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How to Choose the Right Entity for Your New Business

Which entity is right for you?

Part One of a four-part series of posts

When starting a business, the first thing should be to decide what entity it will be. Most business owners don’t think about this until their CPA asks, “What entity is your business?” As a tax-preparer, I have seen the blank stare many times from clients that didn’t completely understand what they were getting into when they started their business.

Hopefully, this information will help.

The right entity for your business will depend on your business goals. You will need to answer questions and think of where you want to take your business in the future before you can answer most of them. Here is an easy to understand lesson in what each option means and a helpful chart (included in the 4th post) to help you choose wisely.

Let’s get started.

The entity that is heard about most often is a sole proprietorship.

A sole proprietorship is indivisible from its owner. It can operate under a trade name. No formal papers have to be filed; the status arises automatically from buying or selling goods.  A sole proprietorship is just a fictitious name or a “doing business as” clause. The real name is you. For instance: John Barr has a plumbing business. John Barr is the real name and the fictitious name is the company he operates, John’s Plumbing. Both John Barr and John’s Plumbing are one in the same.

Taxes for the Sole Proprietor

Because a sole proprietorship is indistinguishable from its owner, sole proprietorship taxation is quite simple. The income earned by a sole proprietorship is income earned by its owner. A sole proprietor reports the sole proprietorship income and/or losses and expenses by filling out a Schedule C along with the standard Form 1040.

A sole proprietor need not pay unemployment tax on themselves, although they must pay unemployment tax on any employees of the business. That means that if the business fails, the sole proprietor does not get unemployment.

Legalities

Sole proprietor’s are personally liable for all the debts of their business. The potential liability can be alarming. For example: Let’s assume the sole proprietor borrow money to operate, but the business loses its major customer, goes out of business, and is unable to repay the loan. The sole proprietor is liable for the amount of the loan, which can potentially consume all their personal assets. In other words, you have no protection since the real name of the company is yours. In order to repay the loan you may have to sell everything else you have to come up with the money. You have no protection against your personal assets. They can all go away.

Advantages of the Sole Proprietorship

○ Owners can establish a sole proprietorship easily and inexpensively.
○ Sole proprietorships carry little formalities
○ Sole proprietors don’t have to pay unemployment tax on themselves
○ Owners may freely mix business and personal assets

Disadvantages of the Sole Proprietorship

○ Owners are subject to unlimited personal liability for loses, debts, and liabilities of the business
○ Owners cannot raise capital by selling an interest in the business
○ Sole proprietorships rarely survive the death or incapacity of their owners and so do not retain value

When choosing an entity, it is important to make a choice based on facts but also to think about the future and do the “what ifs” for you and your family.

Next up: Partnerships

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