As you are helping some of your small business clients establish and grow, one common topic that may come up is the type of entity that is right for their business. What is right for the business on day one may not be right for the business later, so this is a great topic to revisit with your client as they expand. This article will explore the main business entity options you can discuss with your client when deciding what type of entity is best for their business.
Some of the most common small business entity types are:
- Sole proprietorships
- Limited liability companies
There are other less common entity types to consider, such as the following, which are outside the scope of the article:
- Trusts or land trusts
Sole proprietorships are the simplest and most common business structure. There is one owner, the sole proprietor. The business is unincorporated, and there is no legal distinction between the business and the owner.
Pros: Sole proprietorships are easy and inexpensive to form, and an owner can usually create one on his or her own. In fact, no formal action is required to create a sole proprietorship. However, business owners still need to obtain any necessary licenses and permits, as well as a doing business as (DBA) name, if they are operating under a name other than their own.
Another advantage is that the owner has complete control over the business and makes all decisions, including the business strategy, concept, operations and what expenses to incur. The owner is entitled to all of the business’s profits. The next advantage is that tax filing is fairly easy. A sole proprietorship files a Schedule C, along with the Form 1040 that your clients already file. Please note that net self-employment income is subject to the self-employment tax.
Cons: As far as disadvantages go, because there is no legal separation between the owner and his/her business, he/she is personally liable for all debts and obligations of the business. The risk extends to any liabilities incurred as a result of the actions of employees.
In addition, it is often difficult to get money to invest in the business because the business owner can’t sell business stock, and banks are sometimes hesitant to lend because of a perceived lack of credibility if the business fails. Finally, the flipside of having complete control over the business is the burden and pressure that it can impose. The owner is the one ultimately responsible for the successes and failures of the business, and this pressure can be heavy.
Limited Liability Company
A limited liability company (LLC) has a hybrid legal structure and provides a way to limit the company’s liability, while allowing many of the benefits of the underlying taxable organization (sole proprietorship, partnership or corporation). The owners of an LLC are called “members,” and there can be one member or many members. For federal tax purposes, an LLC is not a separate entity, but for some states, it is. If your client chooses to make his/her business an LLC, also consider what type of federal tax entity the business will be.
Pros: The primary advantage to forming an LLC is to protect your client’s personal liability. If the LLC incurs a debt or is sued, the personal assets of each member are generally shielded. However, if the liability is caused by the wrongful act of a member or an employee of the LLC, there is no liability protection. An LLC generally has less registration paperwork than a corporation, as well as fewer restrictions on profit sharing.
Cons: The disadvantages of LLCs are quite light. For example, many states mandate that when a member leaves the LLC, the business is dissolved. The remaining members can decide if they want to start a new LLC to continue the business. Another disadvantage is the imposition of self-employment taxes. Income earned by the LLC is distributed to the members, and is classified as self-employment income, which makes it subject to the self-employment tax. However, there is really no difference between sole proprietorships, partnerships and S corporations.
At a fundamental level, a partnership is an agreement of two or more people to go into business together. For tax purposes, a partnership is not subject to tax. It is a conduit to distribute all income and expenses to the partners. General partners receive their share of income, subject to self-employment tax. There are various types of partnerships, including general partnerships, limited partnerships, limited liability partnerships and joint ventures.
Pros: Like a sole proprietorship, a partnership is fairly easy and inexpensive to form. Most of the time is spent developing the partnership agreement. Another advantage is the shared financial commitment. Since there is more than one owner, there are more people vested in ensuring the success of the company. There is also the benefit of pooled financial resources.
Next, it is ideal for a partnership to leverage the strengths and expertise of each partner. Finally, partnerships can attract highly qualified and motivated employees who have an opportunity to eventually become partners in the business. We see this quite frequently with law firms and accounting firms.
Cons: As far as disadvantages go, depending on the particular variety of partnership chosen, partners could be subject to liability for their own actions, the actions of their fellow partners and the actions of the partnership. The personal assets of all partners could be used to satisfy the partnership’s debt.
Another potential disadvantage stems from the need for partners to work together toward common goals. There are bound to be disagreements. Partners should consult each other on major decisions, make compromises and resolve disputes as amicably as possible. The partnership agreement should explicitly lay out which decisions require all partners to agree, which require a majority and which are within a partner’s discretionary power.
A final disadvantage is that the successes and profits are shared ratably amongst all the partners, but there may be a disproportionate contribution of time, effort or resources, which could create discord among partners.
An S corporation is an entity that is incorporated, but then makes a special election with the IRS. This election helps avoid the problem of double taxation that affects C corporations and causes the S corporation to act much like a partnership, where the profits are passed through to the shareholder owners. There are specific requirements that must be met in order to make an S corporation election.
Pros: Perhaps, the most compelling benefit to creating an S corporation is the potential tax savings. The owner of an S corporation can take a wage and receive his or her share of the business’s income as a distribution, which is oftentimes taxed at a lower rate. Another advantage is that there are some business expenses and credits available to corporations that are not available for individuals or partnerships.
Also, an S corporation designation allows the business to have a life independent of its shareholders. If a shareholder leaves the business, the S corporation can continue to do business as usual.
Cons: On the negative side, S corporations require stricter operational processes than some other entity types. For example, director and shareholder meetings must be scheduled, and specific records for those meetings must be maintained. Another disadvantage of S corporations is that each shareholder must receive reasonable compensation. A combination of a low salary and a high distribution could be a red flag for the IRS.
A C corporation is the entity type that comes to mind for most of us when we think about a corporation. It is an independent legal entity owned by shareholders.
Pros: One of the advantages of C corporations is that shareholders’ personal assets are protected from the liability of the business. Another advantage is that corporations can raise capital through the sale of stock.
Pros/Cons: The taxation structure for corporations is an advantage and a disadvantage. On one hand, owners of a corporation only pay taxes on the salary, bonuses and dividends paid to them, with the remaining corporate profit taxable at the corporate tax rate (which is usually lower than the personal income tax rate). On the other hand, corporate dividends are double taxed – once at the corporate level and again at the shareholder level.
The other disadvantage to C corporations is that they are complex entities. They tend to have higher administrative costs and take more time to start and operate. They also require more recordkeeping and compliance with federal, state, and in some cases, local agencies’ requirements.
Weigh Pros and Cons
As you can see, choosing an entity type for a business is a complex decision with many tax and legal ramifications. You can help the business owner carefully weigh the pros and cons of each type of entity to make the best decision for his/her business.
Choice of entity is just one important piece of helping your clients with tax planning. For more information on tax planning, check out this article on “Tax Planning Moves to Make before Year-End.”