There are various choices that you need to make in the process of starting a business, and one of the most important ones is the type of business entity or structure that you select for your company. The type of business entity you choose will have a direct implication on the amount of tax you need to pay. Also, this will have implications of the quantum of paperwork your company is required to do, the personal liability you face, and it even affects your ability to raise money.
As per the experts, the answer to the question of choosing a particular business entity depends on the individual situation of each of the business owners. So, it would be incorrect to judge that one business entity or structure is better than the other. However, decision of choosing a business structure should be made carefully and you should take the advice of business experts for this as each of the business entities has got its own pros and cons that you need to consider before making the choice. Hence, instead of making this critical decision in a haste and regretting later, it is advisable to consult an experienced attorney or a CPA who can advise you appropriately in this regard.
Types of business entities
Here are some of the most common types of business structures or entities and the differences between them.
Sole Proprietorship is the most common type of business entity. This type of business structure is easy to form and invests total managerial control in the owner. On the flip side, the owner is also responsible for all the financial obligations of the business.
In a partnership business, two or more people are involved who agree to share the profits or losses of a company. The most significant advantage of this type of business entity is that it doesn’t bear the tax burden of profits or the benefit of losses. Profits or losses are instead ‘passed through’ to the partners to report on their individual income tax returns. The main disadvantage of a partnership is that each partner is personally responsible for the financial obligations of the company.
A corporation is a legal entity created for conducting business and is separate from those individuals who have established it and are responsible for the running of the company. Just like an individual, a corporation can be taxed and is legally liable for its actions. One of the most important benefits of a corporation business entity is that personal liability is avoided in this type of business structure. On the other hand, one of the main disadvantages of forming a corporation is that it is costly to form and requires a great deal of paperwork. Also, double taxation is mentioned as another drawback to form a corporation, however, this can be avoided by forming an S corporation (subchapter corporation) instead of the regular C corporation. Through an S corporation, the profits or losses are allowed to be passed through on individual tax returns, just like a partnership.
Limited Liability Company (LLC)
A limited liability company or LLC is a hybrid form of partnership and is popular since it allows the owners to avail the advantage of the benefits of both the corporation and partnership forms of business entities. The main advantage of LLC structure is that profits and losses can be passed through to the owners without the business itself getting taxed while the owners are also shielded from personal liability.
Factors to consider while selecting a business entity
- Legal liability: If you are ready to afford the risk of liability that the sole proprietorship or partnership forms of business entities carry; only then should you consider such type of business structures. So, if you want protection in case of a lawsuit or a judgment against your business, where your personal assets cannot be seized, then forming a corporation is the best bet.
- Tax Implications: As per experts, there are a number of tax options available to corporations than to sole proprietorships or partnerships. As mentioned before, double taxation can be avoided by forming an S corporation.
- Cost of formation and administration: The cost of forming a corporation and the administrative costs associated with it are high, and many cannot afford such costs. In such cases, sole proprietorship or partnership type of business structures can be chosen.
- Flexibility: Depending on your individual situation, you should choose a business entity that offers maximum flexibility. No business situations will be the same, especially when a number of owners are involved.
- Future needs: You should consider what type of situation you and your business will be in after five or ten years and accordingly you should choose a suitable business entity. Hence, you should consider situations where you want to sell your part of the business partnership after a few years or when you are no longer around to run it. While a sole proprietorship or partnership may dissolve if one of the owners dies, a corporation can be easily transferred to family members.
Pros and Cons of each type of business entity
As sole proprietorship is the simplest business structure in which a sole individual owns and operates the company. The tax implications of a sole proprietorship are attractive since income and expenditures from the business are included on your personal income tax return (Form 1040). The profits or losses that your company makes are first recorded on a tax form known as Schedule C, filed along with form 1040. Subsequently, the bottom-line amount from Schedule C is transferred to your personal tax return. This is an attractive prospect since the losses of your business can be used to offset income earned from other sources. In addition, as a sole proprietor, you must also file a Schedule SE along with form 1040 which is used to calculate the amount of self-employment tax you owe.
Also, you must pay quarterly estimated tax payments on your income, and if your net income is $400 or more, then you must make estimated tax payments to cover your tax liability. Additionally, if your last year’s adjusted gross income is less than $150,000, your estimated tax payments must be at least 90 percent of your current tax liability or 100 percent of the last year’s liability, whichever is less. The main advantage of a sole proprietorship is that your business earnings are taxed only once, unlike other business entities. Also, you are the sole decision-maker of your business and thus have complete control regarding all the decisions.
