Choice of Business Entity

Ronald P. Adams

Selecting the right type of entity to conduct your business must be given careful consideration. Selecting the wrong type can adversely impact both your protection against creditor claims and your tax liability. The following briefly describes the various alternatives from which you can choose.

Sole Proprietorship. The simplest legal structure. Assets and liabilities belong entirely to one individual. The owner does not have protection from liability risks associated with the business. Income and expenses from the business are reported on Schedule C of the owner’s individual tax return (Form 1040). Net income is subject to both social security and income taxes.

Partnership. Two or more individuals or entities are needed to form a partnership. In both general and limited partnerships, business income and expenses are channeled to the partners to be reported on their individual tax returns. The general partners in a limited partnership are personally liable for the entity’s obligations, while the limited partners are liable only to the extent of their capital contributions.

C Corporation. Under a C corporation, the business is a separate and distinct legal entity with its own rights and responsibilities. The owners (shareholders) of a C corporation are not personally liable for the corporation’s debts. C corporation earnings are taxed twice -- first at the corporate level, and again when earnings are distributed to shareholders. C corporations must comply with several legal and accounting formalities (for example, establishing and operating under documents of incorporation, electing officers and directors, holding directors’ meetings, keeping minutes of such meetings, filing corporate annual reports and income tax returns).

S Corporation. An S corporation is a corporation that elects to comply with a special set of tax rules. These entities have traits of both C corporations and partnerships. Owners of an S corporation have the same liability protection available in a C corporation structure; however, business income and expenses are passed through to the owners (as in a partnership). An S corporation is limited to 75 qualifying shareholders, and can have only one class of stock.

Limited Liability Company. The owners of an LLC (members) generally are not liable for the debts of the business, except to the extent of their investment. Unlike an S corporation, there are no limitations on the number and type of owners of an LLC. Unlike a C corporation, the earnings of an LLC are not subject to an entity-level tax. Rather, the net income flows through to the owners in proportion to their interests in the entity’s profits. The proportional earnings are included in the members’ individual returns.

Limited Liability Partnership. An LLP is essentially a partnership, general or limited, that has filed a registration statement with the Arizona Secretary of State's Office. As a result, the LLP’s owners have liability protection. Annual filings are thereafter required to maintain that liability protection.