Congratulations! You have decided to start your own business. Along with developing your business plan, getting a handle on your market and your competitors and deciding other details for your business, you would be wise to explore the type of business entity that makes the most sense. The structure of the business entity will impact the taxes that you pay, the amount of paperwork and red tape you may have to endure and the overall costs of doing business.
Despite the advertisements for some of the ‘do it yourself’ software available on the web and the ease with which they tout the mechanics of incorporating, the ‘what’ is more important than the ‘how’. Don’t short change your personal assets and those of your business by going it alone. At a minimum, consult with an attorney or a tax professional on the ‘what’.
There are 5 main types of corporate structures that businesses can choose for their operations:
Limited Liability Corporation (LLC)
We will explore the highlights and pros and cons of each of these structures.
A sole proprietorship is the least complicated and usually the least expensive business model to adopt. A sole proprietorship is owned and operated by a single individual, hence the sole. A sole proprietorship is limited to the life of the individual, making transfer of interest difficult.
Capital may be restricted as it tends to be limited to the amount that the individual can secure personally. This could result in one of the most common reasons for business failure, that of under-capitalization. Therefore, this factor can be significant for the long term success of the entity. The major disadvantage to selecting a sole proprietorship entity is the unlimited liability for business debts as well as personal assets.
Liability for a sole proprietorship extends to the proprietor’s business and personal assets.
Now for the good news. Administrative costs are the lowest and there is minimal red tape for this type of entity. Business income is taxed to the owner on his or her personal return (Schedule C). Income taxes are not withheld on business income, although quarterly estimated taxes may be required. Payroll taxes apply to employees of a sole proprietorship, while the proprietor pays self-employment tax rather than social security tax. There is a substantial tax deduction for the taxes paid. On the flip side, deductibility of fringe benefits is very limited. The IRS is particularly vigilant on reviewing sole proprietorship business expenses to determine validity.
A partnership is an entity that offers its partners the benefit of sharing skills, experiences, and possibly access to capital, beyond that of a single individual. A partnership files a tax return for information purposes but pays no income tax itself. Any income or loss passes through to the partners who then report the income or losses on their individual returns proportionate to their negotiated share in the partnership. Similarly to sole proprietors, partners pay self-employment tax on net income rather than social security taxes on wages.
Another similarity to sole proprietorship with a partnership is the unlimited liability, including liability incurred by fellow partners. The continuity of the entity and the transfer of interest are difficult unless these factors were addressed in the partnership agreement. The chemistry of the partners and their ability to work together are important facets contributing to the success of a partnership.
Limited Liability Corporation (LLC)
The LLC entity combines the general flexibility and income tax considerations of a partnership with liability limitations that accrue to a corporation. An LLC may also be subject to differences at the state level regarding tax treatment. There are different classifications of LLCs that impact the specifics of tax filing requirements.
The administrative costs tend to mirror that of either an S or C Corporations and the treatment of deductibility of fringe benefits is dependent on tax status.
S Corporations may only elect this status if they meet certain criteria. One of the major advantages of this structure is that it combines the limited liability of a corporation with a tax treatment that more closely aligns with that of a partnership. A downside is the restriction on deductibility of fringe benefits, again similar to a partnership, for owner-employees.
An S Corporation does not pay income tax, but rather files a Form 1120S and distributes tax forms (K-1) to shareholders. Shareholders then report their proportionate share of income, losses and/or credits on their personal return. This represents the primary difference between and S and C Corporation structure, the avoidance of double taxation, the biggest drawback of a regular or C Corporation.
A C or a Regular Corporation is the most complex of business entities, with significant reporting rules and regulations and the corresponding red tape. It is a distinct legal entity apart from the shareholders that own it. A corporation limits its owners’ liability to their investment in the company; personal assets are generally not at risk.
Employees of a corporation have taxes withheld by the corporation; the corporation pays payroll taxes on behalf of the employee. A corporation files a tax return and pays income taxes; employees file tax returns on their wages and any dividends or liquidated distributions. Business profits may be taxed twice with this structure, at the corporate level and at the shareholder level (dividends or distributions).
A C Corporation enjoys the highest limit of liability exposure, the highest likelihood of continuance beyond the founders and the ability to most readily transfer interest through stocks. Ease of capital acquisition tends to favor the corporate structures, both S and C, with the ability to issue stock.
This is not intended as an exhaustive review of all of factors nor as a recommendation of what entity may be most appropriate for you and your business. Consultation with a qualified tax attorney or accountant can help you decide which structure will assist you in protecting your assets while being most flexible for your business.