Business Entities: Choosing the Right Entity for Your Business

Mar 11

Overview:

In simple terms, a business entity is a legal structure that defines how a business operates and is recognized by law. Choosing the right entity is a foundational decision for any small business. It impacts various aspects of operations including taxation, liability protection, and financing, and can significantly influence the long-term success of the business. With so many factors at play, it’s important to ask the question “What business structure should I choose?”

For tax purposes the IRS recognizes 4 different types of entities:

Sole Proprietorship
Partnership
S Corporation
C Corporation

Each entity has its own unique features, so it’s important to understand which one best suits your business. As your business evolves, you can transition from one entity type to another, so an initial misstep isn't irreversible. However, choosing the wrong entity type can result in complications, including thousands of dollars in overpaid taxes that otherwise could’ve been avoided.

Limited Liability Companies (LLCs):

LLCs are a popular structure for small businesses, but they’re not recognized by the IRS for tax purposes. They are considered “hybrid entities” that combine some characteristics of a corporation with those of a partnership or sole proprietorship. Like a corporation, they provide limited liability protection, but also offer the option of pass-through taxation like partnerships and sole proprietorships. LLCs are regulated under state statutes, meaning the rules vary from state to state, so you should always check your specific state laws for nuances.

There’s a common misconception when it comes to LLC’s and taxes. It’s important to note that an LLC is a legal entity, not a tax election. Your business can’t be “taxed as an LLC”. Instead, LLC’s can choose how they want to be taxed; as a sole proprietorship, partnership, or corporation, which provides maximum flexibility.

The primary reason for creating an LLC is liability protection, but it does nothing for your taxes. It creates separation between the business and its owners, meaning your personal assets will be protected, and you won’t be held personally liable for any debts or liabilities of the business. That’s why it’s called a limited liability company. LLCs have risen in popularity over the years because of their flexibility and simplicity to set up. They’re basically the standard today for most businesses that want to create separation between the business and its owners.

Sole Proprietorships:

A sole proprietorship is the simplest and most common form of business structure. It is owned and operated by a single individual, and there is no legal distinction between the business and the owner. You are the business essentially.

Benefits:

Simplicity: It’s easy to set up and maintain with minimal regulatory requirements.
Low Cost: It typically has lower startup and operational costs compared to other business structures.
Full Control: The owner has complete decision-making authority and control over the business.
Flexibility: Since it’s owned by a single individual, the owner can adapt quickly to changing business needs without being forced to consult with partners or a board.

Drawbacks:

Unlimited Liability: The owner is personally liable for all debts and obligations of the business, putting your personal assets at risk. This is the biggest downside, and why you should consider forming an LLC once your business gets up and running. Remember, LLC’s give you limited liability.
Limited Funding Options: It may be harder to raise capital as a sole proprietor compared to corporations or partnerships. Typically, the owner will need to put in additional capital themselves or get a loan.
Resource Limitations: The business relies heavily on the owner's skills and expertise, which can potentially limit growth. Typically, the business isn’t able to continue operations if the owner gets sick, disabled, or dies.
Perceived Lack of Credibility: Some clients or vendors may view sole proprietorships as less “professional” than other business types. Typically it’s not a huge concern, but still a potential issue. Another reason why you may want to consider forming an LLC.
Increased Audit Risk: They have the highest audit risk. Less than 1% of all tax returns are audited annually, but this jumps to approximately 2.5% for sole proprietorships, which is more than a 150% increase.

Tax Implications:

The business itself does not pay any tax. Instead, all income, debts, and liabilities “flow through” and are reported directly on Schedule C of the owner’s personal tax return. For example, if your business makes $100,000 in profit during the year, and you will report $100,000 on your personal tax return.

The benefit of this is that no separate tax return is required, so it’s simpler and you can potentially save on tax prep fees.

The downside is that it increases your risk of being audited. As mentioned, sole proprietorships have the highest audit risk of all the entity types. Additionally, if you are audited, the IRS gets access to your personal return, compared to partnerships and corporations which file their own separate tax returns.

Another downside is that you pay self-employment tax on 100% of the profits. This is Social Security and Medicare taxes, which is 15.3% on the first $168,600 of profits. The 12.4% social security tax is capped at that point, but the 2.9% Medicare tax will still be assessed. This can result in higher taxes compared to other entity types. For example, a business that makes $100,000 in profits will pay approximately $15,300 in self-employment taxes.

Partnerships:

A partnership is a business owned by 2 or more individuals that is not a corporation. It’s like a sole proprietorship but with multiple owners. A general partnership is the simplest form, but there are also limited partnerships (LP), limited liability partnerships (LLP), and limited liability limited partnerships (LLLP). Each of them has slight differences, but they all operate the same at the fundamental level of 2 or more people coming together to form a business.

Benefits:

Shared Responsibility: Partners can share the workload and responsibilities, which can make it easier to manage and operate.
Pooling Resources: Partnerships allow for pooling of capital, skills, and expertise, which can make it easier to grow the business and make decisions. 2+ heads are often better than 1.
Flexible Management Structure: Partnerships are very flexible. They can be structured to fit the needs and goals of each partner.
Easy to Establish: Generally, partnerships are easier and less expensive to set up than corporations, with fewer regulatory requirements.

