As a company or business owner, one of the most important decisions you'll have is choosing the best legal structure for your company. This choice will have far-reaching effects on liability protection, tax considerations, and operational flexibility.
Trusts and limited liability organizations (LLCs) are two common and frequently considered solutions. Each has unique advantages and nuances that must be carefully considered to align with your business objectives and needs.
Although choosing the right entity won't ensure success, choosing the wrong entity can prove expensive. Because each of these business types has advantages or disadvantages for the taxpayer, the practitioner can give important advice on this selection.
This article aims to address questions regarding the advantages and disadvantages of using different types of ownership when starting a new business. It is important to identify the features of various types of ownership.
So, Let’s get started!
Why is Choosing a Business Entity Structure Important?
A business entity is the legal and organizational framework that a person or group creates for their business. Entity structures differ in terms of responsibility, transferability, cost, taxes, and simplicity. Choosing your business's structure is one of the most essential decisions you can make when beginning your company since it influences business decisions, tax efficiency, and your potential to expand.
Types of Business Entities
There are four types of business entities: corporations, partnerships, limited liability companies, and sole proprietorships.
1. Corporation
A corporation is a legal entity apart from its owners. It may profit, be taxed, and be held legally accountable. C-corporations, S-corporations, and B-corporations are among the most common corporate structures.
Pros
- Provides the highest protection against personal responsibility for its owners.
- Easily transferable
- Can raise cash through the sale of stocks.
Cons
- More costly to build than other structures.
- Comprehensive record-keeping, operating procedures, and reporting
- Pay income tax on their earnings, which means companies are taxed twice: once on profits and again on the personal tax returns of shareholders receiving dividends.
2. Partnerships
Partnerships are basic business structures formed between two or more persons. It is legally and financially distinct from its owners. There are two major forms of partnerships: general partnerships and restricted partnerships. There are various sorts of partnerships, however some are not legal in all jurisdictions or only apply to specific professions or situations.
Unless otherwise specified in a partnership agreement, each partner bears full liability and all partners are equal.
A limited partnership is approved by the state and is made up of one general partner who is accountable and one or more limited partners who only give money. Limited partners are only responsible for their investment in the business, which protects their assets.
Pros
- Easier and less costly to establish than a company.
- Pass-through taxation results in fewer taxes.
- Simple entity structure to test a business idea before creating it more officially.
- Legal and financial obligations are borne equally among general partners.
Cons
- Partners are answerable for one another's decisions.
- General partners risk their assets.
- An entity can dissolve after the death or bankruptcy of a partner.
- Limited capacity to raise funds.
3. Limited Liability Company
A limited liability company (LLC) is a business structure that combines the characteristics of a partnership and a corporation. It enables members to take benefit of pass-through taxation while protecting them from personal legal accountability.
Pros
- Protection from personal responsibility.
- Pass-through taxes involve avoiding double taxation.
- Simple legal requirements.
Cons
- Limited ability to raise funds without stock options.
- Different restrictions are based on the state.
- The company would dissolve upon the death of a member.
- Transferring ownership may be difficult.
4. Sole proprietorship
A sole proprietorship offers you entire control over your business, but it does not create a new corporate organisation. This is the most common corporate entity structure. For example, Marketinglad, a B2B marketing agency that offers a comprehensive range of digital marketing services to help businesses achieve their marketing goals.
Pros
- Easy to form.
- The owner has full control of the business.
- Ideal for testing a business before incorporation.
Cons
- Personal responsibility.
- Difficult to raise finance
- Banks are unable to provide them to these firms.
How do I Choose the Right Entity Structure for my Business?
Choosing an entity is an important choice. Here are the objectives to consider while selecting a business type.
Tax Savings
The tax costs of running a new or existing business can often be a key issue for its owners. The right entity type can reduce both self-employment and income taxes. Understanding the complete tax position, including corporate and personal income taxes, payroll taxes, and estate tax exposure, plays an important role in determining the appropriate entity option.
Limitation of liability
The primary goal of some people tends to be to protect themselves from responsibility. The owners/partners aren't restricted in responsibility under the proprietorship or general partnership classifications. Limited partnerships, limited liability companies, limited liability partnerships, S corporations, and C corporations may provide liability protection to partners/shareholders depending on the owners' involvement in business activities, employee involvement, lender requirements for personal guarantees, and the application of professional service malpractice statutes. An owner may still be held accountable for criminal conduct carried out on behalf of a limited liability corporation.
