The type of business entity utilized for a new venture is one of the most important decisions facing a new business owner. Choosing an inappropriate entity can have devastating effects, while an appropriate choice can reap tremendous benefits.
While there are many variations, the three main business entity choices are sole proprietorship, partnership (or limited liability company, LLC) and corporation. There are advantages and disadvantages to each, and each may be treated differently among the 50 states.
This discussion will focus on broad characteristics. As always, it is recommended that you seek professional advice when determining which entity is best for you.
Sole proprietorship
This is a default entity. In other words, if you do nothing to create an entity, you are a sole proprietor.
Many businesses start this way due to the inherent simplicity that this choice affords. A separate income tax schedule is prepared (schedule C), which is part of the owner’s income tax return — no separate income tax return is needed. The owner is taxed on the net income of the business without regard to funds the owner “took out” of the business.
The assets of the business are the owner’s assets, but so are the liabilities. These characteristics are both the strength and weakness of a sole proprietorship. In general, if the business venture is an active operating activity, the sole proprietor will be subject to self-employment tax in addition to income taxes.
Partnerships and LLCs
While there are differences between partnerships and LLCs, multimember LLCs are most commonly treated like partnerships from a tax perspective. Partnerships may afford a level of liability protection. However, there are more constraints in taking funds from a partnership then a sole proprietorship, yet the rules are not as restrictive as those for corporations.
The partnership files an information tax return and does not pay tax. The individual partners report their share of the partnership’s activity on their individual tax returns. Like a sole proprietorship, profits are subject to self-employment tax for most LLC members and general partners in partnerships.
Finally, there are complex calculations when determining how profits, losses and distributions are to be made.
Corporations
There are two main types of corporations, the subchapter C corporation and subchapter S corporation (they refer to subchapters of the federal tax code).
The C corporation is the basic corporation. All companies listed on the New York Stock Exchange are C corporations. In this structure, you can have unlimited shareholders and differing classes of stock. Shareholders can be other corporations, mutual funds, foreigners, trusts and partnerships, as well as individuals.
The primary disadvantage to the C corporation is that of double taxation. For example, if your business has net income of $500,000 during the year, corporate tax is paid on those earnings. Then, when you draw a salary, you pay personal income tax on the salary. Dividends paid from a corporation to its owners are also taxable.
If a corporation qualifies, it may elect to become an S corporation. S corporation profits and losses flow through to the corporation’s shareholders and are reported on the shareholders’ returns similarly to how income would be reported from a partnership.
However, unlike a partnership, any profits are not subject to self-employment tax. The S corporation (except in rare instances) pays no income tax, thus eliminating one level of tax. However, not all corporations qualify for subchapter S status. There are limits on types and number of shareholders.
Each of the above entities has its appropriate use. When deciding, you and your adviser should consider the venture’s exposure to risk, cash flow issues, types of owners, assets to be held in the venture and eventual exit strategy. Making the correct choice of entity is crucial, but it’s not set in stone.
If you have an existing entity, consult your adviser to consider the advantages and disadvantages of changing your type of entity.
A tax shareholder at Tauber & Balser PC, Scott Rittenberg has 14 years of public accounting experience dealing with the tax issues of small to medium-sized businesses with an expertise in family business, tax insolvency issues and closely held businesses. Reach him at (404) 814-4974 or [email protected].