Drawbacks:

Unlimited Liability: In a general partnership, the partners are personally liable for all debts and obligations of the business, putting your personal assets at risk. This is the biggest downside, and why you should consider forming an LLC or some type of limited partnership once your business gets going.
Potential for Conflict: Disagreements between partners can arise, which may affect business operations and decision-making. This is why it’s a good idea to have a written agreement in place.
Shared Profits: Profits are typically shared among partners, which obviously limits your individual earnings compared to sole proprietorships where you keep 100%.
Limited Lifespan: Partnerships typically dissolve if a partner leaves or passes away, unless otherwise agreed upon in a partnership agreement.
Limited Funding Options: It may be harder to raise capital as a partnership compared to corporations which can issue stock.

Tax Implications:

Similar to sole proprietorships, the partnership itself does not pay any tax. However, they are required to file a separate tax return. The partnership will file Form 1065, and then issue a Schedule K1 to each partner. All income, debts, and liabilities reported on the K1 will “flow through” and be reported directly on Schedule E of each partners personal tax return. For example, if the partnership makes $100,000 in profit and profits are split 50/50, each partner will get a K1 showing $50,000, and that will be reported on their personal tax return.

Filing a separate tax return will likely result in higher tax prep fees, but it does decrease your chances of being audited.

Self-employment tax will also be assessed on 100% of the profits, just like sole proprietorships, which can result in higher taxes compared to corporations.

S Corporations:

An S Corporation (S Corp) is an entity that is formed by filing incorporation documents with your state. It’s a special type of corporation that must meet specific IRS requirements, allowing it to be taxed under Subchapter S of the tax code. All corporations are owned by its shareholders.

Benefits:

Limited Liability: Unlike sole proprietorships and general partnerships, shareholders are typically not personally liable for the debts and liabilities of the corporation, which protects your personal assets.
Pass-Through Taxation: S Corps avoid double taxation unlike C Corps. Income is passed through to shareholders and taxed at their individual rates, just like a partnership.
Self-Employment Tax Savings: Shareholders can reduce self-employment tax by taking a reasonable salary and receiving distributions. You pay self-employment tax on the salary portion, but not on the distributions.
Credibility: Operating as a Corporation can enhance credibility with customers, suppliers, and potential investors.
Easier Transfer of Ownership: Shares can be transferred to new owners more easily compared to sole proprietorships or partnerships.

Drawbacks:

More Formalities: Corporations must adhere to more regulatory requirements and formalities compared to sole proprietorships or partnerships. This includes holding regular board meetings and keeping detailed records.
Eligibility Restrictions: S Corps have strict eligibility requirements, such as a limit on the number of shareholders (100 max) and restrictions on types of shareholders.
Limited Flexibility in Profit Distribution: Distributions must be allocated in proportion to ownership. Unlike partnerships, which have more flexibility.
Reasonable Compensation Requirement: The IRS requires S Corp shareholders who work for the business to pay themselves a reasonable salary, which must be properly documented.
State-Level Taxes: Some states impose additional taxes on S Corps, which can limit the overall tax benefits.

Tax Implications:

Similar to partnerships, the S Corp itself does not pay any tax, but is required to file a separate tax return. The S Corp will file Form 1120-S, and then issue a Schedule K1 to each shareholder. All income, debts, and liabilities reported on the K1 will “flow through” and be reported directly on Schedule E of each partners personal tax return. All profits must be allocated based on ownership percentages. For example, say the S Corp makes $100,000 in profit. Partner A owns 75% and Partner B owns 25%. Partner A will get a K1 showing $75,000 and Partner B will get a K1 showing $25,000, which will then be reported on their respective personal tax returns.

The biggest benefit of S Corps is the potential to save on self-employment taxes. Shareholders that work in the business can be classified as employees of the corporation. This means they can pay themselves a reasonable salary (W2 wages), which is subject to self-employment tax, while any additional profits are distributed as dividends and are not subject to self-employment tax. Basically, you can split your profits between wages and dividends.

For example, say an S Corporation is owned 100% by one person and earns $100,000 in profits during the year. They can pay themselves a reasonable salary of $40,000 and take $60,000 in dividends. They would pay 15.3% self-employment tax on the $40,000 salary, and no self-employment tax on the $60,000 dividends. That would save them roughly $9,000 in taxes.

It’s important to note that there will be some additional costs to set up and run payroll, and to file a separate tax return, so it may not be worth it if your business doesn’t make very much income. Typically, if your business makes at least $40,000 in annual profit, it’s worth considering an S Corp.

C Corporations:

A C Corporation (C Corp) is like an S Corporation in structure, but provides increased flexibility when it comes to raising capital and issuing shares. It’s an entity that is formed by filing incorporation documents with your state and is owned by its shareholders.

