Business Entity Refresher Course

by Nellie Akalp

Choosing a business structure affects your business’s ability to get credit and obtain funding. It also offers you personal liability protection and affects your tax status. In other words, there’s a lot you need to know to make sure you’ve chosen the best entity for you and your business. Here’s a quick refresher on what you need to know. 

Choosing a Legal Structure

Sole proprietorships:

Sole proprietorships are the most prevalent legal structure in the U.S., mostly because they are the cheapest and easiest to form and require a lot less paperwork than any other entity. The proprietor controls the business and any profits pass directly through to the owner. When tax time rolls around, all income and expenses are reported on the owner’s personal tax return; income tax rates are based on personal tax brackets. Sole proprietorships must still pay into Social Security and contribute to Medicaid. The biggest downside to the sole proprietorship is the lack of protection it offers; the owner is personally liable for all debts and lawsuits. 

Partnerships:

Partnerships are similar to sole proprietorships, but with at least two owners (the partners) responsible for the business’s liabilities and debts. Partnerships also retain pass-through taxation. Partnerships should have an agreement detailing owners’ responsibilities, decision-making powers and what happens in case the business dissolves. 

Corporations:

Corporations offer personal liability protection, unlike sole proprietorships and partnerships. In addition, the Tax Cuts and Jobs Act reduced the corporate tax rate from 35 percent to 21 percent, which makes the C Corp legal structure even more appealing. The protection for owners and shareholders stems from the fact the business is a separate legal entity and all actions of the corporation belong to the corporation only. In other words, personal assets are not affected in case of a lawsuit. Corporations can also sell shares in their business and can go public.

S corporations’ profits and losses are passed through to the owners/shareholders for tax purposes; however, like C Corps, the owners’/shareholders’ personal assets are protected from liability. Both C Corps and S Corps do require a lot of paperwork to remain in good standing and must adhere to annual deadlines. Both must adopt bylaws, hold annual director and shareholder meetings, and keep meeting minutes with corporate records. 

Limited liability corporations, or LLCs:

LLCs are popular because they offer protection from personal liability with less stringent requirements than an S Corp or C Corp. “Members” of the LLC can choose whether they want to be taxed as a sole proprietorship, partnership, S Corp or C Corp. In general, an LLC does not need to have an annual meeting nor a board of directors.

Not a U.S. Citizen? 

Do you live in another country, but want to start a business in the U.S.? Luckily, you don’t need to be a citizen or a resident to start a business in the U.S. Foreign entrepreneurs have only two choices of business structure for their U.S.-based business: The C corporation and the LLC. You cannot choose to form an S Corp in the U.S. because each S Corp shareholder must be a U.S. Citizen or permanent resident alien. You must pay taxes to the IRS on the income earned in the U.S. and must also pay an annual fee to the state where your business is incorporated.

Switching Entities

There are a few circumstances where you may want to change the legal structure of your business. You may decide you want more protection than that offered by a sole proprietorship. You may decide you want to take your business public. Perhaps you just want to take advantage of the new, lower tax rates offered to C Corps. Whatever your reason, switching entities is possible if you know the right steps to take. 

In general, going from a sole proprietorship to a corporation/LLC requires conducting a name search for the entity’s new name and filing the correct documents with your state, such as the Articles of Incorporation for corporations. You’ll also need a new Federal Tax ID or Employer Identification Number (EIN) from the IRS. Finally, you’ll need to set up a new business bank account with the new corporation’s name.

To change from an LLC to a C Corp, all members must first agree to the change in structure. Then, in some states you can simply file a document with your state called a “statutory” conversion, which officially changes your business from one entity to another. In some states, you need to create a new C Corp and then make the original LLC a subsidiary or a DBA (Doing Business As). The IRS considers changing from a C Corp to an LLC a monetary transaction, so you would need to sell the assets of the LLC to the new corporation and pay taxes on any assets that have appreciated in value. 

Choosing the right legal structure can make it easier to achieve business goals such as finding financing or reducing tax liability. Whatever legal structure you consider, get professional advice to determine what works best for your needs both today and in the future of your business.

Read more great posts from Nellie Akalp here.