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Of the four types, which is best?

Everyone has a different answer to this question. Every book has a chart listing the advantages and disadvantages of the different types of business entities and then tell you to ask your CPA or attorney which is best. I will advise the same, but also realize that not everyone has a CPA or attorney to consult with, so I will try to direct you further. Bear in mind that everyone’s business is different and everyone’s tax situation is different. You may want to refer to the following chart for guidance.

Sole proprietorship
I only recommend this type of business entity for the person starting a very small, probably part-time business with no employees. This business would have no assets and its product or service would be one of low lawsuit potential. That is, your customers wouldn’t be likely to be injured by one of your products. My mother used to make crafts and sell them at local craft fairs. This is the ideal sole proprietorship business. It’s usually started just to make a little extra money.

Partnership
The ideal candidate for this type of business entity would fit the same criteria as the sole proprietorship mentioned before except this business would have more than one owner. Like the sole proprietorship, a partnership can be incorporated or converted into an LLC later on if the business grows beyond its initial expectations.

Corporation
This type of organization is best suited for a single entrepreneur who wants a small business that offers tax advantages and tax planning capabilities or a group of entrepreneurs who want to start a business that will grow in size and have employees. Its limited liability aspect makes the corporation ideal for companies with products or services with liability potential.

Limited Liability Company
This type of business organization is ideally suited to those who want the limited liability protection of the corporation but want to be taxed as a partnership, perfect for real estate investment businesses. Partnership taxation means that the business profit or loss ends up on the owner(s) personal return(s), and there are few if any personal fringe benefits.

Many people think that the LLC is best because it’s the latest thing. Newer must be better, right? Well, not necessarily. The LLC was designed for real estate investment, and that’s what it should be used for. The LLC is really just a new twist on an existing type of business organization, a “close” corporation that elects to be taxed as an S Corporation. The close corporation, if available in your state does away with a lot of the administrative requirements of a regular corporation, and choosing S Corporation tax treatment makes it a pass-through entity.

There are only two cases where I’d favor the LLC over the corporation, (1) if the company invested in real estate or (2) if the company was formed in a state where LLC income is taxed at a lower rate than corporation income.

What I Do

Every corporation I start begins as an S Corporation. Since most businesses don't make a profit for the first two or three years, I start with the S Corporation because it is taxed like a partnership, a pass-through entity. This allows me to pass the business losses incurred in the start up period through to my personal return and get a personal tax deduction for losses incurred by the business. The limited deductions offered by the S Corporation didn’t matter because there was no profit available to “spend” on deductions.

Later, when the company started to make a profit, I terminated the S Corporation status by sending a letter to the IRS, and reverted to C Corporation status because I needed more tax deductions to offset the income. I also switched back to a C Corporation to take advantage of the medical and dental reimbursement plan and the retirement savings plan. The C Corporation also allows me to benefit from income splitting, that is, leaving some income in the corporation, which enjoys lower marginal income tax rates, resulting in lower overall taxes.

Some people achieve this same effect by starting out as an LLC when there are business losses, and then “kill” the LLC when the business starts to make money. They immediately replace the LLC with a C Corporation to take advantage of the tax breaks. This strategy can be a lot of trouble, especially if the business grows to any size at all. Reorganizing an existing business is a lot of work.

The Bottom Line

After considering the advantages and disadvantages of the different types of business organizations, I lean toward the corporation for most new businesses. The corporation’s flexibility in tax planning and tax reduction makes it the winner for most people.

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