Choice of entity: Nontax considerations for business owners
When setting up a business, many factors come into play but the most important considerations include the choice of entity. In this article, learn about the nontax factors business owners must evaluate to make a choice of entity.
When starting a business there are many factors owners must consider but arguably the most important is choice of entity. There are a few options and with each comes a complex set of rules involving tax and nontax considerations. The first article in this series will cover the nontax considerations including owner liabilities and ease of formation. The next article in this series will cover tax considerations for owners to consider before making a choice of entity. Choosing an entity is a difficult decision for most. These nontax considerations are related to tax considerations because the final choice of an entity has tax implications for the owners.
Main types of business entity for the choice of entity determination
The type of business entity a business can be classified as depends on the number of owners. Single-owner companies can be sole proprietorships or corporations while companies with more than one owner can only be classified as either corporations or partnerships. For federal tax purposes, corporations can be further classified as a C corporation or they could be an S corporation, if certain qualifications are met.
Limited liability companies (LLCs) are hybrid entities that exist on the state level, but federal tax law does not recognize them as an entity type; instead the federal tax classification is based on the number of owners and the factors discussed below. A single-owner LLC will be treated as a sole proprietorship for federal tax purposes unless the LLC elects to be treated as a corporation. LLCs with two or more owners are automatically classified as partnerships unless they elect to treat the business as a corporation. See more information on the types of LLCs discussed below.
For more information on why businesses change their entity from sole proprietorships to LLCs, see the Insights article, “The most common business entity changes and why people make them: Sole proprietorship to LLC”
But why do businesses choose one entity over another? Often, they base their choice of entity on a myriad of factors.
Choice of entity nontax consideration #1: Liabilities for business debts
When forming a business, usually the first issue prospective owners should ask themselves is--do they want to be on the hook for the debts of the business? The success or failure of a business often depends on when it was opened. Those individuals that started businesses in 2007 likely experienced serious hardships and many even had to close their doors. Whereas if the same business would have opened in 2016 the chances of success were increased. In 2020, businesses may not be able to begin operating or may have to significantly modify their practices during the coronavirus pandemic.
Individuals should think about whether the industry they seek to enter is one that lends itself to increased risk of loss and which entity may provide the protection they need.
Owner consideration: Do the owners think they need protection or can they afford to leave themselves at risk of being on the hook for the business’s liabilities?
Entities where owners are personally liable for business debts
For businesses that don’t carry a high risk of loss, sole proprietorships or partnerships may warrant strong consideration. These entities don’t have a liability shield which means--for sole proprietorships--the owner bears the entire liability if the business is not covering costs. In that case, the owner’s personal assets and wealth are at risk because creditors could pursue collection from them.
This is further compounded in the case of partnerships for two reasons: joint and several liability and agency theory. All general partners have joint and several liability for the partnership’s debts which means that a creditor could go after all the partners together, a select few partners, or even one individual partner, depending on which provides the greatest avenue for collection. What’s more problematic is agency theory which says that all general partners have the authority to act on behalf of the partnership. This essentially means that, barring something in the partnership written agreement, any general partner could enter contracts and make decisions that bind the partnership without the other partners’ knowledge.
When joint and several liability is combined with agency theory, partners that have greater wealth than their partners could expose themselves to greater risk if one or more of the other partners starts to act on their own. Thus, sole proprietorships and partnerships may not be the best choice in high risk industries.
Owner considerations: Are the partners similarly situated and similarly risk adverse? Does a sole proprietorship offer enough protection from creditors?
Entities where owners are not personally liable for business debts
For higher risk industries, owners who need extra protection should consider setting up LLCs or corporations at the state level. These entities can protect their owners from creditors, who then can’t go after the owner’s personal assets and wealth, unless the liability was created by that owner or in a few other limited circumstances. Joint and several liability isn’t an issue for sole owners because it doesn’t apply.
Manager-managed LLCs, which are those where the owners don’t participate in management, and corporations also don’t face the same problems as partnerships arising from agency theory. In manager-managed LLCs, the owners do not participate in management in most cases which means they do not have the power to bind the entity through signing contracts or other activities.
