Before starting a business, it is vital to carefully choose which form of business entity you want to establish. There are many factors to take into consideration, including the type of business, what your day-to-day operations will involve, the level of personal risk and tax liability, to name a few. Seeking the counsel of an experienced corporate business attorney to advise you on the options that are available to you, help you choose wisely and assist you in setting up your business entity can make the process much easier and ensure that you strike the right balance between the benefits and legal protections different entities offer.
Things to Consider When Choosing a Business Entity
Considering federal, state and local legal and tax considerations when you form a business entity is essential. The type of entity you choose affects –
your personal liability,
your capacity to raise capital for your company,
the amount you will pay in taxes, and
the type of paperwork you must file to create and maintain your business entity.
You should decide on a business entity before you register your business with the state. A small business legal advisor who is well-versed in the laws and regulations surrounding the formation of business entities in Pennsylvania can provide invaluable guidance that will protect your rights and ensure you choose an entity that meets your unique needs. Once you have chosen a business entity, he or she can help you obtain a federal tax ID number, assist you with registering a business in PA, and file all other required paperwork. Failing to properly register your business can result in serious tax consequences, unintended dissolution and other problems down the road.
There many different factors that should be taken into account before you choose your business entity:
The degree of control-How much control do you want to have when it comes to investing, day-to-day operations and other business-related issues? The size, financing needs, complexity of the business and other issues should be taken into account when thinking about the degree of control you want to have over your business.
The cost of a business entity-How much will your chosen business entity cost to establish? It’s important to be aware of government fees, regulatory costs and other fiduciary concerns.
Your ability to raise capital-How will you raise money for your business? The ways you can raise cash for your business vary depending on the type of entity you choose.
Personal liability– Which entity will best help you avoid personal liability? Some forms of ownership provide protection from personal liability for business owners.
Federal, state and local taxation-What are the tax advantages and disadvantages of each business entity? The size and type of the business play an important role in this decision. It’s also important to keep business succession plans in mind.
Profit division– How will you divide the profits generated by your business? There are several different ways to divide profits that can also have an effect on your ability to raise capital.
Business succession planning-How do you plan to continue or pass on your business when you retire or if a sudden illness, injury or death should occur? Do you want to transfer business ownership to a family member or someone else? The type of business entity you choose can have a significant impact on these intentions being carried out according to plan.
A sole proprietorship is owned by one individual and gives that person total control of his or her business. A sole proprietor is also entitled to all profits from the business. While it does present a few advantages, sole proprietorship is typically unsuitable for a business that needs outside sources of capital for rapid growth.
Complete control of your business and profits can come with a cost. As a sole proprietor, you will be personally liable for all facets of the business, including creditor claims, damages from lawsuits and paying all taxes owed by the business. If you have substantial personal assets, sole proprietorship is most likely not the best option for your business entity.
Federal taxes due are paid through the owner’s personal income tax return, and are subject to federal self-employment tax, which varies depending on your income. In Pennsylvania, sole proprietors must pay state income tax and local wage taxes on income from the business as well.
If a sole proprietor wants to sell a business, potential buyers may not want to pay as much as they would for a business entity such as a corporation, particularly when a business has built a good name for itself over time. Having an effective business exit strategy in place at the very beginning can help you decide how you would want to sell your business when it’s time. Family business transition planning can also help you decide how you will handle passing your business assets on to your loved ones in the event of your death.
In Pennsylvania, the profit and losses from a partnership pass directly into the partners’ personal incomes. Depending on the type of partnership, you may be fully personally liable for your business’s debts. Some partnerships offer limited liability, which can protect your assets from certain kinds of debt.
General Partnership (GP)
General partnerships are a fairly simple business entity, but do not offer liability protection. All earnings, losses, and various business expenses are included in a GP partner’s personal income.
Limited Partnership (LP)
Limited partnerships work well for companies that need capital without added executive complications. LPs include limited partners, who invest in the company but do not have any managerial involvement. They are not liable for the company’s debts beyond their capital investment. Just like with general partnerships, they pay taxes on their income on personal returns.
Limited Liability Limited Partnership (LLLP)
Business owners who want to limit their personal liability, raise capital, and retain direct control over their business may create limited liability limited partnerships. LLLPs offer liability protection to limited partners for any business debts outside their investment. General partners enjoy protection from certain types of business debts.
There are a few different types of corporations, but they are all business entities that are separate from their owners. Corporations can make a profit, be taxed, and can be held legally liable. Regular C corporations are typically a good choice for medium- or higher-risk businesses, those that need to raise money, and businesses that plan to “go public” or eventually be sold. Corporations have an advantage when it comes to raising capital because they can raise funds through the sale of stock, which can also be a benefit in attracting employees. When forming a corporation, your business attorney can help you come up with business succession planning strategies that address issues surrounding the sale or transfer of your business.
Corporations pay income tax on their profits. In some cases, profits are taxed twice — first, when the company turns a profit, and again when shareholders claim dividends on their personal tax returns. Corporations offer the strongest protection from personal liability, but the cost to form a corporation is higher than other business entities.
S corporations are designed to avoid this type of double taxation. S corporations allow profit, and some losses, to be passed directly to the owners’ personal income without being subject to corporate tax rates. They must file with the IRS to get S corporation status, which is a different process from registering with the state. Special limits are placed on S corporations and strict filing and operational processes must be followed.
Often called 501(c)(3)s, nonprofit corporations are formed to serve charitable, educational or religious purposes. Because their work benefits the public, nonprofits may receive tax-exempt status. Nonprofits must file with the IRS to get tax exemption and follow stringent rules about what they do with any profits they earn.
Limited Liability Company (LLC)
An LLC lets you take advantage of the benefits of both the corporation and partnership, and protects you from personal liability in most cases.
An LLC allows you to avoid paying corporate taxes, and profits and losses can be passed through your personal income. However, owners of an LLC must pay self-employment tax contributions toward Medicare and Social Security. Medium- or higher-risk businesses, owners with significant personal assets, and those who wish to avoid paying corporate taxes can benefit from choosing an LLC.