By: Pooja Srivastava
The first and most important decision for entrepreneurs and startups is choosing the right business structure. Your choice of entity impacts your tax burden, personal liability, ability to fundraise (structure capital), and administrative requirements, among other things.
There is no one size fits all choice of entity, and each business’s decision-making factors will be different. Entrepreneurs should consider several important criteria with their tax professional when selecting an entity:
- Liability: How much liability is your business likely to face, and can you take on risks personally?
- Taxation: How can you minimize the amount you owe on taxes, based on your business and personal situation?
- Administrative burden and cost: Do the benefits of the structure you choose outweigh its downsides for your business, such as administrative requirements?
- Eligibility: How is the organization structured, and does that impact your choice of entity?
Future Goals: What do you envision for your business? You may want to convert to another entity in the future, so you can do things like take on shareholders, for example.
Forms of Business Entities
While there are many different entity types to choose from, the most common are Sole Proprietor, Partnership, Corporations (C Corporation and S Corporation), and Limited Liability Company (LLC).
Sole Proprietorships and Partnerships avoid double taxation, meaning the business is not taxed on profits and losses. Instead, only the personal income of the owner(s) is taxed. However, these two structures subject the owner(s) to personal liability for the business.
S Corporations and LLCs avoid double taxation, and owner(s) are not personally liable for their business’s legal and financial concerns. C Corporations face double taxation but avoid personal liability.
Corporations in general face the highest record-keeping requirements and administrative burden, while Sole Proprietorships are the easiest to operate.
Sole Proprietorships account for more than 70 percent of all businesses in the US. The easiest entity to set up, Sole Proprietorships allows one owner complete control of the business. However, the structure leads owners personally liable for the business.
Key Features of Sole Proprietorships
Sole proprietorships are easy to set up with minimal paperwork and no separate tax filing. One sole owner is personally responsible for profits and losses.
- Sole proprietors assume unlimited liabilities and are legally responsible for debts and legal action against the business.
- Business and personal assets are considered the same from a tax standpoint. Therefore, both are at risk if the owner or business run into financial issues.
- Sole proprietors can “pass through” the profits and losses from their business to their personal tax returns. This means that they are taxed at their personal income tax rate, rather than their business tax rate. Their business losses may offset their income from other sources, for example, reducing their total tax owed. The structure also avoids double taxation.
- Obtaining financing is often difficult under a Sole Proprietorship, and it may be difficult to get a bank loan.
For many small businesses, a Sole Proprietorship is a good place to start for its low administrative burden and tax benefits. However, many Sole Proprietors later need to convert to another business structure as they grow and require more liability protection, funding, or other needs. With the help of a tax professional, businesses should evaluate whether they need additional liability protection, can handle additional administrative requirements that may come with other business structures, and other considerations. If you decide that you would like to convert a Sole Proprietorship to a Corporation or a Limited Liability Corporation (LLC), there may be tax consequences. Consult with your tax professional to determine the best time to do it.
A Partnership may be a good choice when two or more people decide to conduct business together and share the profits and losses. Like a Sole Proprietorship, each partner is personally liable for the business’s financials and legal issues.
General Partnerships are relatively easy to set up and feature two or more active partners that own and operate the business.
Another type of partnership structure is Limited Partnerships, which have general and limited partners. General partners operate the business, and are also personally liable for its profits, losses, and legal issues. Limited partners are basically just investors – they have no liability and are also not involved in the business’s day to day. Limited Partnerships can be more complex and difficult to establish than General Partnerships.
Important Partnership Features
- Partnerships are often created through a verbal agreement. However, written partnership agreements should be created as soon as possible.
- Similar to Sole Proprietorships, there is no double taxation. Partners pay taxes on their personal income from the business, and losses can reduce their taxable income from other sources.
- Partners are jointly and individually liable for the actions of the other partners, whether they are aware of them or not. Each partner may act on behalf of the business and make decisions that are binding for all other partners.
- Profits and losses must be shared. In your written partnership agreement, you can determine how to split profits and losses. Without an agreement, partners must share profits and losses equally.
