Factors to Consider When Choosing Entity Structure

One of the first major decisions many entrepreneurs make is choosing which type of entity to structure their business as. It’s a decision that has major implications in the short, medium, and long term. 

Business owners have many  options, from default choices such as sole proprietorships and partnerships to corporations and LLCs that must be formally registered. This isn’t a decision entrepreneurs should take lightly: your choice of entity structure significantly impacts your business’s  tax, legal, and operational strategy.

In our series on entity selection, we’ve taken a deeper dive into each of the five most common forms of business entity. In this final article of the series, we’ll summarize the key factors that drive the decision of the most appropriate entity structure for a given business. 

It’s important to note that the facts and circumstances of every entrepreneur’s unique situation should guide their choice of entity structure. We recommend that you consult with experienced entity selection advisors, such as the professionals here at Smith + Howard. 

This article is part of our series on entity selection. View our other articles here:

• The Importance of Entity Choice
• An Overview of the Sole Proprietorship Entity Structure
• An Overview of C Corporations: Tax and Non-Tax Considerations
• S Corporations: Key Tax and Non-Tax Considerations for Entrepreneurs
• Partnerships: What Entrepreneurs & Business Owners Need to Know
• Structuring Your Business as an LLC: A Guide for Business Owners
• Factors to Consider When Choosing Entity Structure – Smith and Howard (smith-howard.com)

How to Choose the Right Entity Structure: Key Factors to Consider

Selecting an entity structure is an important decision that has long-reaching ramifications. While changing to a different entity structure is possible and frequently occurs as business needs evolve, doing so can be costly and disruptive. Before making a decision, business owners must consider their position today and in the future. 

Several factors should be considered before establishing a business. They include:

• Desired tax treatment
• Level of liability protection
• Administrative requirements
• Attractiveness to investors

Below, we explore these factors in more detail and outline the trade-offs entrepreneurs should consider when selecting the most appropriate structure for their business.

1. Desired Tax Treatment

Generally, a business can either be a flow-through entity (Sole Proprietorship, S Corporation, Partnership, LLC) or a C Corporation. This distinction determines how the business is taxed, both on an ongoing basis and in the event the business is eventually sold. 

Flow-through businesses pass all of their income and losses through to their owners, who report this activity and pay required taxes on their personal income tax returns (rates vary from 10% to 37% depending on income bracket). Income recognized by a C corporation is taxed twice: once at the corporate level (21%), and again when shareholders receive dividend income (generally, it will be qualified dividends and are currently allowed preferential rates ranging from 0%-23.8% plus state taxes).

In the event a company is sold, the way in which the proceeds of the sale are characterized is also driven by entity structure. Flow-through entities allow sellers to realize a capital gain while providing acquirers with a step up in basis but lack some of the tax benefits of a C Corporation, including the Qualified Small Business Stock (QSBS) Exclusion. 

Calculating the most efficient entity structure for tax planning is complex and should be determined in partnership with experienced tax professionals. 

2. Liability Protections

A key concern for many entrepreneurs is personal liability protection. Some entity structures, including corporations and LLCs, shield business owners’ personal assets against the business’s liabilities. Others, including sole proprietorships and general partnerships, offer no such protections. 

If a business owner opts for an entity structure with liability protections, their personal assets, including their home, retirement accounts, and other assets, can be shielded from their business’s creditors. On the other hand, if a business structured as a sole proprietorship faces a multi-million dollar lawsuit, it won’t just be the business on the line; it’ll be all of the business owner’s personal assets, too. 

3. Administrative Requirements

Each different type of entity comes with unique administrative requirements, both in the initial set-up phase and on an ongoing basis. You can consider this as a spectrum. 

At one end of the spectrum are sole proprietorships. There are no filing requirements or registration processes to set up a sole proprietorship; you can just start doing business. However, you have no liability protections; a significant drawback. 

At the other end of the spectrum is C Corporations. C Corporations are the most expensive to establish, and require regular record keeping, corporate bylaws, frequent filings, and more. However, there are various advantages to C Corporations that offset the administrative burden, from liability protections to their attractiveness to investors. 

Other types of entities fall somewhere in between. Establishing an LLC or an S Corporation comes with some costs and filing requirements, and a partnership requires creating a formal partnership agreement. 

4. Ownership and Capital Requirements

Many businesses, at some point in their evolution, will seek external capital from investors to fuel a new growth phase. 

External investors typically prefer to invest in C Corporations and LLCs since these entity structures have fewer restrictions on ownership and allow companies to issue multiple classes of stock. S Corporations are particularly limiting, only allowing companies to have 100 shareholders, all of whom must be U.S. taxpayers and typically can only be individuals (with some exceptions). 

But before considering the needs of potential future investors, it’s also important to think about the ownership structure of your business today. If you have several owners, a partnership might be the best option, whereas if you’re a solo founder, other options might make more sense. 

Smith + Howard: Experienced Entity Selection Advisors

While the factors explained in this overview are among the most important when selecting the most appropriate entity structure for a business, there are additional factors to consider. From the location of your business operations to the ability to create Employee Stock Ownership Plans (ESOPs), it’s important to assess every element of your business before making a decision. 

This is an extremely important decision that will have implications for years to come. For that reason, it’s always advisable to consult with experienced tax and advisory professionals with the expertise to help you make the right choice. 

At Smith + Howard, our entity selection team brings a proven track record advising entrepreneurs at every stage of their journey. Our professionals work closely with clients to make recommendations that weigh every consideration: from tax to liability and operational concerns. 

To learn more about Smith + Howard’s entity selection advisory services, contact an advisor today.