More about Business Entities

What is an entity?

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To start a business, you must first decide what form your business will take--in other words, you must choose an entity. You, the business owner, create the entity. You give the entity its existence and its name. It may live independently of you. It may sue or be sued. It may even be fined if it behaves illegally. Depending upon its type, the entity may be taxed on its income. A business entity is usually, though not always, a group of persons joined together for a particular purpose--an organization. A corporation and a partnership are examples of business entities. Though such entities may have many owners, each is nonetheless considered a single entity, separate from its owners. (A sole proprietorship, however, is considered an extension of the owner.)

Pass-through entities

  • Sole proprietorship (SP)--An SP is a one-owner/one-operator business. The primary advantage of this type of business is its simplicity. Generally, a person need only begin doing business to be considered a sole proprietor. The sole proprietorship is not taxed as a separate entity. Instead, the sole proprietor reports the business's profits and losses on his or her personal tax return. On the other hand, however, the owner is personally liable for all liabilities of the business. If you choose this type of entity, don't forget to buy liability insurance.

  • General partnership--A general partnership must consist of at least two owners (partners), although there is no limit to the number of partners in the partnership. Forming a general partnership is generally simple and inexpensive. There may be fewer formalities to follow than with a corporation. There is no entity level taxation on the partnership. Instead the individual partners are taxed on the profits. The general partnership doesn't offer limited liability. Moreover, a general partnership will typically not allow you to freely sell your interest.

  • Limited partnership--A limited partnership combines limited liability and centralized management, often associated with a C corporation, with a pass-through taxation feature. This entity consists of two types of partners: general and limited. Only limited partners receive liability protection. If the limited partners participate in management, their liability protection is lost. Only the general partners can manage the partnership. In return for the ability to manage the partnership, general partners remain personally liable. (Certain publicly traded partnerships are taxed like C corporations rather than as partnerships.)

  • S corporation--Like a limited partnership, an S corporation combines limited liability with pass-through taxation. Unfortunately, an S corporation is limited to 100 shareholders. Although stock with different voting rights may be issued, different classes such as preferred and common are not allowed. Stock ownership is typically restricted to individuals, estates, and certain trusts. If stock is sold to an ineligible shareholder (such as a partnership), the corporation loses its "S" status and the (tax) benefits that go along with it.

  • Limited liability company (LLC)--An LLC with multiple owners can be taxed as either a corporation or a partnership. If taxed as a partnership (the typical choice), an LLC will offer limited liability and pass-through taxation without some of the disadvantages of a limited partnership or an S corporation. For example, owners of an LLC (called members) can contribute to management without compromising their limited liability protection. Unlike an S corporation, an LLC is not restricted regarding the type or number of owners, or the types of stock that can be issued. An LLC with a single owner will be treated like a sole proprietorship for federal income tax purposes if it does not elect to be taxed as a corporation. However, you should be aware that some states do not recognize or permit LLCs with a single owner.