The Pros & Cons of Corporate Entity Formations
The business entity formation by an individual or individuals will impact a business owner’s taxes, access to types of capital, and risk exposure. To establish your business entity the business owner will need to register in the state your business is headquartered. While various states will recognize a significant number of corporate entities, the traditional small-business owner will encounter six options:
- Sole Proprietorship
- General Partnership
- Limited Partnership
- Limited Liability Company
While some of these entities are entirely up to the business owner, there are aspects that will narrow the scope of the decision. For example, if you have more than one owner you are unable to form a sole proprietorship because that is limited to only one owner. A C-Corporation pays taxes at the corporate level and any distributions are paid at the individual level. It is commonly referred to having double taxation and it also has greater federal and state requirements than partnerships, proprietorships or LLCs.
Sole Proprietorships have the advantage that there is no need to register it with the state, but depending on the business’ industry and state the business owner will need to pursue local business licenses and/or permits. This entity is utilized for those with one owner. Overall, less than 10% of the businesses Expansion Capital Group (ECG) finances are sole proprietorships.
|Easy to establish – don’t need to register||Lack of liability coverage – |
business owner is responsible for all liabilities
|Income or loss is utilized on personal tax return||Personal assets at risk|
|Tax filing is quick and easy||Capital / Financing becomes more difficult as it runs the risk of being classified as personal loan|
|Less structure around corporate / board duties|
Given the disadvantages, many small businesses will start as a sole proprietorship but quickly transition to another form to cover liability risk.
The key difference between a partnership and sole proprietorship is a general partnership (GP) is conducive to when there are more than two owners. Typically, a partnership will either be a general partnerships or a limited partnership. Regardless of the type, all partners actively manage the business and share in the profits and losses and partnerships do not register with the state.
One of the critical elements of any partnership is the Partnership Agreement that is created at the onset. It is established to provide a clear understanding and protection against conflicts or disputes about the business. It will outline the (i) ownership structure; (ii) operational execution and decision making; (iii) decisioning and dispute resolution; (iv) why the company exists; and (v) employee base, along with hiring and firing capabilities / decisioning. Partnerships that are successful often align ownership interests and are a result of a shared vision for the company.
|Easy to establish – don’t need to register||Owner liable for debts and liabilities|
|Less paperwork, not expensive to establish, and simple to dissolve when partners decide to go their own way||Risk of liability for other partner behavior or actions|
|Profits and losses allocated based on ownership||Not a registered entity which can make it difficult when dealing with banks, customers, or vendors|
|Tax deduction of losses|
An alternative form of a general partnership is a limited partnership (LP).
A Limited Partnership has become the key vehicle for the world of private equity. It is a registered business entity and the owners must file paperwork with the state. Partners in an LP consist of operating partners (hands on in the business) and investors or passive partners. The operating partners assume the liability for the LP, while the investors, often referred to as limited partners, have minimal control over the business. Operators tend to utilize the LP structure when raising a large capital base from many investors.
The other option under this structure is a limited liability partnership (LLP). ECG as a capital provider backs a number of these companies and most states have certain regulations that only allow it to be utilized by businesses operating as accountants, legal advisors, medical professionals and other professional service firms. The rationale for utilizing is so a partner can avoid liability due to a partner’s actions. Given between 7% and 10% of ECG’s business is medical, the most common thing we hear is doctors that want to mitigate unlimited burden due to another doctors’ actions.
Limited Liability Company (LLCs)
Expansion Capital Group operates as an LLC and a significant number of the businesses we provide capital to operate as LLCs. The advantage is protection of personal assets and when the business owner doesn’t intend to raise additional equity from many outside investors this is usually the best option. It also positions the business to raise outside debt capital versus a sole proprietorship where there is always a question of if it is a personal or business loan. This entity must have a registered Federal Employer Identification Number (FEIN) as well as a business bank account and is governed by an operating agreement that clearly outlines member accountability, voting governance, spending and operational limits, and any other key items that require total member (or Board) votes. Like a partnership, an LLC is referred to as a pass-through entity thus for tax purposes the owners are only taxed once as a form of personal income.
|Single taxation, as personal taxes||Given profits are pass-through, higher self-employment taxes|
|Less burdensome on filings and paperwork||Less attractive to larger, institutional investors – favors smaller individual investors|
|Governed by operating agreement which provides the business owner major flexibility to outline or negotiate with investors|
A corporation (C-Corp) separates the entity from its owners. It provides the greatest protection to its owners from personal liability but the challenge for small businesses is it is also the most costly to form and operate. Small businesses are the largest number of operating companies in the U.S., but larger companies (public and private) do tend to have the larger employee bases given their scale. Prior to the Pandemic, pass-throughs represented 95% of the operating businesses in the U.S. while only 5% were C-Corps. While costs are the biggest challenge for a small business to operate as a C-Corp, there are other considerations to consider.
|Limited Liability benefits for ownership||Complexity and resources to manage and maintain|
|Ownership is more easily transferable versus a pass-through||Double taxation|
|Entity life extends beyond founders||Higher degrees of regulation and compliance|
|Capital access more easily attained||Less flexible for structures or pursuing other options|
An alternative to the C-Corp is an S-Corp, which operates as a hybrid. It offers the limited liability protections that are associated with a C-Corp, but for tax purposes it is established as a pass-through entity. Thus, profits and losses are passed through to the owners on their personal taxes. This eliminates the double taxation issue often discussed in C-Corps. To form or convert an existing entity to an S-Corp, it requires filing Form 2553 with the IRS. This can be done on offerings such as LegalZoom relatively quickly for a nominal cost and the filing costs are often tax deductible. There are three things to note with an S-Corp as a business owner considers it.
- An S-Corp is limited to 100 shareholders. This potentially can minimize the ability to take the company public or attract various investors.
- Shareholders must be individuals (there are a few exceptions you should consult with legal representation) and a US citizen or resident.
- There can only be one class of stock.
Ultimately your decision as a small business owner on the entity you will form to operate will impact your risk, tax base, and ability to raise capital. Understanding the costs and benefit of each is required to understand which path fits your business needs. It is highly recommended you make the investment to consult with a tax and legal professional as you make this decision. Many small businesses that access capital from Expansion Capital Group start as sole proprietorships or general partnerships, but as they grow, they look to limit liability and form LLCs, LLPs, or corporations. Consulting and planning with a professional is the best way to set your business up for success.