Member-managed LLCs, which are those where the owners participate in management, may have issues arise from agency theory because the members have the authority to bind the LLC, but the only risk of loss they are subject to is if the business closes or if the assets they contributed to the LLC are at risk. But this is where the members’ risk of loss ends; they don’t have to worry about their personal assets and wealth being taken by business creditors.
Thus, if owners do not need to participate in management, and they seek a strong liability shield, LLCs or corporations may be the better choices. If management is important to the owners and the industry does not lend itself to increased risk, sole proprietorships or partnerships might be best. While liability certainly plays a major role in the decision-making process, owners should also consider the level of formalities and ease of creation before setting up the business.
Owner considerations: Is management of the business important to the owners? Do the owners want extra protection from liability because the business is at a higher risk of loss or the owner is risk-adverse?
Choice of entity nontax consideration #2: Ease of creation and formalities required
Ease of creation may influence those who are new to business ownership or don't have a lot of startup money. And the type of business makes a huge difference when it comes to paperwork.
Entities that are easy to create and require few to no business formalities
Sole proprietorships and partnerships are the easiest entities to form because there are no state business filings required aside from a fictitious name filing (or other registration) in some cases, depending on the state. This means that these businesses do not require a fee paid to the state in order to create the business nor do owners need to pay an attorney or CPA to draft a state application, which helps keep administrative costs low. It is important to note that there may be tax filings at the federal and state level, as well as potential required licenses for certain industries. For partnerships, it’s always a good idea to have an attorney draft a partnership agreement even if the state doesn’t require submission of formation documents.
This ease of creation becomes ease of running these businesses because both sole proprietorships and partnerships benefit from not having to follow any business formalities. For example, they do not have:
- required annual meetings,
- a board of directors,
- shareholders, or
- required minutes at meetings.
This makes running the business cheaper and easier because more formalities mean more CPA and attorney’s fees to ensure tasks are performed correctly. Therefore, a sole proprietorship or partnership may be the best choice for new business owners with limited capital.
Owner considerations: Are the owners trying to keep start-up costs limited? Does the particular kind of business require licenses or other filings at the state level? Should a partnership agreement be drafted by an attorney even if not required?
Entities that are harder to create and require more business formalities
LLCs are unique and a little more difficult to create because the owners generally must file an “Articles of Organization” or other organization documents with the state they are doing business in. But, like sole proprietorships and partnerships, LLCs don’t require many business formalities. This is why LLCs are referred to as “hybrid entities” since they combine many of the rules from partnerships and corporations. In some states, LLCs are required to have an “Operating Agreement” drafted or submitted, and it is always a good idea to have an attorney draft the document even in states where it isn’t required. Like partnerships, having an agreement allows all the owners to know what their rights and responsibilities are and can provide resolution to disputes that may arise later.
Corporations are more difficult to form because an “Articles of Incorporation” must be filed with the state the entity will be doing business in. An attorney typically prepares this document because each state has its own rules on what needs to be included. This increases the administrative costs upfront just like LLCs. Unlike LLCs, there are a lot of formalities that have to be followed in order to operate a corporation. The most common ones include drafting of bylaws, electing a board of directors, holding annual meetings and keeping of minutes at meetings. This can be complicated, and most corporations have an attorney to make sure all of these are done correctly which increases administrative costs.
Owner consideration: Do the owners need to clearly define their rights and responsibilities? Is it beneficial to clearly define rights and responsibilities even if not required?
Choice of entity nontax final consideration: Get help from an advisor
Therefore, when looking at nontax factors in business entity choice we can break it down by saying that partnerships and sole proprietorships put a lot of liability on the owners, but they are easy to form with few formalities. In contrast, LLCs and corporations have a strong liability shield and they are harder to form with more formalities. Choosing an entity is a difficult decision for most and these factors should be thought about along with certain tax factors, to be discussed in the next part of this series.
The best practice before setting up any business is to consult a business lawyer who can help owners understand all of the issues impacting choice of entity and give personalized advice about liability for business debts. Need more business tax help? Check out the small business specialty services available through Block Advisors today.