What business entity is right for you?

You’re in business, now what?

Choosing the type of legal entity that a business will operate under is one of the most important issues that clients face. There are several options in most cases, and no right or wrong answers, though there are advantages and disadvantages to all of the choices.

Sole Proprietorship

This is the simplest choice, and it’s how many businesses start. The business is reported under the owner’s personal name,  though the business name might be registered as a DBA, or “Doing Business As.” For tax reporting purposes, the business income and expenses are reported on Schedule C of the owner’s Form 1040.  The main advantage of sole proprietorship reporting is the simplicity of formation, because little or no paperwork is required. Additionally, if the business incurs net losses, as often happens in the first year or so, those losses can be deducted against the owner’s other income. The disadvantages of the sole proprietorship structure are that the owner doesn’t have any liability protection from lawsuits and that all of the net profit of the business is subject to self-employment tax, which can result in a substantial tax liability even when profits are modest. Sole proprietorships do allow the owner to potentially take a deduction for 20% of the net profit for “Qualified Business Income” under the new tax law.

Partnership

A partnership can be something as simple as a handshake agreement between two business owners or as complex as a major global law firm. Partnership status gives businesses with multiple owners the ability to allocate the business income and expenses according to the partnership agreement, rather than strictly by ownership percentage. That flexibility can be useful for large groups of professionals, in particular. Partnership net income, like sole proprietorship net income, is subject to self-employment taxation, so that is a disadvantage relative to some other choices. Partnerships also provide little or no liability protection to the business owners. Like sole proprietorship income, partnership income “passes through” to the partners’ personal tax returns and is taxed there. Partnerships themselves don’t pay income tax. Partnerships also allow the owner to potentially take a deduction for 20% of the net profit for “Qualified Business Income” under the new tax law.

Corporation

A corporation is formed by registering with the state the business operates in. A corporation is treated as a separate legal entity from the owner(s), so it does provide the owners with liability protection. Corporations, commonly called C-Corporations to distinguish them from S-Corporations, below, pay income taxes on their net income. The business owners, or corporate shareholders, are paid wages for their services to the business, and may be paid dividends as well. The wages are deductible in determining the corporation’s taxable income, but the dividends are not, even though they are taxable to the shareholders. That “double taxation” is one of the disadvantages of corporate status, along with the general complexity of forming and operating one. However, for large and very successful businesses corporate status can provide the most tax advantageous way for the owners to receive the profit the business is generating, due especially to the fringe benefits that corporations can provide to their employees. The wages that a corporation pays the owner/shareholder are subject to FICA taxes, which is what self-employment tax is, but the net profit of the corporation is not subject to FICA or self-employment taxes. Corporate income does not allow the owner to take a deduction for “Qualified Business Income” under the new tax law.

S-Corporation

S-Corporation status is a tax status, not a legal status. A corporation can elect S-Corporation status, and so can a partnership or LLC (below). S-Corporations are separate legal entities from their owners/shareholders, so they do provide some liability protection, but they don’t pay taxes, unlike C-Corporations (above). S-Corporations are pass-through entities like sole proprietorships and partnerships, meaning the business income is taxed on the owner’s personal income tax returns. The main advantage of S-Corporation status is that there is no double taxation, as there is with shareholder dividends paid by C-Corporations, and not all of the business income is subject to self-employment/FICA taxes, as is the case with sole proprietorships and partnerships. S-Corporation shareholders are required to pay themselves wages for their services to the business, and those wages are subject to FICA taxes, but the remaining income passes through to the owner’s tax return free of self-employment/FICA taxes. Because payroll reporting is required, as well as a separate tax return, there is more complexity and more compliance costs than for a sole proprietorship, but those are typically far outweighed by the savings in self-employment tax relative to sole proprietorship status. S-Corporations are also required to adhere strictly to ownership percentage when it comes to allocation of income and expenses, which makes them less flexible than partnerships. S-Corporation status does allow the owner to potentially take a deduction for 20% of the pass through income as “Qualified Business Income” under the new tax law.

Limited Liability Company (LLC)

LLCs are also formed by registering with the state the business operates in. But their formation is simpler than the formation of a corporation. Operating a business under an LLC gives a business owner the most flexibility of any of the choices in terms of tax reporting, and the entity does provide the owner with som liability protection. If the LLC only has one member, then the default tax status for the LLC is a disregarded entity, meaning the business is still taxed as a sole proprietorship. For that reason, many business owners form an LLC to operate their business but stick with Schedule C reporting for the first few years to take advantage of the simplicity mentioned above. Of course the disadvantage mentioned above also applies to an LLC taxed as a sole proprietorship, in that all of the net profit is subject to self-employment tax.

LLCs with multiple members are taxed as partnerships by default, and many business owners choose to report their business as partnerships for tax purposes due to the flexible allocations between the owners that partnership reporting allows. LLCs, whether they have only one member or multiple members, can elect to be taxed as corporations, and can subsequently elect to be taxed as S-Corporations. So many small businesses find the best course of action to be to operate as an LLC taxed as a sole proprietorship for a few years until their profit grows to the point where the self-employment tax savings that would result from electing S-Corporation status justify the increased red tape and expense.