Choosing the best entity structure for your business may seem like something you just come up with and get started. However, there are major implications based on what you choose.
Nobody wants to pay more than they need to, whether that’s for cable, insurance, or taxes. And that’s where having the right business structure comes into play. The business structure with which you conduct business can make a massive difference in how much you’ll end up paying in taxes.
If you’ve been running your business for some time and you may be asking yourself: Do I have the best business entity for my business?
This article will help give you a better idea of whether you have the best setup right now or if you need to think about changing your business structure.
What is a business entity and why choosing the right one is important?
A business entity is the type of structure with which your business will be recognized legally at a state level. From an entirely practical perspective, your business entity structure determines what paperwork you need to file, how much in taxes you will pay, how you can raise money, any insurance you need to acquire, and the extent of your personal liability.
What fees need to be paid and what forms need to be filled out to start a business in any given structure are state-dependent. Likewise, the process to switch from your current business structure to a different one will be different from state to state.
Whether you are starting a new business or growing your existing one, choosing the right business structure needs to be a part of your business plan. Having the wrong structure can literally prevent your business from being able to access critical resources such as funding.
Sole proprietorship
As the name implies, sole proprietorship is a business entity that has one owner who owns and operates the business. This is the easiest to set up as in most states you don’t need to register or do anything at all.
When it comes to taxes, you and the business are one and the same. There’s no need to file different returns which makes it easy from a tax filing perspective.
Since you and the business are the same, there is no limitation to the liabilities you can be subject to. This means the owner is responsible for any debt and liabilities the business may incur during the course of its operation.
Pros:
- It’s easy to set up
- No unemployment tax: Because you and your business are seen as one in tax purposes, you don’t need to pay FUTA or SUTA for your own payments.
- Simple tax filing
Cons:
- Owners are liable for any debt the business may acquire
- You can’t raise capital by selling shares of the business
- Often little or no tracking of financial health
Who should consider Sole Proprietorship?
- Freelancers
- Small business owners
Partnerships
A partnership is a business structure where 2 or more individuals share ownership of a business. There are 2 main types of partnerships: general and limited.
A general partnership is similar to a sole proprietorship in the sense that they are very easy to set up and all the owners share liabilities for the business.
A limited partnership is a structure where one partner, called a general partner, is responsible for all operations and debt incurred by the business. The other partners have limited liability and act solely as investors.
Pros:
- They are simple to set up
- Paperwork is simple
- Easy to dissolve
Cons:
- The personal assets of each partner are at risk
Who should consider Partnerships?
- Startups where the partners want to get up and going as quickly as possible
- Sole proprietors who want to bring in partners to their business should consider a limited partnership as an option
C-Corporations
When you hear the term incorporated or simply corporation, what is usually referred to is a C-Corporation. The main feature of this business entity is that it entirely separates business and personal assets. Due to this reason, forming a corporation is a more complex and expensive process. Each state has its own guidelines on what the requirements for the formation of a corporation are, and typically this process is handled by a corporate attorney.
Pros:
- They separate business and personal assets
- The best structure to raise capital by selling shares
- It can issue an Initial Public Offer (IPO) by which it can attract an unlimited amount of investors
Cons:
- It’s a far more complex structure that requires detailed reporting and accounting
- Owners of the corporation pay a double tax on the business’s earnings
Who should consider a C-Corporation?
- Growing businesses that have the intention of selling shares or going public at one point.
S-Corporations
You can think of an S-Corporation as the small business-friendly version of a C-Corp. It offers similar benefits, such as the separation of business and personal assets of the shareholders. Also, many of the same requirements and regulations that apply to C-Corporations apply to S-Corporations.
One of the main reasons why many small businesses migrate to the S-Corporation entity is due to the tax savings that come as a result of a pass-through tax structure. That way shareholders don’t get taxed twice like on a C-Corporation.
Pros:
- Simpler accounting than a C-Corporation
- Tax benefits and same personal asset protection as a C-Corporation
Cons:
- Shareholder number limited to 100. This limits the amount of capital that can be raised
- More complicated and expensive to set up than a sole proprietorship or partnership
- No foreign investors can be involved in an S-Corporations
Who should consider S-Corporation?
- Small businesses that are looking for tax savings and want to be open to the possibility of additional shareholders
A primary reason to choose an S-Corp is to separate yourself as an owner from the business entity in tax purposes. Now your profit and excess cash is taxed at a corporate tax rate, rather than personal income tax rate. Only your own W-2 income is taxed at the income tax rate.
This carries some additional regulations.
First, in an S-corporation, the owner is required to take a salary, paid as a W-2 employee. Then, when you take distributions, you have to take them in proportion to ownership in the company.
A simple example: if you own 90% and another shareholder has 10% equity, if you take a $900 distribution, you’re required to pay a $100 distribution to your partner.
Limited Liability Companies
A Limited Liability Company (LLC) is a business entity that combines some of the best parts of partnerships and corporations. This is basically the liability protection and the pass-through taxing. Also, setting up an LLC is easier and less expensive than setting up a corporation. LLCs are often preferred over S-Corporations, as they offer many of the same benefits in a manner that makes sense for smaller businesses.
An LLC provides a bit more flexibility than S-Corps in how owners are paid. Instead of a W-2 salary, an LLC allows owners to take distributions or guaranteed payments.
Pros:
- Easy to set up and cost-effective
- Offers liability protection to the owners
- Straightforward documentation and accounting
- No limit on the number of shareholders
- Flow-through entity: Meaning if the company has losses, this “flows through” to the members which can be applied to offset personal tax liabilities
Cons:
- They can’t exist independently of their shareholders like a corporation can. The company is forced to dissolve if one of the owners no longer continues.
Who should consider an LLC?
- Anyone who needs some degree of liability protection. It’s a great move for freelancers and startups who are growing their business
Which is right for you?
Choosing the right business structure is a big deal for your business and for you personally, since depending on which structure you choose you and your assets are liable for whatever your business does.
And yes, it can be confusing. That’s why if you are thinking that what you currently have set up is not optimal you should consult with a trusted accounting advisor.