This post outlines some of the basic considerations to take into account when starting a business. There are many legal structures available to meet a business’s needs, and they each have their own unique characteristics. As used in this article, ‘entity’ means the types of legal structures available to businesses. For example a corporation and a limited liability company are two examples of an entity type.
Whether you own a business or are thinking of starting one, understanding the types of entities that are available can be a critical factor in fostering your business’s ongoing success. Some basic factors to consider are liability protection, tax consequences, and cost.
This article will begin with a basic description of these three considerations. The next post in this series will examine popular entity types, and how those entity types interplay with the considerations presented in this post. As this series progresses it will dive into more sophisticated issues, such as how the entity type can affect the permissible ownership structures or future investments in a business.
Most, but not all, entities offer limited liability as their primary benefit. Essentially, by creating an entity for your business you can protect your personal assets from the business’s liability. For example, if you buy stock in a major corporation, you do not have to worry about creditors calling you personally to recover the corporation’s debt. This is because the concept of limited liability.
At the simplest level, limited liability means your potential loss is limited to the amount you have invested in the business. Unfortunately, all entity types do not limit liability, so liability protection is a primary factor to consider when selecting an entity type for your business. Additionally, it is possible to erode the liability protection associated with your entity, due to improper management of your business.
In the context of a corporation, overcoming the corporation’s liability protection to target the personal assets of a business owner is known as piercing the corporate veil. Legally it is difficult to pierce the corporate veil; however, it is important to understand the actions that can lead to piercing the veil. Thus in order to maintain liability protection a business owner must maintain a separation between the business’s assets and the owner’s personal assets. Comingling personal and business assets is one of the most common mistakes that leads to piercing of the corporate veil. If the veil is pierced, a business owner may be required to utilize personal assets to cover the liabilities of the business.
There are two primary ways entities are taxed in the United States: double taxation and pass through taxation. Traditionally, double taxation is associated with corporations and pass through taxation is associated with partnerships and limited liability companies. However, this generalization is not universal, so it is important to understand the tax consequences resulting from your choice of entity. This is especially true as there could be tax implications if you want to change your business’s entity type at a later date.
Double Taxation is exactly what it sounds like. Income is taxed twice, once at the corporate level and again at the individual level. Unsurprisingly double taxation can have a dramatic effect on the amount of taxes that are ultimately paid on each unit of income, therefore many businesses choose an entity type that allows them to avoid double taxation.
Pass Through Taxation, also known as flow through taxation, only taxes each unit of income once. Stated differently, in pass through taxation, a business is not taxed on its profits, instead the profits are taxed on the owners’ personal tax returns. For example, if ‘Jim’ is the sole owner of an entity with pass through taxation, the business itself is not taxed. Instead the business’s profits are taxed only taxed as if they are Jim’s own income, and therefore the profits are included on Jim’s personal taxes as income.
Double v. Pass Through Taxation
The critical difference between double taxation and pass through taxation is the number of times each unit of income is taxed. In double taxation profits are taxed at the business (entity) level and again at the individual level. In pass through taxation profits are not taxed at the business (entity) level and are only taxed at the individual level. Thus pass through taxation generally reduces the total amount paid in taxes, and therefore is preferable to double taxation.
As with any business decision, cost is a critical factor in the choice of entity. From a broad prospective both liability protection and taxation represent a type of cost. However this section is focused on purely monetary costs.
As entity creation is largely controlled by state law, it is important to check with Secretary of State or State Department of Assets and Taxation for the fees associated with the each type of entity. Generally there will be a few fees to consider. First is the cost of filing. This is the fee, charged by the government, to file the paperwork to create your business. Second is annual costs. Annual costs can manifest themselves in a number of ways; some states charge an annual franchise fee, while others states charge personal property taxes, with annual minimums. Third is administrative costs. Some examples of administrative costs include required filings and fees to update filings, such as annual reports. Again it is important to look to the state you are filing in for more specific information as these costs will all vary from state to state. For example, in some states it is more expensive to create a limited liability company as opposed to a corporation, however in some states the filing fee is the same for both types of entities.
Now that you have a basic guidelines for comparing types of entities, you can start to look for the entity and state of incorporation that are right for you and your business.
It is easy to file the paperwork to create an entity, but it is easy to overlook an important consideration. Each entity type has advantages and limitations, which is why it is important to carefully consider your business goals when creating your entity. For example, each entity type can be structured in a variety of ways, so there are several sub-groups within each entity type. A business attorney can tailor your entity choice to your business needs, providing value throughout your company’s entire lifespan.
Look for the next post in this series for an overview of popular and new entity types!
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