When you are choosing an entity there are a number factors you should consider. For instance, you should think of how you would like to manage the business, protection against liability and your preferred tax treatment. Below are brief descriptions of several business entities that may suit your needs and some of the advantages and disadvantages of choosing those entities.
The sole proprietorship is the simplest form of business. A sole proprietorship is not an entity separate from you. Though the sole proprietorship is a simple and convenient way to operate your business, you should beware, you will be exposed to unlimited personal liability if you operate your business as a sole proprietorship. The owner of a sole proprietorship is directly and personally liable to creditors and other claimants.
A corporation is a business entity created under state law and is as an independent legal "person" apart from its shareholders and directors. A corporation's shareholders are generally not liable for the obligations of the corporation and are thus generally shielded from the corporation's creditors even if the corporation cannot pay its obligations. Corporations must comply with statutory rules which are typically more restrictive and require considerably more formality than limited liability companies.
The distinction between a C Corporation and an S Corporation relates to the corporation's tax treatment. Some of the advantages of a C Corporation are that ordinarily you may deduct the entire value of the fringe benefits offered to shareholders who also serve as employees, the number of shareholders the entity may have is unlimited and they may be either individuals, entities, U.S. residents or foreign. C Corporations also have significant flexibility to carry corporate losses forward to future tax years. But, operating as a C Corporation usually subjects you to double taxation, i.e., tax at two levels. First, the net earnings of the corporation are taxed, and then, the shareholders will be taxed on the earnings of the corporation distributed to the shareholders. For example, if a corporation issues dividends to its shareholders, it has already paid income tax on that money, but the dividends remain taxable as income to each shareholder.
An S corporation is a regular corporation that has elected "S corporation" tax status. An S Corporation provides the limited liability of a corporation and the tax treatment of a partnership or a limited liability company. With respect to non-tax considerations, the S corporation is essentially identical to a C Corporation. The significant tax advantage with the S Corporation is that the corporation does not pay any income tax on its earnings. Some disadvantages to an S Corporation are that only once class of stock is permitted and you must limit the shareholders to 100 individuals, none of which may be an entity (with the exception of estates and certain types of trusts) and none of which may be non-resident aliens.
Unincorporated Entities - Limited Liability Company
The limited liability company (LLC) has characteristics of both a corporation and a partnership. The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of "pass-through" income taxation. Unlike a corporation, few of the LLC statutory rules are mandatory and most of its governance is dictated by an operating agreement executed by its members The management powers in the LLC can be retained by the members of the LLC or centralized within a board of managers (who may or may not be members). Another advantage of the LLC is that its flexibility allows for much less administrative paperwork and record keeping than a corporate structure. Some disadvantages of an LLC are that some investors are more comfortable with a corporate structure (although this may only be an issue once the company is ready to take on significant investors and not in the early stages of your business) and some creditors may require that you, and other members, personally guarantee a loan to your LLC.
In a general partnership, each partner has full and equal control over the partnership. The partnership is a "pass through" entity for tax purposes. While partners have considerable flexibility in structuring their relationship, partners run a great risk of loss because there is no limitation to a partner's liability. Partners have joint and several liability for the acts of each partner within the scope of partnership business.
Under a limited partnership (LP), unlike a general partnership, the limited partners are not responsible for partnership debts, obligations and liabilities. An LP may have an unlimited number of limited partners, but must have at least one general partner who is responsible for the management of the partnership. The general partner remains personally liable for partnership debts, obligations and liabilities, but the general partner can be a limited liability entity to add a layer of protection to the individuals managing it. Like the general partnership, the LP is treated as a "pass-through" entity. A disadvantage of the LP is that the limited partners must be careful not to become engaged in the decision making of the business or they will run the risk of losing limited liability protection.
Limited Liability Partnership
A limited liability partnership (LLP) is a variation of the LP which allows a limitation of liability without the restriction on active participation required with an LP. Under an LLP, partners remain liable for their own acts and are generally not liable for the acts of others, unless the partner has acted negligently or committed misconduct. As with the general partnership and the LP, an LLP is treated as a "pass-through" entity for tax purposes.
Bottom Line: There is no "one size fits all" answer to the choice of entity question. You should give careful consideration to your needs and the needs of your business before settling on an entity. Since the factors in consideration may be significant and the tax analysis complex, it may be wise to consult your tax advisor or an attorney to assist you in the decision process.