Choosing the entity type, or tax structure, for your business is a critical choice and one that deserves serious consideration. There is no one-size-fits-all solution. Your entity selection can have a big impact on your exposure to liability as an owner and it will also impact the way that your company is taxed. In addition, entity type can affect how you grow, how many owners or shareholders your company can have, and how much money you can raise for your company. There are several options. The goal of this blog post is to explore the pros and cons of each in an effort to make the choice a little more clear.
Sole Proprietorship – The simplest and often the default option. Not only is it easy to create a sole proprietorship, but it also simplifies the tax process. All an owner has to do is report the company’s profits or losses on their personal tax record because a sole proprietorship is considered a “disregarded entity” by the IRS. Business income is reported on the owner’s personal tax return (Form1040), instead of on a separate business return. Be cautious because this simple structure means that the company is tied to personal assets. If the business fails, you could lose your personal property and savings to pay for any debt.
Partnership – A general partnership is similar to a sole proprietorship in the sense that it is often the default entity structure for businesses with partners. Like the sole proprietorship, partnerships retain full, shared liability among the owners. Partners are not only liable for their own actions, but also for the business debts and decisions made by other partners. In addition, the personal assets of all partners can be used to satisfy the partnership’s debt. It is a flow-through entity and the profits and losses of the company pass to each partner. Although partnership agreements are not legally required, they are strongly recommended in order to document how business decisions will be made. An agreement should include how the partners will divide profits, resolve disputes, change ownership, and even how the partnership will be dissolved.
Limited Liability Company – A limited liability company (LLC) is a newer types of business entity, in which members form the company under state law and adopt an operating agreement. An LLC can have just one member or many members, allowing great flexibility. The LLC has a few major benefits. First, it protects its members from personal liability by legally separating the individual from the company. Second, it has the flexibility to choose the taxation method that best meets its needs. For a single member LLC, income is taxed as a flow through entity and the income passes directly to the owner’s individual return, while multi-member LLCs can either be taxed as a partnership or as a corporation.
Corporation – This is a very common entity type, though the paperwork and effort involved in the incorporation process may scare some business owners away. However, by incorporating, owners are greatly protecting personal assets by creating a separate entity. When taxes are involved, a C-corporation files corporate tax returns and pays taxes on its profits. The funds that remain after taxes may be distributed as earnings to shareholders in the form of dividends. Shareholders are then taxed on dividends, which means that the owners effectively pay taxes on the same earnings twice – once at the corporate level and again as individuals. After incorporation, owners can choose to elect an S-Corporation status. The S-corporation is a hybrid form of business entity, which offers the limited liability of a corporation while allowing profits to flow-through directly to the owners instead of being taxed at the corporate level. Through the S-corporation formation, the double taxation problem can be eliminated.
When choosing the entity type right for you, be sure to consider the future needs and specific situation of your company, not just its position in the present. There are pro’s and con’s to each type, but if you consider them carefully, the most appropriate entity will likely be clear. Before making your final decision, it is wise to consult with your CERTIFIED FINANCIAL PLANNER™ professional, attorney, and accountant to have your options clarified and questions answered.
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