Benefits:

Limited Liability: Shareholders are typically not personally liable for the debts and liabilities of the corporation, which protects your personal assets.
Unlimited Growth Potential: C Corps can issue multiple classes of stock and have an unlimited number of shareholders, making it easier to raise capital.
Attracting Investors: The corporate structure is often more appealing to investors and venture capitalists.
Perpetual Existence: The corporation exists independently of its owners, which ensures continuity even if shareholders change.

Drawbacks:

Double Taxation: C Corps are taxed on their profits at the corporate level, and shareholders are taxed again on the dividends they receive.
Complexity and Cost: Setting up and maintaining a C Corp involves more regulatory requirements, formalities, and higher costs than other entity types.
Administrative Burden: C Corps must hold regular board meetings, maintain detailed records, and comply with various regulations.
Limited Flexibility in Profit Distribution: Dividends are typically subject to tax, which can limit flexibility in how profits are allocated.
Higher Audit Risk: C Corporations typically face a higher audit risk compared to partnerships and S corps because of the increased regulations. Especially regarding employee benefits and compensation.

Tax Implications:

C Corps are different than all the other types of entities. It is not a “flow through” entity like sole proprietorships, partnerships, and S Corps. Instead, it’s treated as a separate entity that pays its own tax and files a separate tax return on Form 1120.

C Corps pay a flat tax rate of 21% on all profits at the entity level. Then, shareholders will pay taxes again on any dividends that are paid out based on their personal tax rate. This is called “double taxation” which is one of the primary disadvantages of a C Corp.

If a shareholder is also an active member in the business, you can pay them a salary, which will be taxes as normal wages. This is a good way to potentially reduce taxes by avoiding double taxation.

Qualified Small Business Stock (QSBS) is a potential way that C Corp founders can get favorable tax treatment upon sale of the company. It’s a complicated area of tax law, so it’s recommended to get professional advice if you think your business may qualify.

Questions to Consider:

Here are some questions to ask yourself when considering which entity makes the most sense for your situation:

What is your tolerance for risk to personal assets?

When you run a business, you always run the risk of a lawsuit. Sole proprietorships and general partnerships have unlimited liability, meaning your personal assets could be at risk if the business gets sued. If you want to make sure your personal assets are protected, you’ll want to consider setting up either an LLC, some type of limited partnership, or a corporation. Each of those structures offer limited liability, meaning that your personal assets are separated from the business in the event of a lawsuit.

How do you want your business to pay taxes?

Sole proprietorships, partnerships, and S corporations are pass-through entities, meaning the business itself does not pay tax. Instead, the profits flow through to the owners and is reported on their personal tax return.

C corporations are considered separate entities. They pay a flat 21% tax at the corporate level, and then owners will pay taxes again at their personal rate whenever dividends are paid out. This is known as “double taxation”.

How formal do you want your business structure to be?

Sole Proprietorships are the easiest business structure to establish and generally don't require formal operational documentation.

Partnerships are usually governed by an agreement that defines the business operations. While it can be tailored to suit your needs, the agreement should at a minimum address how profits are shared and outline the procedures for situations like a partner’s retirement, disability, bankruptcy, or death.

Corporations involve the most formalities, including a legal requirement to have a board of directors that oversees the company's strategy and decision-making on behalf of shareholders.

LLCs offer flexibility in management, allowing the business to be run by its members or a separate management team, which may include both members and nonmembers. LLCs usually create an operating agreement to clarify roles and responsibilities.

How much administrative complexity are you comfortable with?

For sole proprietorships and partnerships, the initial paperwork and fees are minimal, making it manageable for owners to complete without specialized knowledge (though consulting a lawyer or accountant is usually a good idea). Typically, any ongoing requirements need to be completed annually.

In contrast, S and C corporations require greater administrative complexity, necessitating the assistance of a lawyer and accountant. Each state has its own tax and legal regulations that corporations must follow to stay compliant. Missing deadlines, failing to pay the required fees, or not filing the necessary forms can lead to penalties.

LLCs are somewhere in between. Not as simple as a sole proprietorship or partnership, but not as complex as a corporation. The requirements vary by state, but typically involve filing article of organization, creating an operating agreement, establishing a registered agent, and filing annual reports to remain in compliance.

What are your long-term goals for the business?

The ideal business structure isn’t just based on your current situation, it should also reflect your long-term goals for the business.

If rapid growth is a key objective, which requires significant capital, C corporations are a strong choice. They allow for multiple types of stock and have no limits on the number or kind of shareholders. This makes them the best option if you plan to seek funding from outside investors or if you envision transitioning to a publicly traded company.

Another important factor to consider is how the business will be impacted if you or another owner passes away, files for bankruptcy, or wants to leave the company. While corporations continue to exist after such events, most other business structures typically dissolve unless prior arrangements are made.

Consulting With A Professional:

Choosing the right business entity is a crucial decision when it comes to your small business's long-term success. Taking the time to understand your options and consulting with a qualified professional can help ensure you make an informed decision that aligns with your business goals. Ultimately, the right choice will provide a solid framework for growth, stability, and success in your entrepreneurial journey.