets and is directly responsible for all business debts and liabilities. All income and losses are reported on the owner’s Form 1040.

Since this business type does not require any specific legal organization outside of the usual licenses and permits that may be required to operate, it is the simplest form of business.

A partnership is a legal entity that has rights and responsibilities of its own under the law. It can sign contracts and borrow money. A partnership can take two legal forms, general or limited.

In a general partnership, two or more individuals join to run the business and each individual has ownership of company assets, authority in running the business and responsibility for liabilities. How partners share authority, share profits and losses, and hold responsibility for liabilities may all be modified by a partnership agreement. However, regardless of the agreement, creditors may pursue the personal assets of any of the partners to settle debts owed by the partnership in most cases. A partnership agreement is not required, but it is a good idea to create and maintain one to make sure there is clarity in the responsibilities and obligations of partners. 

In a limited partnership, one or more general partners are responsible for running the business and are liable for partnership debts while one or more limited partners contribute capital and share in the profits or losses of the business, but do not share in the running of the business or responsibility for partnership debts.

A partnership typically does not pay income tax, but instead must file an annual information return (Form 1065) reporting income, gains, losses, and deductions. The business passes through profits or losses to its partners who each report their share of the partnership’s income or loss on their individual tax return using a Schedule K-1 provided by the partnership’s return.

An LLC or LLP is an unincorporated organization of two or more persons permitted to be formed by the laws of the state to enter business transactions. This entity is formed to provide a business entity that can protect its members from personal liability for debts and obligations of the business. Usually an LLC/LLP is classified as a partnership for federal filing, but it can elect to be taxed as a C corporation and could elect S corporation treatment.

A C corporation is a separate legal entity formed under the authority of state law with essentially all the legal rights of an individual which is entirely responsible for its own debts. Usually, the owners or shareholders of a C corporation are protected from the liabilities of the entity although small C corporations may be required by creditors to provide personal guarantees from the principal owners to receive credit. A C corporation must adopt and file articles of incorporation and by-laws which govern its rights and obligations to its shareholders, directors, and officers.

A C corporation must file income tax returns and pay taxes on its income to both the IRS and any states in which it does business. The elections made in a corporation’s initial tax returns can have significant impact on how the business is taxed in the future, so it is important to ensure you seek the advice of business-oriented accountants in addition to competent legal counsel while setting up a corporation.

The legal protection afforded the owners of a corporation can far outweigh the additional expense of starting and administering a C corporation. Incorporating a business allows for several other advantages such as the ease of bringing in additional capital through the sale of equity or allowing an individual to sell or transfer their interest in the business. It also provides for business continuity when the original owners choose to retire or sell their interest.

An S corporation is a corporation that could be a C corporation or even a single member LLC but has elected for S corporation tax treatment.  This change in entity type comes with significant differences. Unlike a C corporation, the income or loss generated by the S corporation flows through to the shareholders. Any income is taxed on the individual federal tax return and any loss is deductible to the extent of basis for the individual . However S corporations potentially still could be taxed directly at a state level. In addition, this change in status changes the treatment of fringe benefits for shareholders of more than two percent. One pitfall to S corporation status is that otherwise tax-free benefits to the shareholders are taxable to them as compensation, ensuring the deduction at the corporate level.

Electing to file as an S corporation may help save on taxes if the individual rates are lower than the corporate rates. It also avoids double taxation upon sale of corporate assets or if the corporation is liquidated. This status can also help avoid some excessive compensation problems  by taking additional S corporation distributions over reasonable compensation while retaining limited liability for shareholders. However, this status can introduce some limitations that may not make it worthwhile for a corporation including limiting the number of shareholders to 100, only one class of stock available, shareholders must be U.S. resident individuals, the entity must use a calendar year end (with few exceptions), and more.

Each entity type has its own benefits and drawbacks, so it is important to make sure you have a full picture before committing to your decision. Talk with a tax advisor with expertise in business entities as well as experienced legal counsel to make sure your long-term vision for your company matches up with the entity type you plan to move forward with.