- Some employee benefits are not deductible from business income on tax returns.
- Partners’ income is subject to self-employment taxes.
- This entity type allows property to be distributed to partners in a tax-deferred manner.
- The flexible structure can complicate accounting and tax preparation.
Corporations are considered unique and separate from their owners, protecting partners from personal liability when the business faces trouble. Corporations can be taxed and sued, and can enter contractual agreements. This structure carries a high cost, and burdensome requirements for record-keeping. Corporations must be based in a state and subject to its laws.
While C Corporations face double taxation, S Corporations allow profits and losses to be “passed through” and only taxed once on the owner’s personal tax returns.
For all types of corporations, the owners are considered its shareholders. All corporations must prepare documentation including articles of incorporation, corporate bylaws, and more. Corporations must comply with their rules of incorporation, or else courts can hold owners personally liable for the business’s debts.
After the Tax Cuts and Jobs Act (TCJA), all corporations are taxed at a flat rate of 21% as of 2018.
C Corporations are considered the standard or default corporation type by the IRS.
Key Features of C Corporations
- This structure limits the liability of its shareholders if the business is adequately capitalized and corporate formalities are followed.
- There is no limit on the number of people who can own stock.
- Multiple classes of stock can be issued to shareholders.
- Shareholders can easily trade publicly held shares.
- C Corporations are taxed at the entity level. Shareholders are taxed only on distributed dividends, or money that they earn from selling stocks. However, there is no tax on undistributed income, or unsold stocks.
- Capital gains taxes are reduced on the sale of qualified small business stock.
S Corporations are taxed as a flow-through entity, allowing shareholders to be taxed only at the individual level. This is a distinct advantage compared to the C Corporation, which faces double taxation at both the corporate and individual level.
Defining Features of S Corporations
- Employment taxes are calculated based on the salaries taken by owners, and not including other forms of compensation. To make sure employment taxes are fair, owners’ salaries must be “reasonable” and comparable to similar roles in the field.
- Because of “flow through” taxation, shareholders’ losses can offset their income from other sources on their personal tax returns.
- Owners face limited personal liability.
- Profits must be strictly divided according to a shareholder’s ownership, unlike some other entity types. For example, a shareholder who has contributed 25% of the business’s capital must receive exactly 25% of the business’s net profits and losses.
- In other business structures, fringe benefits to employees are not taxable. For S Corporation shareholders that own more than 2% of the company’s stock, certain fringe benefits are taxed.
- The total number of shareholders is limited to 100 individuals.
- S Corps can only offer one class of stock to shareholders.
Limited Liability Companies (LLCs)
LLCs are a hybrid business structure, combining some of the benefits of partnerships and corporations. Like a partnership, profits and losses can be “passed through” to the owners without double taxation. And like a corporation, owners have limited personally liability for the financial or legal issues faced by their business.
Critical Features of LLCs
- Owners can choose to be taxed as a Partnership or Corporation.
- Owners can receive different-sized distributions of profits and losses, which do not have to be tied to how much capital each person has contributed.
- This structure offers flexibility for tax planning and rewards for employees who bear more responsibilities.
- There is no limit to the number of shareholders that an LLC can have, but LLCs cannot issue stock.
- LLC laws vary by state:
- Some states limit the number of owners in an LLC.
- Some states do not permit international investors for LLCs.
- For tax purposes, LLCs may decide to be classified as a Partnership, Corporation, or a disregarded entity (separate from its owner, but not for tax purposes).
- If they have employees, LLCs are treated like Corporations for employment tax purposes.
- If there is just one owner, LLCs are treated as a single member. A multi-member LLC, can make an election to be treated as a Partnership or Corporation.
- Members of an LLC pay self-employment taxes as a percentage of total profit, not just their personal salary.
There are a multitude of tax issues to consider when selecting a business entity, and the factors used to make the decision vary from one business to the next. Business owners should meet with their tax professional to fully analyze the relevant impacts of their entity choice. Connect with an experienced Chugh professional to help you choose the business structure best suited to your company’s needs.