Management
One of the most prevalent reasons for an entrepreneur to establish a business is the ability to make major decisions. The degree to which one individual may make all choices, or how decision-making responsibilities are distributed among a group, is determined by the business's ownership structure.
If more than one person holds equity in a business, it cannot be operated as a sole proprietorship. If all owners agree to give management services, a limited partnership is not an option since limited partners cannot supply management services without jeopardizing their limited partnership status. Other companies limit the responsibility of management-level owners.
Motivation
Most new entrepreneurs have diverse motives for starting and running their firms. Some people want to establish a business that will become big enough to have an IPO and be traded on a national stock exchange. These business owners may choose an entity that facilitates the transition from a private to a public firm or the process of acquiring external funding.
Ownership Transfer
In many circumstances, a change in entity status serves to complete a transfer of ownership. Whether the purpose is to transfer ownership to a successor via gifts, installment sale, stock redemption, bequest, or a mix of ways, it is sometimes required to use a different form of business to achieve client objectives.
Trust vs LLC: What is the Difference?
Trusts and limited liability corporations (LLCs) are two legal structures that can be used to safeguard assets. Both are formed at the state level, but they have different features and purposes.
Trusts are usually used to avoid taxes when passing down family assets from one generation to the next. LLCs are legal business organizations, similar to simplified corporations, whose key characteristic is the ability to protect business owners from legal accountability for the company's acts. Consider seeing a financial expert while you make important estate planning and business choices.
LLC Features
An LLC is formed by filing documentation, including a certificate of formation, with the secretary of state in the state where the firm will be legally located. It is one of the most prevalent forms of business entity, alongside sole proprietorship, partnership, and corporation.
An LLC is a legal entity that exists independently from its owners. This implies that the owner's assets are protected from creditors if the company incurs debt and fails to repay it. Similarly, if the business is obliged to pay monetary damages as a result of a lawsuit, the payment must be made from the corporate assets, while the owners' assets are secured.
LLCs have a simpler management structure than ordinary corporations. They also avoid double taxation on corporate profits by distributing dividends directly to their owners, who pay income taxes at their rates.
LLCs can also help transfer corporate assets to heirs. In many states, an LLC-organized firm can be passed down to the next generation without the time-consuming probate process. In addition to commercial assets, LLC owners can include other types of assets in the entity, allowing more of their estate to avoid probate.
Other benefits of LLCs for investment property owners include:
- Single-member LLCs are not required to submit a federal tax return.
- LLCs may use 1031 exchanges.
- The LLC is the plaintiff in the eviction proceedings.
Trust Features
Trusts are also formed at the state level and used to hold assets before transferring them to beneficiaries. A trust, unlike an LLC, is not a business entity, and establishing one does not need the filing of any paperwork with a government body. Trusts can contain a wide range of assets, such as cash and bank accounts, real estate and securities, and ownership interests in an LLC or other business organization.
The assets in a trust are transferred from the original owners' control to the trust, which is managed by a trustee. The trust also includes instructions for how the assets will be allocated to beneficiaries in the case of the owner's death.
When the owner dies, the assets do not have to go through probate, which can dramatically minimize estate taxes payable on intergenerational asset transfers. Instead of going through probate, the trustee simply distributes the assets as provided in the trust terms.
Trusts also have the following advantages for individuals, couples, and families:
- A trust can maintain ownership interests in an LLC so that the LLC and its assets avoid probate.
- The individual or individuals who form the trust have complete authority over the trust assets, which includes the ability to simply amend or cancel the trust.
- A married couple's trust can result in a savings of over $1 million in inheritance taxes for the heirs.
Considerations in Choosing to Use One, or Both
Trust vs LLC: While trusts can help with estate taxes, they do not protect personal assets from responsibility in disputes, as LLCs do. They also do not have the same income tax benefits as an LLC.
Individual circumstances determine whether to form an LLC or a trust. LLCs are more effective at protecting corporate assets from creditors and legal responsibility. Trusts may handle a variety of assets and are more effective at avoiding probate and lowering estate taxes. In some cases, it may be beneficial to handle the estate through both an LLC and a trust.
Conclusion
Whether you select a corporation, a partnership, a limited liability company, or another organization, you should carefully evaluate each of these aspects. Once in place, changing entities is possible, but complicated.
You must pick the right business organization for your needs. Consider how it will impact your business, money, and legal exposure. When deciding on a business entity, ensure that your tax legal counsel and corporate lawyer agree.