Choice of Business Entity - Part 1

Editor's Introduction

Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories. First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.

In this, our first ‘theory’ article, Contributing Author Rob Shaff begins a 2-part mini-series on choosing the right business entity type for your business.  It’s easy to see how critical this is not only from a foundational standpoint governing everything applicable to your accounting for end of year tax forms, and a slew of other record-keeping requirements, but from a practical standpoint it is one of those first essential questions you are required to complete when you start your new subscription to Zoho Books.  After all, if you fail to select the proper ‘entity type’, you can count on the fact that many of the accounts within the chart-of-accounts will be improperly coded as will a great deal of your reports.

You can see in the above figure that Business Type is configured within the ‘Organization Profile’ of your Zoho Books company file. So with this practical step in mind, let's look at the theory behind making this crucial and significant choice.

At some point, every individual dreaming of owning their own business has to face the decision of the type of entity that will hold their new business. But, most entrepreneurs don’t have the requisite knowledge or experience to determine the optimal entity type. Rather, they know they want unimpeded freedom to make the necessary business decisions, and, of course, to pay as little tax as possible. Finding that balance can be difficult, but it doesn’t have to be.

As the new owner begins exploring entity options, he is faced with several choices – sole proprietorship, LLC, corporation (both Sub-chapter C and S), or partnership. So, which is it? What makes the most sense? The new owner will typically seek advice from friends who own their own businesses, an attorney, or an accountant. But, line these ‘trusted advisors’ up, and the owner will likely end up with different answers from each. Which one should he trust?

I am asked these questions by new business owners often, and as a result, I’ve had to develop visual options to assist my clients. One helpful process is to offer a comparison of the entity types, the major attributes of each, and the effects on a business and the business owner.

In this article, I will provide some basic information regarding the primary attributes of several types of business entities. While this information will not result in an obvious decision for the business owner, it will provide a decision tree of sorts allowing the owner to match his personal preferences to a particular business entity. The attributes of each entity type are presented in the matrix-style table below.

ENTITY TYPES AND THEIR ATTRIBUTES

The entity types discussed in this article are:

  • Sole Proprietorship
  • Partnership
  • Limited Liability Company
  • S-corporation
  • C-corporation

Each of the entity types has their own peculiarities, advantages, and disadvantages, which is why it is highly advisable that any prospective entrepreneur carefully study the attributes, obtain counsel from their chosen advisor, and contemplate the best structure for their business. Sure, if you make a mistake and choose the wrong entity for your business, you can correct it, but not without a cost.

The prime attributes discussed in the first table below include:

  • Formation requirements
  • Liability exposure to owner(s)
  • Taxation and tax reporting
  • Compensation
  • Number of owners
  • Self-employment taxes
  • Accounting methods available

Every new business owner should carefully consider their specific business, industry, geographic region, general economy, experience, capital sources, and a variety of other issues before making this important decision, as well as consulting their chosen advisor.

And in the remaining portion of the table, you will find the topical areas of:

  • Retirement Plans
  • Primary advantages
  • Primary disadvantages

CLICK TO DOWNLOAD A COPY OF THE ABOVE CHARTS

Next week, we will discuss the various entity structures described, and I will provide some experiential commentary for your consideration.