When starting a new business venture one of the first business decisions that need to be made by the founder, is; what type of business entity should be created to operate the business through?
There are multiple different types of entities one can form to operate a business, the answer to which entity to form lies in the question; which entity is best for you and your business’s needs?
Choosing the proper type of entity is very important, this decision will have an impact on the amount of taxes you will have to pay, the amount of paperwork your business is required to do, and the personal liability you will have.
Four main types of business entities are; Sole Proprietorship, Partnership, Corporation, and Limited Liability Company.
- A sole Proprietorship is the most common form of business organization. It is easy to form and offers complete managerial control to the owner, however in this type of entity, the owner is personally liable for all financial obligations of the business.
A Sole Proprietorship generally involves just one individual who owns and operates the business. From a tax point of view, the income and expenses from the business are included on the owner’s personal income tax return (form 1040). The profits and losses are first recorded on the Schedule C which is filed along with the form 1040. The bottom line amount on the Schedule C is then transferred to the owner’s personal tax return. Potential business losses have the ability to offset income earned from other sources, thereby acting as a deduction. Additionally, a sole proprietor will also have to file a Schedule SE with the 1040 to calculate the amount of self-employment tax that is owed.
Self employed individuals with net earning of $400 or more must make estimated tax payments to cover their tax liability. If prior years adjusted gross income (AGI) was less than $150,000.00 the estimate tax payments must be at least 90% of your current years tax liability or 100% of the prior years liability, whichever is less.
- A Partnership is like a sole proprietorship. However, a partnership involves two or more people who agree to share in the profits or loses of the business, and the partners are each personally responsible for the financial obligation of the business. A partnership itself does not bear the tax burden of being taxed on the profits, rather the tax burden is directly passed through to the individual partners to report on their individual tax returns, just as in a Sole Proprietorship.
Partnerships comes in two varieties; general partnerships and limited partnerships.
In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and other obligation.
In a limited partnership, there are generally both; limited and general partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only and have no control over the company and therefore are generally not subject to the same liabilities as the general partners.
A partnership does not pay taxes on its income, but passes through any profits or losses to the individual partners. Each partner files a K-1 which indicates his or her share of the partnership income, deductions, or tax credits. Even though the partnership itself does not pay any taxes, it must compute its income and report it on a separate informational return form 1065.
Each general partner can act on behalf of the partnership; take out loans and make business decisions that will affect and be binding on all of the partners.
At the outset of a new partnership I cannot stress enough the import of drafting a partnership agreement amongst all of the partners. The partnership agreement will guide the partners as to what their underlying responsibilities in the partnership are; What is each partners investment? How to resolve disputes when they arise? What are the duties and obligations of each partner? What happens if one partner wants to leave the partnership?
- A corporation is a legal entity created to conduct business through. The corporation becomes an entity separate and distinct from those who founded it. The corporation is generally taxed separately from the individuals who founded/formed the corporation and the corporation can be held legally liable for its actions separate from the individuals who founded/formed the corporation. A key reason why people choose to form a corporation is because of its key benefit of avoiding personal liability. A disadvantage to forming a corporation is the cost, record keeping, and potential double taxation; taxes due at the corporate level and individual level for dividend distributions to the shareholder.
A corporate structure is more complex and generally more expensive than forming a sole proprietorship or partnership. A corporation is an independent legal entity that will survive perpetually. A large benefit one obtains from forming a corporation is the liability protection one receives, corporate debt is now considered that of the owners and therefore when a corporation obtains a loan (unless there is a personal guaranty) the forming shareholding does not put any personal assets at risk.
A corporation is also an independent taxable entity, and therefore, a corporation can retain some of its profits without the owner paying tax on it. Since the corporation is an independent taxable entity, the corporation itself is liable for taxes and the shareholders must pay taxes on their dividend distribution, thus the shareholders pay double taxation; at the corporate level and the individual level. To avoid double taxation, the corporation can distribute money as salaries, since the corporation is not required to pay tax on earnings paid as reasonable compensation, the salary payments can be deducted as a business expense.
Once a corporation is formed, there are sub tax classifications that must be chosen; generally S or C.
The S -Corp is more attractive to small business owners primarily because of the tax benefits. In an SCorp the corporation’s income and losses are passed through to the shareholders and included on their individual tax return, and therefore only one level of income tax to pay. An S-Corp has limits on the number of shareholders and types of shareholders; individuals, estates, certain types of trusts, and tax-exempt organization, can be stock holders in an S-Corp. Additionally, a profits and losses are distributed in proportion to the shares held.
- A fourth type of legal entity is the Limited Liability Company (LLC). This type of entity allows the organizers to enjoy the benefits of both the partnership and corporation advantages. The individuals who form an LLC are protected by limiting their liability and unlike a corporation, the LLC is not taxed separately, the profits and losses are passed through to the shareholders without taxation on the business entity itself.
Limited Liability Companies, LLCs have been in existence since 1977. An LLC is a mix of the best features of a partnership and Corporation. LLCs provide business owners with the liability protection that corporations enjoy without the double taxation.
An LLC is differentiated from an S-Corp by not containing the same limitations of an S-Corp, such as a limit on number of shareholders or limitation on who could be a member.
However, an LLC may not be the best vehicle for the organizers of the business to operate through. An LLC does not have any stock certificates or offer different classes of stock to disperse to its different stock holders. Additionally, depending on which state the business decides to organize itself, there may be a requirement to have multiple members, suck as in Massachusetts or Washington D.C. Additionally, LLC members, like sole proprietors must pay self employment tax calculated on 15.3% of profits as opposed to an S-Corp stock holder who only pay Self Employment tax on salary earned.
|C-Corp||S-Corp||LLC||General Partnership||Sole Proprietor|
|Owners have limited liability for business debts and obligations||X||X||X|
|Created by a state-level registration that usually protects the company name||X||X||X|
|Business duration can be perpetual||X||X||X|
|May have an unlimited number of owners||X||X||X|
|Owners do not need to be U.S. citizens or residents||X||X||X||X|
|May be owned by another business,
rather than individuals
|May issue shares of stock to attract
|Owners can report business profit and loss on their personal tax returns||X||X||X||X|
|Owners can split profit and loss with the business for a lower overall tax rate||X|
|Permitted to distribute special
allocations, under certain guidelines
|Not required to hold annual meetings or record meeting minutes||X||X||X|