Choosing a Legal Business Entity: Corporation, LLC or Sole Proprietorship?

Choosing a legal business entity is one of the biggest decisions a small business owner will make. When deciding on an entity, one should consider the exposure of personal assets to liability, potential tax advantages, the ability to transfer ownership and the management structure desired.  When leasing or buying an commercial warehouse or manufacturing building, your business entity will be placed either on the lease form as Lessee, or it will hold fee title to the property you buy.  On the flip side, landlords often use LLC’s to hold title to industrial properties in Southern California and Los Angeles.  The LLC is now the favored holding entity for commercial real estate.  Here is a primer on the most common entities:

Sole Proprietorship: If a business is owned by one owner and is not incorporated, it is a sole proprietorship, which is a simple and inexpensive way to conduct a business. It’s also the most prevalent type of small business in the country. The owner is taxed on individual tax returns. The big drawback with sole proprietorships is that the owner is fully liable for business obligations, meaning that personal homes, cars and savings can be pursued by creditors.

Limited Liability Company: As liability increases, business owners should consider a limited liability company, which can cost between $200 and $250 to set up. LLCs protect owners from individual liability, while still allowing the owners full or limited management rights as they desire. As a separate legal entity, an LLC can own property, incur debts, enter into contracts and be a party to civil actions. LLCs offer several taxing options. If the LLC has two or more members, the entity can choose to be taxed as a partnership or a corporation. An LLC that elects corporate treatment may opt for S corporation treatment. If no election is made, the IRS will tax the entity as a partnership.

Partnerships: Partnerships consist of an association of two or more persons who have not incorporated and carry on a business for profit as co-owners. Partnership arrangements are flexible, allowing partners to split ownership and profits however they wish–general partnerships, limited partnerships or a limited liability partnership. General partnerships can be formed without any formalities. General partners are liable for the obligations of the partnership, and each partner can bind the partnership contractually with third parties. A limited partnership requires at least one general and one limited partner, with the limited partner having no management responsibility. Limited partners are liable only for the money invested in the partnership, while the general partner remains liable for all partnership obligations. Through their individual tax returns, partners pay taxes on their interest in the partnership’s profits and losses.

Corporations: Corporations are advantageous because they shield personal assets, allow free transfer of ownership and ensure continued existence if a shareholder dies or leaves. A corporation is a separate legal entity that can own property, sue and be sued, and has status as a separate taxpayer. To organize as a corporation, articles of incorporation must be filed with the state. Corporations must also establish bylaws, issue shares and hold annual meetings. Ownership is through stock, which can be categorized in different classes and freely transferred. Corporations can be taxed either as C corporations or S corporations, which refer to their respective subchapters in the Internal Revenue Code. The S corporation does not pay taxes; instead, the income and deductions pass through to the shareholders, who are taxed on their individual tax returns. A C corporation pays tax on its net taxable income, but shareholders must also pay tax on dividends they receive. C corporations can obtain tax deductions for business expenses, which are not available to other entities.

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