Tax

Choosing the Right Business Structure

Choosing the right business structure

Launching a business is an exciting venture filled with a myriad of decision-making and planning. One of the most important decisions you must make centers around the business structure under which you will operate. This decision will impact how your business is viewed, how it will be taxed, and how it will operate.  There are far-reaching implications launching from this one early decision.

Let’s review the top business entity structures with a topline overview including the pros and cons of each in a for-profit environment.

Sole Proprietorship

A sole proprietorship is the most common and easiest business structure for small and medium-sized businesses. There are no required filings to get started. The Bureau of Labor Statistics as of January 2023 reported 10.1% of the workforce (roughly 16.2 million people) is self-employed. Of this 9.635 million are sole proprietors while 6.56 million are incorporated. IRS defines this structure as “someone who owns an unincorporated business by himself or herself.” So, basically, you get it all and you are responsible for it all.

Pros: Start up is quick and easy. Cost for the start up is low. The tax reporting is done on the business owner’s individual income tax return, so there is no separate income tax filing required.

Cons: Liability protection is all on the business owner. Profits from the business are subject to both ordinary and self-employment tax. Audits on this business structure are not business-owner friendly and can be an easier target than other entity structures.

Partnership

When a business is being formed by more than one business owner, a partnership may be the solution. Partnerships are ideal when the business owners are not related, have different talents they bring to the business, or to allow for varying distributions between the partners.

The two most common partnership structures are the general partnership and the limited partnership. The general partnership shares equally between the partners. Conversely, a limited partnership is made up of at least one general partner (the one in control of the operations) and one or more limited partners (who may help on a limited basis or be a financial or consulting contributor).

Partnerships should have a partnership agreement drafted. This document is designed to address issues such as control, decision-making, financial obligations of the partners, exit strategies for a partner, and a variety of other contingencies that the partnership may face.

Pros: Formation is relatively easy. Most states have no formation filings required aside from a fictitious name. Obtaining business loans may be easier having multiple owners and credit histories to consider. Distributions from a limited partnership can be issued disproportionately to the partners percentage of interest in the business.

Cons: More people in the ownership can lead to disagreements. Liability may be less for limited partners, but general partners will be held fully liable for actions by both limited and general partners. Partnership income is subject to self-employment tax, over and above the partners own ordinary tax.

C Corporation

The standard corporation is referred to as the C corporation. It is a stand-alone entity. It conducts business, realizes the net income or loss on that business activity, and pays its own taxes. Shareholders receive distributed profits or dividends. There is no pass-through with a C corp. It all starts and ends with itself.

Corporations have historically been seen as strong and secure organizations with financial stability. They depict a larger organization, maybe with an international component, but come with many reporting and filing requirements that the other business structures do not.

Pros: There is no limit to the number of shareholders. Shareholders do not have to be US residents. The structure is beneficial in attracting investors or at the point of selling the business or a shareholder’s interest. High-rate taxpayers may benefit from lower corporate tax rates.

Cons: Profits are taxed at the corporate level and then at the shareholder level when distributed, resulting in double taxation. Formation of a corporation can be costly. Corporate governance can become an administrative burden. Tax preparation fees are often much higher.

S Corporation

Also known as a pass-through entity, the S Corporation is a mutation of the C corporation. It conducts business like the C corporation, but passes the profits and losses along with deductions and credit to its shareholders on a pro rata basis. Therefore, taxes on the business activity are actually paid by the shareholder on their income tax returns. The S corporation does not pay federal income taxes.  Depending on the state, it may pay a franchise or other similar fee.

The image of the S corporation is much like that of a regular corporation. It stands out as prominent and steadfast. Unlike the C corporation, shareholders in an S corporation are subject to reasonable compensation rules – the concession established in 1958 in exchange for the assessment of self-employment tax.

It is important to note that the S corporation is a tax election, not an entity structure. To become an S corporation, you form a C corporation and then ELECT to be taxed as an S corp. 

Like partnerships and corporations, an operating agreement is always encouraged. These can be created in varying formats and with standardized and unique operational concerns.

Pros: There is no double taxation; there is no self-employment tax. Through tax law changes like the Tax Cuts and Jobs Act of 2017 (TCJA), there are tax-favorable benefits including the 20% deduction on qualified business income. Shareholders can also benefit from loss balancing where losses from the business pass-through to the shareholder and reduce the shareholder’s other individual income. 

Cons: Formation can be costly. The corporation can only have up to 100 shareholders. There are additional restrictions on who can be a shareholder. Only one class of stock can exist. The S election must be granted by the IRS. Failure to meet the S election requirements can result in an involuntary conversion to a C corporation where tax rates will vary and double taxation thrives.

SPECIAL NOTE on the one class of stock requirement – An S corporation can only have one class of stock. The shares can have voting rights that differ, but they must contain identical rights for distributions and liquidation proceeds. If a shareholder owns 5% of the corporations shares of stock, then that shareholder must receive 5% of any distribution or liquidation proceed. Failure to maintain one class of stock can jeopardize the IRS-granted S Election.

Limited Liability Company

This funny entity structure is quite unique because it is a design created on the state level under a state’s statute. On the federal side, the IRS refers to the LLC based on the tax election it makes. Owners of the LLC are referred to as members, and the restrictions for who can be a member are just lower than that of other entity structures. Further, not all businesses can be an LLC. Banks and insurance companies, for example, are restricted from being LLCs.

LLCs must make a tax election or accept the IRS defaults based on the number of members. An LLC with one member is considered a single-member LLC (SM-LLC) and is treated like a sole proprietorship. Two members will be treated as a partnership; three or more members will be treated as a C corp. LLCs can make an election other than the default. For example, the LLC with one member can elect S corp taxation. Specific rules and timing will apply.

Taxation for the LLC will vary depending the tax election made.

Like corporations and partnerships, an LLC operating agreement should be prepared, especially if there are two or more members in the LLC. In some states, this operating agreement is required.

Unlike the C corporation which can be maintained in perpetuity, LLCs are not a forever-type entity. There are events that will terminate the LLC such as the demise of a member or a state’s statute limiting its length of existence.

Pros: LLC formation is often easier and less expensive than incorporating. LLCs offer limited personal liability, a flexible management structure, and some tax advantages based on the tax election made.

Cons: Some tax elections will generate higher tax rates. Flexibility with multiple owners may be an issue in the same fashion as partnerships. Operating agreements can be costly to maintain.  LLC status can be terminated upon a terminable event. State statutes govern the LLC requirements as well as fees charged by the state; they will differ from one state to the next.

Conclusion

Choosing the right business structure is integral to your business’s long-term success. Each business structure has unique advantages and disadvantages to consider.  Take your time, know your tolerances and seek assistance from your legal and tax professionals.

If you are interested in starting a business, the professionals at Vantage Point Business Services Corp can help you decide which structure is right for you. Make your first steps as a business owner the RIGHT steps for your continued success.

#BusinessEntity #SCorp #CCorp #LLC #Partnership #SoleProprietorship

Kimberley Pollard is the President/CEO of Vantage Point Business Services Corp.  She holds a Bachelor’s Degree in Accounting and is an Enrolled Agent, QuickBooks ProAdvisor, and NTPI Fellow. 

The content of this blog is to be used for informational purposes only. It is not intended to be a substitute for  business, legal, or tax advice.

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