WHICH BUSINESS ENTITY IS RIGHT FOR ME?
Last month I wrote about why every American should start a small business—even if it’s just setting up a lemonade stand or buying a condo to rent to tenants. I explained how there are significant tax benefits to business owners that aren’t available to someone who is only an employee with a W-2 paycheck. Now that you’ve decided to start a business, what is the right type of business entity for you?
Let’s start with a list the different types of ways you can own a business: Sole Proprietorship, General Partnership, Corporation, Limited Partnership, Limited Liability Company. These are the main entities (or in the case of Sole Proprietorship, lack of entity) that we can use to own a business. I’ll give a description of each type and then for the tricky part: With some entities, you can choose different types of tax classification.
Sole Proprietorship: This is the simplest way to own a business. It’s just in your personal name. You don’t have to register as a business entity with the state, and you only need to fill out a form to get a General Excise Tax License (license to do business in Hawaii). A Sole Proprietorship is taxed on Schedule C of your 1040—your regular tax return with the IRS. You don’t need a separate business tax return for your sole proprietorship.
General Partnership: Also called a Partnership can also be formed without registering an entity with the State of Hawaii. You may simply engage in business with a partner to form a partnership. However, I always recommend having a lawyer assist you in creating a partnership agreement so that you and your partner(s) are clear on what your rights and responsibilities are with each other and who will do what. Even if you think there will never be any problems between you, this will help to clarify who has what responsibilities and how the profits will be distributed. There is no limited liability with a Partnership and all partners are liable for what their other partners do in the business. Partnerships allow for very flexible distribution of profits and allocation of taxes.
Corporation: A corporation has the added benefit of separating business assets from personal assets so that if the business fails or gets sued, you won’t lose your home, car, and other personal assets with it. Your losses are limited to the amount you invested in the corporation. It requires filing Articles of Organization with the State to create the corporation and there are other drawbacks. Primarily, it is more expensive to set up and maintain with more legal formalities, but also it must file its own tax return and profits are usually subject to “double taxation” as they are taxed once on the corporate level and then again when they are distributed as dividends. However, if the stockholders of the corporation all meet certain requirements, you can choose to have it taxed as an S-Corporation, which has “pass-through” taxation similar to partnerships. This eliminates the double taxation problem.
Limited Partnership: Unlike a general partnership, a limited partnership must be created by filing with the State. Limited partners have limited liability, but no say in how the business is run on a day to day basis. That is all managed by the general partners. A Limited Partnership always has to have at least one general partner whose liability is not limited. Limited partnerships also allow for very flexible distribution of profits and allocation of taxes.
Limited Liability Company: This is the most flexible of all the business entities. It does limit the owners’ liability like a corporation, but doesn’t have as onerous requirements to comply with the law. You can be the only owner of an LLC (a single member LLC) which is by default treated as a sole proprietorship for tax purposes, or you can own it together with one or more people (multi-member LLC) which is by default treated as a partnership for tax purposes—but either way the members can choose to have the LLC taxed as a regular corporation (C-Corporation) or an S-Corporation instead of a sole proprietorship or partnership.
If you are planning on holding real estate in your business, one word of caution: DO NOT USE a corporation or an LLC that has elected to be taxed as a C-Corporation or S-Corporation to hold real estate. There are severe tax consequences when you try to get the property out of the corporation or sell the property in the future, so it’s usually best to use an LLC that is taxed as a sole proprietorship or as a partnership to hold real estate.
As you can see, we’ve barely scratched the surface about business entity choice, and you can save a lot of headaches and potentially tens of thousands (or millions) of dollars by selecting the correct entity and getting appropriate advice up front. Be sure to consult with a competent attorney before starting your business so you know what the best approach is for your situation.
OKURA & ASSOCIATES, 2015
Honolulu Office (808) 593-8885
Hilo Office (808) 935-3344
Ethan R. Okura received his Doctor of Jurisprudence Degree from Columbia University in 2002. He specializes in Estate Planning to protect assets from nursing home costs, probate, estate taxes, and creditors.
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This column is for general information only. The facts of your case may change the advice given. Do not rely on the information in this column without consulting an estate planning specialist.