Attributes of different entities - Choosing a Business Entity

When launching a new venture, one of the first decisions you will make is determining which structure, or "entity," your business will assume. Depending on which entity you choose, the decision may affect your own and your business's tax situation, the level of protection your personal assets (including your home) receive, and the amount of control you have over the business.

Following is a brief primer to help guide you in your choice. You may want to consult a qualified attorney or CPA before making your final decision.

Attributes of different entities

Formalities of existence Some types of entities are simple and inexpensive to form and maintain, while others must meet specific requirements. If you want to keep the overall management of your business as simple as possible, you might choose an entity with few formalities.

Liability

Chances are you've heard the term "limited liability." An entity that offers limited liability means that an owner can lose nothing more than his or her investment in the business. Personal assets--such as a home and personal savings/investment accounts--are insulated and cannot be used to satisfy an owner's financial obligations. On the other hand, some entities offer little in terms of liability protection. When choosing an entity, consider carefully how much you are willing to risk.

Taxation

Some entities are considered "pass-through," which means profits pass to the owners for income tax purposes. By contrast, businesses that are not structured as pass-through entities are required to pay taxes at the corporate level.

Although it may be tempting at first to avoid a pass-through entity--thereby avoiding a personal income tax obligation on all of the company's profits--in reality it may be more beneficial to structure your business in this manner. The reason? As a separate taxpaying entity, the business will pay taxes on the corporate profits, and any dividends that are passed on to the owners will be subject to taxes again on the owners' individual income tax returns. This is known as "double taxation." Of course, the final decision depends on your unique needs, as well as those of the business and any partners you may have.

Example: Assume that Shareholder A is the owner and sole shareholder for Acme Corporation, a pass-through entity, and is in the 35% individual income tax bracket. Acme Corporation has $100,000 in profits, which are passed along to Shareholder A. The total tax obligation is $35,000 ($100,000 x 0.35).

Example: Now let's assume that Acme is not a pass-through organization and is in the 34% corporate tax bracket. With $100,000 in corporate profits, Acme would pay $34,000 in taxes ($100,000 x 0.34). If the remaining $66,000 is then passed to Shareholder A in the form of dividends, the amount would be taxed again at the 15% qualified dividend rate, resulting in an additional tax obligation of $9,900 ($66,000 x 0.15). The combined effective tax rate in this example is 43.9%, or $43,900, $8,900 higher than in the first example.

These examples have been simplified for illustrative purposes. Actual results would differ.

Centralized management

Some entities permit centralized management, while others do not. An entity has centralized management if a person or relatively small group of people (such as a board of directors) has responsibility for making key governance decisions. If you hope to manage the bulk of the major decision making within a small group of people, choose a structure with centralized management.

Flexibility in sharing profits and control

Some entities are more flexible than others in sharing profits with their owners (including the types of stock that can be issued). If you would like to maintain control over distribution of the profits, keep this point in mind when selecting an entity.

Continuity of life

Some entities can "live" forever, even when an owner dies, goes bankrupt, retires, or becomes incapacitated or disabled in some way. Others are required to dissolve upon these events.

Transferability of interests

Free transferability of interests exists when owners are permitted to sell their ownership interests to others without restriction. Some types of entities restrict an owner's ability to transfer interests.