Choosing The Best Business Entity Structure Is The Most Important First Business Decision
Starting your own business is a very exciting venture. However, deciding on the business entity structure is sometimes overwhelming. There are different pros and cons to forming a business entity in NJ. We have broken down four different business entities for your review so you can get an understanding of what will work best for your business structure and goals.
According to the U.S. Small Business Administration, a sole proprietorship is the simplest and most common business entity structure chosen for new businesses. It is an unincorporated business owned and operated by one individual with no distinction between the business and the owner. You are entitled to all profits and are responsible for all your business’s debts, losses and liabilities.
A sole proprietorship is ideal for someone who wants to start a one-person business quickly and inexpensively. The owner will not be seeking outside investment and has limited liability protection.
The advantages of a sole proprietorship business entity structure include:
- Low startup costs, no organizational documents, no legal fees for drafting documents and no filing fees.
- Ease of formation – the owner does not have to file any formation documents with governmental agencies (other than a “Doing Business As” (DBA) certificate if the business is under a name other than the owner).
- Owner control and entitlement of profits
- Small business owner tax advantages including no double taxation. The business and the owner do not pay income taxes separately so all income taxes can be handled on the owner’s personal tax returns.
The disadvantages of sole proprietorship business entity structure include:
- Personal liability- the owner will be held personally liable for all of the business’ activities, including its debts and liabilities.
- No continuity of existence – upon the death or incapacity of the owner, the business ceases to exist.
A business that will be owned by two or more individuals may want to look into a general or limited partnership.
A general partnership is one in which each partner shares any losses, profits and the management of the business. However, each partner is personally and equally liable for debts of the partnership. Limited partners share in the profits of the business, but their losses are limited to only what they invest. Limited partners have no control over a company, are usually not involved in day-to-day operations, and do not have the same liability as general partners.
The advantages of a partnership business entity structure include:
- Additional sources of capital
- Broader management and responsibility
- Relatively inexpensive and easy to form – since there are generally no formalities to form a general partnership, it is less expensive than other entities – at start-up and during the process. However, there will be legal fees associated with the drafting of a partnership agreement.
- Separate legal entity – in most states, a general partnership is a separate legal entity with partnership interests that can be issued and transferred.
The disadvantages of a partnership business entity structure include:
- Personal liability-every partner in a general partnership assumes unlimited liability for the partnership’s debts and liabilities.
- Divided authority-only general partners can participate in the control of the business. Due to the limited personal liability, limited partners cannot participate in the control.
- Compatible partnership – each partner has an obligation to the other partners including
- a fiduciary obligation, undivided loyalty and fair dealing standard with all matters affecting the business.
- Limited partnerships require different state filed paperwork and agreements
LIMITED LIABILITY COMPANY (LLC)
A Limited Liability Company, also known as an LLC, is a business structure type that combines some characteristics of a sole proprietorship and a corporation while offering a limited liability to the owners of the business.
An LLC is ideal for any business that desires protection against personal liability, pass-through tax treatment, and flexibility with respect to distributions, allocations and/or management.
The advantages of an LLC business entity structure include:
- Limited liability – in most cases an LLC is an effective shield against personal liability.
- Flexible ownership structure – an LLC is flexible in respect to the distribution of cash and other assets, the allocation of income or losses, as well as officer assignment.
- Pass-through tax treatment – profits and losses flow directly through the entity to the individual members which avoids the double taxation of profits and permits the members to write off certain business losses.
The disadvantages of an LLC business entity structure include:
- Expensive to organize and set-up
- More regulations- each state has its own rules and regulations for establishing an LLC. Read more here about setting up an LLC in NJ here.
A corporation is a separate legal entity created under state law, with a legal existence distinct from its owners. There are two different types of corporations, a C Corporation and an S Corporation.
A C corporation is the most common type of corporation with many advantages. However, a C corporation is subject to double taxation. This means that first the corporation is taxed on its profits, and second, each of the shareholders are taxed on any dividends distributed to them.
An S corporation is a type of corporation that establishes it as a separate legal entity with a legal existence distinct from its owners. Unlike a C corporation, this type is a pass-through entity and thus is not subject to double taxation.
The advantages of a Corporation business entity structure include:
- Limited liability – corporation is the most widely-accepted and well-established entity for the protection against personal liability.
- Specialized management
- Ownership is transferable
- Continuous existence
- Easier to raise capital
- Pass-through tax treatment- the profits and losses of an S corporation flow directly through the corporate entity to the individual shareholders, which is often desirable.
The disadvantages of a Corporation business entity structure include:
- Closely regulated
- Extensive record-keeping – corporations are subject to tedious formalities and filings under state law as well as required annual meetings and maintenance of separate books, records and accounts.
- Double taxation, except when organized as an S Corporation – the biggest disadvantage of a C corporation is that it is not a pass-through entity which is subject to double-taxation and any losses do not pass through to its shareholders.
- Costly set-up and maintenance– as a result of the tedious corporate formalities the costs for forming and maintaining a corporation are relatively high.
- Limitation on type and number of shareholders
- Limitation on capital structure for an S corporation
Picking the right business entity is a very important step in the entrepreneurial journey. An uninformed choice could mean that you’ll be paying double the amount of taxes. Or, even worse, a mistake could mean that you are personally liable for the company’s actions.
It is strongly recommended that if you are unsure of which structure is best for your business, you seek professional advice from an attorney.