Updated: Jan 25
When starting a business, one of the significant questions an entrepreneur may miss is “What kind of business entity do I form?” In my experience, it is a question I’ve raised with potential clients, only to be met with the thousand yard stare. Yeah, you know what I’m talking about…think Ferris Bueller’s classmates stuck in a room with Ben Stein. Now you get it! Here’s what you need to get started on selecting a business entity for your business.
Purpose of Business Entities
In order to carry on a business or trade, the federal and state governments require a type of business entity be chosen. In essence these are legally required constructs for operating a business. Essentially there are four types of entities to choose from: sole proprietorship, partnership, corporation and limited liability company. Why are there different forms? The short answer: Each has different operational, legal and tax requirements and benefits that may work better for the owner dependent upon the business market you serve. Below is the super short version of some of the distinctions between the entity types.
Sole Proprietor – This is a self-employed individual operating a business where he or she is liable for all tax consequences and all profits, losses, liabilities and debts, too. So, on one hand, there is no protection from creditors and self-employment tax on net earnings of the business, but on the other hand, it is super easy to set up and dissolve and simple to file as part of your tax return through Schedule C. These are great for small, often home-based, businesses with minimal legal risk on product or services provided.
Partnership – This would be two or more individuals engaged in a business operation. The partnership is considered a separate entity for tax purposes, where the partners allocate income/losses based on a contractual agreement. Quick analysis of Pros and Cons: Easy to create, unlimited partners, flexible allocations and no double taxation. The Cons include: Self-employment tax on earnings, separate tax return required annually and no legal protection from creditors. Businesses requiring equity capital and expected to last beyond the lives of the original partners are likely candidates to consider this entity type.
Corporation – This is where things get a bit tricky. There are two types of corporations: Regular “C” Corp and Subchapter S Corporations (or “S” Corp). These are extensive and complex to set up and maintain. Businesses that select C or S Corp status are those with significant exposure to liability, such as manufacturers. Again, there are a number of differences between the two types of corporations.
Limited Liability Company – This is a hybrid entity type incorporating some of the features of a partnership and limited liability of a corporation. This option is available in most states. Quick analysis of Pros and Cons: Income is allocable (like a partnership) and not subject to double taxation. Also, as the name suggests, there is liability protection from creditors. Cons: Income subject to self-employment tax and requires a separate tax return to file. Even within this category, some states (Kansas) allow for single member LLC’s to be formed that essentially share the features of sole proprietorship with legal protection. I find this useful and recommend it to those individuals with small start-ups where the product or service they provide has significant risk inherent in it. The cost is minimal and the benefits are worthwhile.
Filing for Business Entity with IRS
Once you have identified the appropriate business entity for your business, it is time to get a federal identification number (FEIN). The document for that is IRS Form SS-4. This document can be completed online with the IRS and a FEIN can be obtained almost within moments via a pdf document. Please keep in mind that you need to do a name search with your Secretary of State’s office to ensure the name you want to use for your business is actually available in your state, BEFORE you file the SS-4.
State Filing Requirements
This is where it gets complicated. The laws and the mechanics of each state vary significantly. You will need to check with the Secretary of State’s office or website to learn what they require for forming a business in their state. This is where an attorney or CPA can really be of assistance. Check with several of your associates in business and see who they recommend.
Once you have filed the appropriate documents with the IRS and your local state, you will be subject to a number of new reporting requirements, the most likely are:
Quarterly estimated income taxes – both Federal and (typically)State.
Sales and compensating use taxes
Payroll taxes – if employees exist – both Federal and State
Dependent upon your industry, there may well be more requirements. Just make sure to document these requirements in your calendar or tasks, so they are addressed timely. You don’t want to get behind on these, as the penalties and fines are extensive!
Choosing a business entity can be a scary proposition at first blush and it certainly adds to the emotional weight of creating a business. If you’re just plain confused by the options above, contact a trusted attorney or CPA to help you navigate through the process. I am available, as well. If you have questions or comments on this article, I welcome feedback. Comment on our Facebook page. If you’d like to set up an appointment to talk to us, click on this link.
Just a reminder; the next article in the Where Do I Start? series addresses the question of 6 Types of Insurance Coverage To Consider for Your Business