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Checklist of Factors to Consider When Choosing a Business Entity

BusinessteamBusiness Entities for Entrepreneurs and Lawyers

For tax, legal and practical reasons, it is critically important to select a business entity that suits the needs of both the business and its owners.  Selecting an improper business entity can result in the assessment of unnecessary taxes against the business or its owners, either during the course of operating the business or upon its sale, merger, or termination.  Selecting an improper entity can also result in management difficulties and the needless exposure of one or more of the business owners to personal liability for the debts and liabilities of the business.  Additionally, an improper business entity may result in the imposition of management or organizational structures that do not fit the needs of the business and may stifle it growth or give rise to unnecessary conflicts among the business owners.

Checklist of Factors to Consider When Choosing a Business Entity

The first step in the process of selecting a business entity is to determine the needs of the business and the needs and desires of the business owners.  In selecting an entity for a small business enterprise, there are several factors that should be considered.  The relative importance of each factor varies with the business setting.  The factors that should be considered include the following:

  1. The type of business owners.  Will the business be owned by individuals, corporations, trusts, U.S. residents, foreign residents, or other entities?  This factor is important because certain business entities (primarily S corporations) are not available to certain types of owners.
  2. The number of business owners.  Will there be one owner, a few owners, or numerous owners.  This factor is important because certain types of business entities are not available to one-owner businesses and other types of entities are either not available or not practicable if the number of owners is too high.
  3. The primary purpose of the business venture.  Is the primary purpose of the business to provide employment for the business owners or is investment the primary purpose?  Is the primary purpose of the business the same for each owner or are some of the owners involved primarily for employment purposes and others primarily for investment or other purposes?  This is important because the business entity must be capable of being structured so as to accomplish the purposes of all of the owners.
  4. Whether the business is startup or existing.  If the business is already in existence, certain types of entities might not be feasible because of the impracticality of reorganizing the business into that entity.  For example, if an existing business is being operated as a corporation, it may not be practicable (taxwise) to reorganize the business into an LLC or partnership.
  5. How the business will be capitalized?  Will it be capitalized primarily by debt or equity?  If it will be capitalized primarily by debt, an LLC, partnership, or S corporation might be preferable to a C corporation because a portion of the debt may be includible in the tax basis of the owners’ interest in the business.
  6. The importance to the owners of pass-through taxation.  If this is important, a C corporation should not be used.  If the owners anticipate net losses in the business operation during its early years and if it is important to the owners that these losses be passed directly to them in the year of incurrence, then a C corporation should not be used.  An LLC, partnership or S corporation will clearly be preferable in this instance.
  7. The importance to the business owners of personal liability protection.  If it is important to the owner or owners that they not be personally liable for the unassumed debts and liabilities of the business, then a sole proprietorship or general partnership should not be used unless the partnership is a limited liability partnership.  As a practical matter, from a personal liability standpoint, it is almost never advisable for an individual to operate as a sole proprietor.
  8. The extent to which the owners wish to have personal control over important business functions, such as the admission of new owners, a change in the type of business conducted, the transfer of ownership interests, or the discontinuance of the business.  While controls over these functions are possible under any type of entity, they are most easily imposed in a general partnership or LLC.
  9. Do the owners wish to distribute profits not in proportion to equity ownership or capital contribution?  If so, this can most easily be accomplished in a partnership or LLC.
  10. The importance of being able to retain earnings in the business for purposes of expansion or other future capital needs without it being reportable as income by the business owners.  If this is important, a C corporation should be used.
  11. The importance to the business owners of being able to participate in the employee benefit plans of the business.  If this is important to the owners, a C corporation offers significant advantages because of the restrictions imposed on partners, LLC members, and shareholders of S corporations who own 2 percent or more of its stock.
  12. The importance of being able to raise capital or expand the business by selling ownership interests to large numbers of outsiders or to the public.  If this is important, a C corporation is usually preferable because of the universal recognition of corporate stock as an indicia of ownership.  However, the sale of ownership interests may also be feasible in an LLC or limited partnership.
  13. The limitation imposed by the owners on the amount of initial organizational expenses that they wish or can afford to incur.  If this factor is important, a sole proprietorship, partnership or LLC should be used because they are usually easier and less expensive to organize and set up than C or S corporations.

In selecting a business entity it is important to weigh the needs and desires of the business and each of its owners against the advantages and disadvantages of each available type of business entity.  More information is available in Argyle’s Attorney’s Handbook on the Law of Small Business Enterprises.