When starting a business, one of the most important decisions you will make is choosing the right business entity. Clients call our small business attorneys to ask “what type of business entity should I form for my business?” The answer to this question affects many aspects of your business, including your taxes, legal liabilities, and management structure. The right business entity can protect your personal assets and simplify your taxes, while the wrong choice can leave you vulnerable to lawsuits and other risks.
With so many options available, and lots of (mis)information on the internet, it can be overwhelming to decide which business entity is right for you. In this comprehensive guide and blog post, we will help you understand the different types of business entities and provide tips on how to choose the best one for your business.
Sole Proprietorship
A sole proprietorship is the simplest and most common form of business entity. As the sole owner, you have complete control over the business and all its profits and losses. However, you are personally liable for all debts and legal liabilities of the business, which means your personal assets are at risk.
At Lopes Law, we generally advise clients to avoid doing business as a sole proprietorship. The liability risks are too high because sole proprietorships do not provide any legal separation between the business and the owner. As a sole proprietor, the owner and the business are essentially the same entity, which means that the owner is personally liable for all of the business's debts and obligations. This means that if the business is sued or incurs debts that it can't pay, the owner's personal assets, such as their home or personal savings, can be at risk. This lack of legal separation also makes it difficult to raise capital or secure loans, as banks and investors are often hesitant to lend money to sole proprietors without collateral or a track record of business success.
Additionally, sole proprietors are typically subject to a higher self-employment tax rate than other business entities, which can result in a higher overall tax burden. By choosing to operate as a different type of business entity, such as an LLC, corporation, or partnership, individuals can limit their personal liability, improve their ability to raise capital, and potentially reduce their tax burden.
If you have additional questions about sole proprietorships, consult with a small business attorney at Lopes Law, to determine the best business entity for your specific situation and goals.
Partnership
A partnership is a business owned by two or more people who share in the profits and losses of the business. Partnerships can take two forms: general partnerships and limited partnerships.
General Partnerships
In a general partnership, all partners share equally in the management of the business and are jointly and severally liable for the business's debts and legal liabilities. This means that each partner is responsible for the full amount of the partnership's obligations, regardless of their individual contribution to the business. In other words, if the partnership is sued or cannot pay its debts, each partner can be held personally liable for the full amount.
Limited Partnerships
In contrast, in a limited partnership, there are one or more general partners who manage the business and are personally liable for the business's debts and legal liabilities, and one or more limited partners who contribute capital but have limited liability. Limited partners are typically passive investors who do not participate in the management of the business and are only liable for the amount of their investment in the partnership. This means that their personal assets are generally protected from the partnership's creditors.
Partnerships are governed by partnership agreements, which set forth the rights and responsibilities of each partner, as well as the terms and conditions of the partnership. Partnerships are also subject to state laws, which vary by state.
One of the advantages of a partnership is that it is relatively easy and inexpensive to form compared to other business entities, such as corporations. Partnerships also offer flexibility in terms of management and taxation. Partnerships are generally taxed as pass-through entities, which means that the profits and losses of the business are passed through to the partners, who report them on their personal income tax returns.
However, partnerships also have some significant drawbacks. Partnerships can be less stable than other business entities, as they are subject to the personal financial situations and decisions of each partner. Additionally, partnerships can be complicated by disagreements among partners over management decisions or profit sharing.
Overall, partnerships can be a good option for businesses that are owned and operated by two or more individuals who want to share in the management and profits of the business. It's important to consult with a legal or financial professional to determine whether a partnership is the right business entity for your specific situation and goals.
Can two LLCs (or other entities) form a partnership or joint venture?
Yes. Forming a partnership or joint venture between two or more businesses can provide a number of benefits, such as combining resources and expertise, sharing risk and expenses, and expanding into new markets or industries (all while maintaining the separate limited liability protect for the individuals who own each entity).
A partnership or joint venture between two LLCs is typically formed by entering into a partnership agreement or joint venture agreement, which sets forth the terms and conditions of the partnership or joint venture. This agreement outlines the rights and responsibilities of each LLC, as well as the purpose, scope, and duration of the partnership or joint venture. When two LLCs form a partnership or joint venture, they retain their separate legal identities and continue to operate as separate businesses. However, they share in the management, profits, and losses of the partnership or joint venture.
It's important to note that forming a partnership or joint venture involves some level of risk, as each LLC is jointly and severally liable for the partnership or joint venture's debts and obligations. As such, it's important to carefully review and negotiate the terms of the partnership or joint venture agreement, as well as consult with legal and financial professionals to ensure that the partnership or joint venture is structured in a way that is beneficial and minimizes risk for all parties involved.
Overall, forming a partnership or joint venture between two LLCs can be a strategic and effective way to achieve business goals and growth. However, it's important to carefully consider the potential benefits and risks before entering into any type of business arrangement.
