Small Business: What Entity Should I Consider?
December 2, 2008
By Philip I. Frankel, Small-Biz Focus, July/August 2008
This article first appeared in the July/August 2008 issue of Small-Biz Focus produced by Support Services Alliance, Inc. (SSA).
Perhaps the most common question I receive from prospective start ups is, "Which legal form should my business take?" Deciding on which entity choice is right for your business involves consideration of not only your current plans, your future expectations and tax considerations. The ease and low cost of creating certain entity types may create headaches later if your business grows or takes on new partners. This is a preliminary overview of the main entity choices which most New York business owners elect together with some advantages/disadvantages for each. [There are other considerations that should be considered, but are outside the boundaries of this Article.]
A sole proprietorship refers to a single-owner business and can be the most advantageous entity choice for a small business owner. It is simple and inexpensive to form (simply file an Assumed Name Certificate with the County Clerk). The owner retains complete control over all decisions and keeps all of the business's profits. For tax purposes, items of income and loss are reported on the proprietor's personal tax return.
The main disadvantage for a sole proprietorship is that the owner has unlimited exposure for liability. If a sole proprietorship is sued, the owner's personal assets are at risk. Insurance is critical to maintain in a sole proprietorship.
A partnership is an association of two or more people who share ownership and control over a business. Generally, a partnership is treated similarly to a sole proprietorship for management, tax, and registration purposes. But while partnerships do not need to register with New York, it is important that partners have an agreement which dictates how decisions will be made, profits shared, and disputes resolved. Disagreements frequently arise over the amount of time, energy, and money each partner contributes to the business. Oral agreements are hard to enforce. Each partner remains personally liable for the partnership debts.
One way partners may minimize their liability for the partnership's debts is to create "Limited Partnerships." A limited partner is one who invests in the company, but does not retain control over the day-to-day operations. A limited partner's liability is capped at the amount he/she invested in the partnership.
A corporation is a legal separate entity from those who own it. Corporations can be sued, taxed, and enter into contractual agreements. The main advantage of a corporation is that its owners (shareholders) and managers (officers and directors) generally cannot be held liable for a corporation's debts and can only lose what they have invested in the company. For tax purposes this is know as a "C" corporation.
The main disadvantage of incorporating your business is the concept of double taxation. A "C" corporation is taxed at the corporate level and the monies later paid to the shareholders are then taxable to the shareholders. However, corporations with fewer than 75 shareholders (and certain other restrictions) may file as an "S" corporation. Unlike a "C" corporation, an "S" corporation allows pass-through tax treatment to eliminate the double taxation. This is filed on both the federal and state tax basis. Another disadvantage to creating a corporation is the burdensome initial requirements. It is very structured and formal in its operations. All corporations must create by-laws, have annual meetings, and pay an annual "franchise" fee to New York State even if never does any business. Other expenses include Shareholder Agreements to protect the integrity and continuity of the company in the event of certain unforeseen events.
Limited Liability Companies
Limited liability companies (LLCs) often present business the "best of both worlds" -- the limited liability of a corporation along with the pass-through tax advantages of a partnership. They have quickly replaced partnerships and corporations since New York began recognizing this entity type in 1994. This entity choice offers limited liability to every owner, regardless of involvement in the company. LLC's, however, like corporations must register with the state and pay an annual fee, have an operating agreement and go through the costly obligation of newspaper publication in its formation. The decision to create this entity should be made upfront since the conversion of a corporation to a LLC can be quite costly tax-wise.
These are a few of the many entity choices which a new NY business owner has available. As with any important business decision, it is a good idea to speak with a lawyer and accountant before deciding on which entity choice fits your business's needs. There are many long-term implications to an entity choice, so be sure to check with professionals before making this important decision.