What are the types of business entities? There is no one perfect choice for any business.
You must determine which of the options best fits both your current needs and your business plans. Some of the things you’ll consider include:
- The cost and complexity of creating and maintaining the business structures
- Your current income tax situation
- The potential risks and liabilities of your Business
- Your personal risks and liabilities
- Your investment needs and income projections
The different business structures include:
- Sole proprietorship
- General Partnership
- Limited Partnership
- Limited liability company (LLC)
- S-Corporation
- C-Corporation
The Sole Proprietorship is the most common form of structure in the US for one-person businesses. You don't have to register with the state, pay annual state fees, nor do anything else special other than obtain the required business licenses. You are the business; and while this generally makes paperwork much easier to do, remember that you may end up paying more in taxes with this default option, and you'll be personally liable for all business debts and obligations.
Similarly, a General Partnership is an association owned by two or more people that hasn't registered with the state as a legal corporation or company. You have the same advantages as a sole proprietorship (simplicity and quick startup); but have a significantly larger disadvantage in that a general partner is responsible not only for his own actions and those of his employees, but also for those of his partners.
Limited Partnerships are associations registered with the state. These structures provide liability protection for the limited partners, although the general partners still bear unlimited personal liability for the consequences of their actions.
You’ll need:
- At least one Limited Partner
- At least one General Partner
Either or both partners can be companies or corporations
Limited Partnerships are more costly and time consuming to set up and run than sole proprietorships or general partnerships, and can be at least as expensive to run as an LLC or corporation. The General Partner controls the day-to-day operations of the business, and is personally liable for all business debts and obligations that cannot be settled with the assets of the limited partnership. Limited partners who take part in the running of the business can lose their liability protection and find themselves in the same position as the general partner(s). The liability exposure of the general partner can be contained by making the general partner an LLC or corporation, which has its own built in liability protection. Profits and losses flow through directly to limited partners as passive income and to general partners as active income. Instead of getting W-2 income, partners take "draws" and are responsible for their own taxes.
Limited Partnerships may be useful where a group of investors will have no involvement in the business and a general partner will be directing operations. This limits the liability of the passive investors, and ensures that the return on their investment comes to them as passive income without self-employment tax.
Corporations Unlike partnerships and sole proprietorships, corporations are independent legal and tax entities. From both a legal and tax perspective, the company is completely separate from the people who own, control, and manage the company.
The primary difference between an S-corp and a C-corp is how the profit or loss of the corporation is handled.
The C-corporation pays income taxes in its own right. Shareholders of the C-corp pay taxes only on what they take out of the corporation in the form of salaries, bonuses or dividends. The business taxes are paid by the C-corp itself. The S-corporation, on the other hand, may pay some state and local tax in its own right, but it is primarily a pass through entity, passing the net income or loss to the individual shareholders/owners, who report it on their personal taxes.
A C-corporation exists only in law. Like an individual, it can incur debt, own property, sue and be sued, and have a credit score. It files taxes as a separate entity (like an individual) and continues its existence despite changes in ownership or management. Perhaps the best aspects of a C-corporation are the large number of tax deductions that can be taken and the range of benefits that can be offered.
There are only three ways to get money out of a C-corporation prior to dissolution:
- as W2 wages;
- as a dividend, which is a distribution of profit which has been taxed at the corporate level, then is taxed again at the individual level;
- as a loan, preferably to another entity that will use the money for other investments.
An S-Corporation is a legal entity that is designed for small businesses, where the owners typically need most of the money earned to pay for living expenses. The IRS allows the shareholders of an S-corp to take money out of the corporation two ways:
- as W2 wages, with the attendant payroll and income taxes;
- as a distribution, with attendant income taxes only. No payroll or self-employment tax is owed on this money.
Unlike partnership draws, there are restrictions on how distributions are split among shareholders; and unlike C-corporations, there are severe restrictions on who can hold the shares of an S-corp.
Limited Liability Companies (LLCs) were a gift to small businesses. Not only are they less formal structures than corporations to manage, they provide their shareholders with the liability protection of corporations and the flexibility of deciding how the business will be taxed.
By default, a single member LLC will be taxed as a sole proprietor and a multi-member LLC as a partnership: the profits or losses will flow through directly to the members. However, you can elect to have an LLC taxed like a Corporation, either C or S. With these tax elections, you get all the benefits of being taxed as a corporation together with the greater simplicity of managing a less formal structure.
Although an LLC does not require the same formal paperwork as a corporation, bear in mind that the liability protection of the company is based upon the fact that it is an entity separate from its owners. To prove that this is the case, the company must be run professionally. All professional organizations document decisions; so don't forget the paperwork altogether.
Should I form an LLC (Company) or Corporation?
Let’s assume that you’ve decided limiting your personal liability and saving money on taxes is a good idea. Now, you have two main choices – form a Corporation, which is the more familiar approach, or try out the new streamlined Limited Liability Company (LLC). Which do you choose? Like anything, there’s no one "right" choice. However, there are a few guidelines you can follow.
When an LLC might be a better choice
The LLC is simple and flexible, and therefore makes the better choice for most small businesses. It also combines the liability protection of a corporation with the flexibility of deciding your tax election. This is especially useful if your business will hold real estate that is increasing in value. You certainly want the liability protection in case you are sued by a tenant. However, in a C-corporation, when the property is sold the gain will be taxed as ordinary income at the prevailing tax rate for the corporation. If the gain is significant, this rate can be quite high. Moreover, if the gain is distributed to the shareholders in the form of a dividend, the proceeds will be taxed again at the individual level. In an LLC taxed as a partnership or sole proprietorship, the gain will flow down to the members as passive income to be taxed as long term capital gains without payroll or self-employment tax or double taxation.
When an Corporation might be a better choice
Certainly a corporation is the only choice if you want to raise money for your business from a public stock offering. If your company is growing and you want to encourage key employees, you can offer stock options and stock bonus incentives through a C-corp. Corporations also have a different cache from an LLC. If you are in an industry where image is important, you might consider a corporation. C-corps also have the richest offering of benefits and the most legitimate business expenses of an entity.