Limited Liability Company (LLC)
A LLC is a popular type of business entity that offers the best of both worlds when it comes to liability protection and tax benefits. As a flexible business structure, LLCs provide their owners with personal liability protection, meaning that their personal assets are typically shielded from any debts or legal liabilities incurred by the business.
In addition to liability protection, LLCs also offer several tax benefits. Unlike corporations, which are subject to double taxation (i.e., the corporation is taxed on its profits, and then the shareholders are taxed again on their share of the profits), LLCs are pass-through entities. This means that the business itself is not taxed at the federal level; rather, the profits and losses are "passed through" to the owners' personal tax returns, and they are taxed at their individual tax rates.
Long story short: LLCs offer personal liability protection for the business owners, but they are also subject to self-employment taxes.
This pass-through taxation is a significant advantage for LLC owners, as it avoids the double taxation issue that corporations face. Additionally, LLC owners can take advantage of certain deductions and expenses that are not available to corporations, such as the ability to deduct business losses against their other income on their personal tax returns.
It's worth noting that while LLCs offer liability protection, there are certain circumstances in which an owner's personal assets may be at risk. For example, if an LLC owner personally guarantees a loan or debt for the business, they may be personally liable if the business is unable to repay the debt. It's important to consult with legal and financial professionals to fully understand the scope of liability protection offered by an LLC and to take steps to protect personal assets.
Overall, an LLC can be a highly effective business structure for small business owners, entrepreneurs, and investors. With its combination of liability protection and tax benefits, an LLC offers a flexible and attractive option for those looking to start or grow a business.
If you need help with the PA LLC Act or NJ LLC Act, click here to read more about how we can help you.
Corporation
A corporation is a legal entity that is separate from its owners. It is owned by shareholders who elect a board of directors to manage the company. The biggest advantage of a corporation is that it offers personal liability protection for its shareholders, but it is subject to double taxation, meaning that the corporation is taxed on its profits and the shareholders are taxed on their dividends.
S Corporation
A Subchapter S Corporation, or S Corp for short, is a type of corporation that provides liability protection to its shareholders while offering certain tax benefits. Like LLCs, S Corporations are considered pass-through entities, meaning that the profits and losses of the corporation pass through to the shareholders' personal tax returns. This means that the corporation itself is not taxed on its income; instead, the shareholders are taxed on their share of the profits.
To qualify for S Corporation status, the corporation must meet certain eligibility requirements set forth by the Internal Revenue Service (IRS). One of the key requirements is that the corporation must have no more than 100 shareholders. Additionally, the corporation must be a domestic corporation, have only one class of stock, and its shareholders must be individuals, certain trusts, or estates.
One significant advantage of S Corporations is that they offer the liability protection of a corporation. Shareholders are generally not personally liable for the corporation's debts or legal liabilities, as the corporation is considered a separate legal entity. This means that shareholders' personal assets are typically protected in the event of a lawsuit or bankruptcy.
Another advantage of S Corporations is that they offer certain tax benefits. While S Corporations are not taxed at the corporate level, shareholders must pay themselves a "reasonable" salary, which is subject to employment taxes. However, any remaining profits are distributed to the shareholders as dividends, which are not subject to self-employment taxes. This can result in significant tax savings for S Corporation shareholders compared to other types of business entities.
It's worth noting that forming an S Corporation can be more complex than forming other types of entities. The corporation must meet certain eligibility requirements, and there are additional formalities and filing requirements that must be followed to maintain S Corporation status.
Contact Lopes Law to speak with a tax attorney or small business lawyer who can help you determine if a S Corporation is the right choice for your business.
C Corporation
A Subchapter C Corporation, or C Corp for short, is a type of corporation that is considered a separate legal entity from its owners or shareholders. This means that the corporation is taxed on its profits at the corporate income tax rate, and the shareholders are also taxed on any dividends they receive from the corporation. This double taxation can sometimes be a disadvantage for C Corporations, especially for small businesses that do not need to retain earnings or reinvest profits.
However, C Corporations offer significant advantages for businesses that are looking for unlimited growth potential and the ability to raise capital by selling stock. C Corporations can sell shares of stock to raise capital, making it easier to attract outside investors and potentially raise large sums of money. Additionally, C Corporations can offer a variety of benefits and retirement plans to their employees, which can be tax-deductible expenses for the corporation.
Another advantage of C Corporations is that they offer personal liability protection for their shareholders. Shareholders are generally not personally liable for the corporation's debts or legal liabilities, as the corporation is considered a separate legal entity. This means that shareholders' personal assets are typically protected in the event of a lawsuit or bankruptcy.
It's worth noting that C Corporations are subject to a number of formalities and filing requirements that must be followed to maintain their legal and tax status. They are typically more complex and expensive to form and operate compared to other types of business entities, such as LLCs or S Corporations. Additionally, C Corporations are not the best choice for businesses with relatively low profits or those that do not plan to raise outside capital. However, for businesses that are looking for unlimited growth potential and personal liability protection, a C Corporation may be the best choice.
