How to Choose the Best Form for Your Business
There are numerous decisions an entrepreneur must make when they’re starting a new business, but choosing a business form is one of the most critical. The one you select will guide your business decisions, tax efficiencies, and your business’s ability to scale. Choosing the correct entity can mean reduced exposure to liabilities, money saved, and a business that is financed and managed efficiently.
According to CooleyGo, your primary considerations when entity planning should be how to protect your personal assets from business liabilities and minimizing tax liability. Some tax strategies include maximizing the tax benefits of startup losses, avoiding double or triple layers of taxation, and converting ordinary income into long-term capital gain, which is taxed at a lower rate.
Although there are many different kinds of business entities, the most common are limited liability companies (LLC), general partnership, sole proprietorship, and corporation. There are benefits and drawbacks of each, so it’s important to examine all of them before coming to a final decision.
The Limited Liability Company (LLC)
A limited liability company, or LLC, is a registered business with limited liability for all members, meaning all of the members’ personal assets are protected from lawsuits. There is no limit to the number of members involved in an LLC and, according to JustBusiness, it is the members’ choice whether the company is taxed as a corporation or as a pass-through entity.
Additionally, LLCs are a great option for small businesses or start-up companies because they provide an enormous amount of protection for owners but are easier to navigate than a corporation.
Tax Implications of LLCs
Owners of an LLC are not subject to double taxation, which is when both a company’s income and dividends are taxed. Additionally, many states do not require LLCs to pay a corporate franchise tax.
There may also be exclusive tax deductions available for LLCs. An article by The Balance Small Business describes one known as the Qualified Business Income Deduction, which allows LLC members to deduct 20 percent from their net income.
On the flip side, LLCs are typically required to pay taxes on profits, even if they have yet to be distributed. They also have to pay both employer and employee portions of self-employment taxes (Social Security/Medicare), which can quickly add up.
Benefits and Drawbacks of LLCs
Probably the biggest benefit of an LLC is that owners do not claim personal responsibility for any of the business’s debts or liabilities. They have fewer formalities than corporations and, again, the owners can choose how the business is taxed. The one major drawback of an LLC is that they can be more expensive to establish because they need to be registered with the state in which their base of operations is located.
A general partnership is an unincorporated business with two or more owners who share business responsibilities. Each partner will have unlimited personal liability for the business’s debts and obligations and each is responsible for reporting their individual profits and losses on their tax returns.
General partnerships are fairly common because they’re easy to set up, understand, and file taxes for. Investopedia notes that this entity allows the owners more flexibility and closer control over day-to-day operations compared to a corporation.
Tax Implications for General Partnerships
According to JustBusiness, general partnerships do not pay business income taxes. Instead, the income and losses of each owner are reported on their personal tax returns. In other words, each owner is responsible for paying the income tax rate on their share of the business profits.
Benefits and Drawbacks of General Partnerships
The main benefit of a general partnership is how easy it is to establish and maintain. General partnerships don’t need to be registered with the state and there are no annual reports due. Additionally, because the business itself is not taxed, most losses may be able to be deducted from the owner’s personal tax returns.
The biggest drawback of a general partnership is the amount of personal liability held by the owners. Besides being responsible for any debts or obligations accrued by the business, owners can potentially be held liable for each other’s negligent behavior. This can lead to disputes between partners, which could ultimately tank the business if an adequate partnership agreement isn’t established.
A sole proprietorship is an entity with one person (or a married couple) acting as the singular owner and operator of the business. A new business with only one owner will automatically be considered a sole proprietorship under the law with no need for registration. Per JustBusiness, sole proprietorships are the most popular business entity in the United States because of how simple they are to establish.
Tax Implications of a Sole Proprietorship
Similar to a general partnership, sole proprietorship businesses are not taxed. Profits and losses for the business are reported via the owner’s personal tax return. Sole proprietors are responsible for paying the employer portion and half of any employees’ portions of self-employment taxes as well.
Benefits and Drawbacks of the Sole Proprietorship
The majority of benefits associated with a sole proprietorship stem from how easy they are to set up and operate. They don’t require any registration or formal reporting, most losses are tax-deductible, and tax filing is incredibly simple.
A major drawback of a sole proprietorship is liability. The owner incurs any and all liabilities associated with the business and their personal assets cannot be protected in the event of a lawsuit. It can also be difficult to secure a loan or build credit as the owner of a sole proprietorship because the bank sees little separation between the business and the individual.
There are two main types of corporations: C-corporations and S-corporations. According to a piece by BizFilings, a C-corporation is a standard corporation under IRS rules, whereas an S-corporation is one that has elected a special tax status.
A C-corporation is a business that exists independently from the owners. Typically, a team made up of shareholders, a board of directors, and officers will be in control and guide the decisions of the corporation. There is a great deal of paperwork involved when it comes to registering as a C-corporation, but this is to minimize liability and taxes.
An S-corporation is considered a pass-through entity, similar to a sole proprietorship or general partnership. This means that although it is run like a corporation with shareholders, a board of directors, and officers, there is no corporate taxation on the business. Profits and losses are reported on the owner’s personal tax returns. An S-corporation maintains the same limited liability as a C-corporation, however.
Both types of corporations come with a significant amount of regulations they must follow as well as annual reports and other kinds of paperwork in order to keep the business accountable.
Tax Implications of a Corporation
C-corporations file and pay corporate taxes, meaning they are in a completely different category than the entities previously discussed. If some of the income is distributed to the owners as dividends, then the owners may be double taxed. C-corporations are eligible for more tax deductions than any other kind of business entity and owners will typically pay lower self-employment taxes.
S-corporations, as previously mentioned, are pass-through entities. They cannot be double taxed and are not subject to corporate taxation.
Benefits and Drawbacks of the Corporation
A primary benefit of both corporations is the limited liability. Because corporations are considered totally separate from the owners, the owners cannot be held legally responsible for any of the company’s debts or liabilities.
An additional benefit that only applies to C-corporations is the ability to offer stock options. They’re able to do this because C-corporations are allowed an unlimited number of shareholders, whereas S-corporations are restricted to 100.
Some drawbacks of both corporations are the cost of establishing them and the rigorous formalities they need to maintain, such as holding board meetings and creating bylaws.
For more information on entity planning, contact Lora Vega CPA at (520) 271-3230. The call and initial consultation are completely free and there is no obligation.