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So you have decided to start a new business. You have your business plan and have arranged for the necessary financing. The next critical step that a business owner needs to take is to select the type of entity to use to operate the business.
Choosing Your Business Structure
There are several entity choices: sole proprietorship, limited liability company (LLC), partnership, C-corporation or S-corporation. These entities present choices and differences in liability protection as well as tax consequences that need to be balanced to provide the proper amount of liability defense, ownership flexibility, and tax advantages.
Here is a general breakdown of the most common business entities:
C-corporation & S-corporation
In the past, the C-corporation was utilized principally to shield shareholders from creditor liabilities. Unfortunately, tax law makes corporations inflexible for small and mid-sized businesses, including the fact that net operating losses are carried forward at the corporation level and cannot be used to offset a shareholder’s personal income within the corporate structure. Another disadvantage is the cost to form a corporation and the extensive record-keeping that’s required. While double taxation is sometimes mentioned as a drawback to the standard C corporation, the S corporation (or Subchapter corporation, a popular variation of the regular C corporation) avoids this situation by allowing income and losses to be passed through on individual tax returns, similar to a partnership.
Another disadvantage is the cost to form a corporation and the extensive record-keeping that’s required. While double taxation is sometimes mentioned as a drawback to the standard C corporation, the S corporation (or Subchapter corporation, a popular variation of the regular C corporation) avoids this situation by allowing income and losses to be passed through on individual tax returns, similar to a partnership.
Sole Proprietorship
A sole proprietorship is the most common form of business organization. It’s easy to form and offers complete managerial control to the owner. However, the owner is also personally liable for all financial obligations of the business.
Partnership
A partnership involves two or more people who agree to share in the profits and losses of a business. A primary advantage is that the partnership does not bear the tax burden of profits or losses. All profits and losses are “passed through” to partners to report on their individual income tax returns.
A primary disadvantage to the partnership entity is the liability. Each partner is personally liable for the financial obligations of the business. Furthermore, while there is great flexibility in determining how income is distributed among the partners, all of the net earnings of a partnership are subject to FICA and Medicare taxes. Bummer.
Limited Liability Corporation (LLC)
Today, the entity that has garnered the most popularity is the limited liability corporation. A hybrid form of partnership, the LLC, is gaining in popularity because it allows owners to take advantage of the benefits of both the corporation and partnership forms of business. Specifically, an LLC combines the spending flexibility of a partnership with the liability protection of a corporation. A substantial advantage for most owners is that there is generally no tax paid at the entity level; the entity’s income is subject to tax only at the individual level, and losses may be used to offset an owner’s personal income.
Making the Right Decision for Your Business Structure
When you’re first starting out in business, it’s not uncommon to be “caught up in the moment”. You’re consumed with getting the business off the ground and usually aren’t thinking of what the business might look like five or ten years down the road. Take a deep breath, just as things are completely frenzied and exciting, and speak with a business tax specialist to ensure you select the most appropriate business entity for your new company that meets your personal and professional needs.