Contact Lopes Law to speak with a tax attorney or corporate lawyer who can help you determine if a C Corporation is the right choice for your business.
B Corporations
A B Corporation, also known as a Benefit Corporation, is a relatively new type of business entity that is designed to prioritize social and environmental goals over profits. B Corporations are required to meet rigorous standards of social and environmental performance, accountability, and transparency. They are certified by a third-party organization called B Lab, which evaluates their impact on society and the environment. B Corporations are not only legally bound to consider the impact of their decisions on their stakeholders, but they also have a fiduciary duty to create a positive impact on society and the environment. While B Corporations are still a relatively new concept, they are becoming increasingly popular among businesses that want to prioritize their social and environmental impact while still generating profits.
What about Doctors, Lawyers, and other Professionals (PLLC, PC, etc.)
Professional Limited Liability Companies (PLLCs) and Professional Corporations (PCs) are business entities that are designed for licensed professionals, such as doctors, lawyers, accountants, and architects. These entities offer personal liability protection to the owners while allowing them to maintain their professional licenses. In a PLLC, the owners are referred to as members, while in a PC, they are referred to as shareholders. PLLCs and PCs are subject to certain state regulations and licensing requirements, and their ownership is usually restricted to licensed professionals in the same field. Choosing between a PLLC or a PC depends on the specific regulations of your state and the structure and needs of your professional practice. It is important to consult with a legal or financial professional who is experienced in professional entity formation to ensure that you choose the right entity for your professional practice.
PLLCs and PCs are typically created by licensed professionals who want to protect their personal assets while maintaining their professional licenses. The specific regulations for creating a PLLC or PC can vary by state, but generally, the process involves filing articles of organization or incorporation with the state and obtaining any necessary licenses or permits. In some states, PLLCs and PCs may be required to have a certain number of licensed professionals as owners, and the ownership may be restricted to professionals in the same field. It is important to consult with a legal or financial professional who is experienced in professional entity formation to ensure that you meet all the necessary requirements and regulations for your state.
In Pennsylvania, for example, professionals such as attorneys, doctors, pharmacists, accountants, architects, and engineers can form a Professional Corporation (PC) or Professional Limited Liability Company (PLLC) to protect their personal assets while maintaining their professional licenses.
To form a PLLC in Pennsylvania, all of the members must be licensed in the same profession, and the name of the PLLC must include "Professional Limited Liability Company" or an abbreviation such as "PLLC" to indicate its status. Both PCs and PLLCs in Pennsylvania are required to file articles of incorporation or organization with the Pennsylvania Department of State and obtain any necessary licenses or permits.
It's important to note that the rules and regulations for PLLCs and PCs may vary by state, and it's important to consult with a legal or financial professional who is experienced in professional entity formation to ensure that you meet all the necessary requirements and regulations for your state.
How are PLLCs and PCs taxed?
PLLCs and PCs are taxed differently depending on how they are structured. By default, both PLLCs and PCs are taxed as pass-through entities, which means that the income and expenses of the business pass through to the individual owners, who report them on their personal income tax returns. The profits and losses are allocated to the owners based on their ownership percentage in the business.
However, PLLCs and PCs can also choose to be taxed as C corporations by filing Form 8832 with the Internal Revenue Service (IRS). If they elect to be taxed as C corporations, the business pays taxes on its profits at the corporate tax rate, and any dividends paid to the owners are also taxed at the individual level. This can sometimes result in double taxation, where the business is taxed at the corporate level and the owners are also taxed on their individual tax returns.
It's important to consult with a tax attorney or accountant to determine the most advantageous tax structure for your PLLC or PC, based on your specific circumstances and goals. You can contact Lopes Law if you are considering starting a PLLC or PC and need to speak with a tax attorney for assistance.
So which entity should you choose?
Choosing the right business entity for your business depends on several factors, including your business goals, management structure, and tax situation. Here are some tips to help you make the right choice:
Consider the level of personal liability protection you need
Evaluate the tax implications of each business entity
Think about the management structure you want for your business
Consider the ease and cost of formation and ongoing maintenance
Seek the advice of an business attorney (contact Lopes Law)
Still can’t decide, contact us for help in choosing the right business entity for you
Choosing the right business entity is a critical decision that can affect your business's success and longevity. We hope this comprehensive guide has helped you understand the different types of business entities and provided you with valuable tips on how to choose the best one for your business.
This guide is not a DIY guide, and not intended to be legal advice. This guide is here to help you better understand business organizations to make a better decision when seeking the advice of a legal or financial professional.
Our advice: contact Lopes Law now for a FREE consultation to help you decide which business entity is right for your business. Our business lawyers can help you make an informed decision and avoid costly mistakes.
We are your business lawyer Philadelphia (click here for more information). We represent businesses in Philadelphia, Pittsburgh, Lancaster, and Harrisburg, as well as NJ businesses.