However, there are certain disadvantages of a sole proprietorship. In this type of business structure, you are personally responsible for the liabilities of your company and hence your own assets are at risk, especially if you need to clear a business debt or fight a legal claim against you. Also, raising money for a sole proprietorship can be difficult as banks are reluctant to offer business loans.
There are two types of partnerships, general partnerships, and limited partnerships. In a general partnership, the partners of the company manage it and take responsibility for the liabilities and other obligations of the company. However, in a limited partnership, there are two types of partners. The general partners own and operate the business and take responsibility for the liabilities of the company. On the other hand, the second type of partners are called limited partners who only serve as investors and have no say in the running of the company nor are subject to the same kind of liabilities as the general partners.
If you are not expecting to have many passive investors, then you should avoid forming a limited partnership company due to the massive amounts of filings and administrative complexities. A major advantage of forming a partnership company is the kind of favorable tax terms it enjoys. A partnership doesn’t pay tax on its income but ‘passes through’ any profits or losses to individual partners. During the time of paying taxes, each of the partners files a Schedule K-1 form as one of the tax forms, indicating their share of partnership income, deductions, and tax credits. In addition, each partner is required to report profits from the partnership in their individual tax return.
Even though a partnership company pays no income tax, however, it must calculate its income and report it through form 1065. Just like a sole proprietorship, general partners are personally liable for the obligations and liabilities of a partnership company. In addition, each general partner has the power to seek loans and make business decisions that will be binding on all the partners. Partnership companies are more expensive to establish as compared to sole proprietorships since they require extensive legal and accounting services.
A corporation is more complicated and expensive than most of the other business entities. Since a corporation is an independent legal entity, distinctly separate from its owners, it has to follow more regulations and tax requirements. The benefit that a corporate business structure provides is the protection against liability of the company. Since the owners of a corporation are not liable for the debts of a company in this type of business structure, they are not putting their own personal assets at risk. Also, a corporation can retain some of its profits, and the owners need not pay tax on them. Another advantage of a corporation is that owners can easily raise money through this type of business entity by selling stocks. In addition, corporations can continue indefinitely, even if one of the shareholders dies, sells shares or becomes disabled.
However, there are a number of drawbacks to the corporation business entity. One of them is the high costs associated with forming a corporation. Since corporations have to be formed as per the specific laws of each state with their own distinct regulations, you need to seek expert guidance of an attorney. Also, as a corporation needs to adhere to complex rules and regulations than a partnership or sole proprietorship, it also requires the services of a Certified Public Accountant (CPA). In addition, another drawback of a corporation is that they are subjected to double taxation on business earnings. Corporations need to pay income tax at both the federal and state levels, and also any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on the personal income tax returns of the owners.
To avoid double taxation, instead of dividends, you can pay the money as salaries to you and other corporate shareholders. A corporation is not required to pay tax on earnings paid as reasonable compensation, and such kinds of payments can be deducted as business expenses. However, the IRS has set limits on what it believes to be reasonable compensation.
Forming the S corporation is more attractive to small-business owners than a standard corporation as the former provides tax benefits and also gives protection against the liabilities that a corporation may have. In an S corporation, income and losses are passed through to shareholders and can be included in their individual tax returns resulting in just one level of federal tax to pay. Also, those who own an S corporation and don’t possess any inventory are permitted to use the cash method of accounting, which is far simpler than the accrual method.
In cash accounting, income is taxable when received and expenses are deductible when paid. In addition, the Small Business Job Protection Act of 1996 has made S corporations even more attractive for small-business owners. Before this law was passed, S corporations were limited to 35 shareholders. However, after the passing of the Small Business Job Protection Act of 1996, this limit was raised to 75. This enables a greater number of investors to invest in an S corporation and thus attract more capital.
However, there are some disadvantages associated with an S corporation. As in the case of a C corporation, the cost of formation is high, and they have to follow complex legal and tax requirements. They must file articles of incorporation, conduct directors and shareholders meetings, maintain corporate minutes and allow shareholders to vote on major corporate decisions. In addition, an S corporation can only issue common stock. This can create difficulties in raising capital. Moreover, unlike a C corporation, S corporation stock can only be owned by individuals, estates and certain types of trusts.
Limited Liability Companies (LLC)
A Limited Liability Company (LLC) is popular among small business owners as it is a hybrid business entity, combining the best features of partnerships and corporations. By forming an LLC, business owners can avoid double taxation and also enjoy liability protection. Moreover, unlike an S corporation, there is no limit on the number of shareholders in an LLC. Also, any owner of the LLC is entitled to a full participatory role in the running of the business, while in a limited partnership, limited partners don’t have any say in how the business is managed. On the other hand, LLCs don’t enjoy a perpetual life and some states have laws enacted that the company must dissolve after 30 or 40 years.