Choosing the Right Entity Type

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We can’t count the number of times we’ve been asked: “Sole proprietorship, partnership, Limited Liability Company (“LLC”) or Corporation? Obviously, each entity has its merits, or it wouldn’t exist. However, 80 plus percent of the time, we answer, after hearing what the company will be doing, LLC.

From a legal perspective, a “sole proprietorship” or “partnership” are the “defaults” if a person or persons go into business and fail to create a juristic entity (LLC or Corporation). As sole proprietorships and partnerships are “automatic,” there are no costs or documentation necessary. However, while this might seem appealing at first, business owners operating as sole proprietorships or general partnerships are subjecting themselves to unlimited personal liability for the company debts and wrongdoing – not a good idea. This is particularly true for a foreign entity wishing to do business in the United States as either one of these entities will subject all that entities’ income, both here in the U.S. and abroad, to exposure to U.S. taxes. Moreover, partnerships are often formed without the parties realizing it, and as a result, they never reach formal agreement regarding the many issues which should be discussed in advance. In such a case, the parties are resultantly operating subject to a Uniform Partnership Act and its default rules (which are not always desirable) to govern disputes that might arise. There are very few, if any, circumstances for a business owner to not choose a different entity type, such as a Limited Liability Company or Corporation.

An LLC is now the most common business entity type for companies. As described by its name, an LLC limits the liability and exposure of the “members” (what owners of an LLC are called) of the company. This means that (absent extreme circumstances) the members of the LLC cannot be sued personally for the business debts or liability of the LLC. Simply put, this means that if the LLC becomes obligated on a debt or obligation, the members would not be held personally liable for the debt or obligation.[1] Aside from the legal advantages of forming an LLC, there are tax advantages as well. LLC’s are considered a “disregarded” entity for income tax purposes, meaning that members list the income from the LLC on their tax returns, rather than such income being subject to another income tax. However, because LLC can be taxed as partnerships, foreign entities in particular likely want to “elect” to be taxed as a corporation to ensure their non-U.S. income and revenue is not subject to U.S. tax exposure. Other advantages of an LLC, particularly for foreign owners, are:

  • unlimited number of members;
  • members do not have to be U.S. citizens; and
  • can be owned by individuals, partnerships, corporations or another LLC.

The alternative choice is a Corporation. Corporations, like LLCs allow “shareholders” to allocate percentages of the company to other persons, making it the most desirable option for entities considering investors or share offering’s at some time in the future. Like the LLC, shareholders of a corporation have limited personal liability for the debts and actions of the Corporation.

The two most common types of corporations are “C-Corp” and “S-Corp.” The decision between a C-Corp and S-Corp is primarily one of tax implications and complexity. For example, a C-Corp pays its own taxes on net profit, while an S-Corp files an “information return” and the net income “flows through” to the shareholders in proportion to their ownership interest and are then taxed at the individual level. Further, as an S-Corp is limited to 100 shareholders, none of which can be a foreign person or entity and can only have one class of stock. A C-Corp on the other hand can be owned by a foreign person or entity andhave an infinite number of shareholders. As a result, C-Corps are much more attractive for foreign owners and entities interested in or needing investors.

Of course, with all of the foregoing decisions, certain filing and other regimens come into play and there are deadlines, corporate formalities and filing parameters that are required for LLC’s and Corporations, that are less onerous with a sole proprietor or partnership. However, we strongly recommend forming either an LLC or corporation for your business as we believe the advantages far outweigh the costs and resulting effort.

If you’d like to know more, are thinking about forming an entity, changing your existing entity type or simply want to learn more about the benefits of creating an entity, please reach out to The McHattie Law Firm. We specialize in general corporate and intellectual property law.

[1] On a practical note, banks and creditors will often require a “personal guarantee” which would make the shareholder signing the guarantee personally liable on for that particular debt or obligation.