For Small Business Owners & the Self-Employed

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5 Factors to Consider When Choosing a Business Entity

Selecting the proper type of business entity is an extremely important decision. And it's not only for new businesses.  Find out what factors you should be thinking about before making a choice.

by Alex Goumakos, CPA

One of the first things to think about when starting or acquiring a business is selecting the appropriate form of legal entity. The appropriate form for your circumstances depends on a variety of tax and non-tax considerations.

Keep in mind the following 5 factors when deciding on what type of entity your business should be:

1. Liability Protection - Personal liability should be your number 1 factor in determining what entity you should choose. Know that sole proprietorships and general partnerships offer NO liability limits for their owners/partners (i.e., your personal assets are up for grabs). If you're in a "high risk" industry, then consider a limited partnership, LLC, LLP, S or C Corp.
   
   
2. Taxes – Taxes are a MAJOR factor in choosing an appropriate business entity. There can be significant cost savings in picking one form over another, especially when it comes to self-employment and income taxes. But don’t forget payroll and estate taxes either. You can literally save thousands each year by having the right entity. There are still plenty of 4 leaf clovers in the US tax code. One of them is the fact that S-Corp net income is still NOT subject to the self-employment tax.
   
   
3. Management Structure – Your company's management structure will determine which entities you can or cannot have. Obviously if a business is owned by more than one individual, you can’t be a sole proprietor. In addition, if you wish to offer your KEY employees minority ownership, you’ll need to plan in advance and choose the entity that best accomplishes that. [You may also want to consider splitting up your business into several different companies, i.e., one business for sales and marketing, another for production, etc., and make them different legal entities. I have worked with many clients using this strategy and we have had some pretty outstanding results. But it isn’t for everybody.]
   
   
4. Ownership Transition– While this situation doesn't present itself frequently, in some circumstances you may need to change your company’s form of entity to accomplish a transition in ownership (perhaps you have a child coming into the business?). A thoroughly planned strategy here can save you boatloads of cash (i.e., gift, bequest, installment sale, stock redemption, etc. – Since this can be a highly complex and involved area, it's absolutely essential that you talk to a professional about your particular circumstances.
   
   
5. Capitalization – Finally, at some point your business may need to raise capital from external sources in order to fund expansion and growth. Picking the right entity in this case will help you get the money you require. Mind you, this doesn’t necessarily mean an IPO (initial public offering). I know of several businesses that raised plenty of money issuing private debentures with convertible stock warrants (bonds and/or debt financing). Obviously, you’ll need something more advanced than a sole proprietorship. [Incidentally, alot of small business people are not aware that you don’t have to be a BIG company to raise money by issuing bonds with warrants or other debt. As long as you have a small private offering, you can absolutely raise money for your small business using debt financing.]

There are also other factors in determining the proper legal entity for your business, but these, in my opinion, are the more important ones. Keep in mind that you don’t necessarily have to be a new business to think about which entity is best for you.Many established businesses should review their form of legal entity on an annual basis to determine if it’s still cost effective and the best way to go. 

Keep in mind that your form of business entity is like having a car. At some point if your business gets bigger, you’ll need something with more room and power. The reverse is also true. What’s the sense in having a station wagon, when a compact will do?