When starting a business there are so many things to consider, least of which is what kind of legal entity your business should be. There are three major areas to consider when choosing the legal entity structure of an operating entity: legal protection for the owners, tax implications for the owners and investors, and management of the company. The four best options for a legal entity are sole proprietorship, partnership, S-corporation, or corporation. Each structure has advantages and disadvantages.
A Sole proprietorship in the simplest and most common business structure. It is an unincorporated business owned by one individual. There is no legal separation from entity and its owner, which makes it very easy to create as there are very few formation filings needed. The disadvantage of no legal separation of the entity is that the proprietor is not exempt from liabilities incurred by the entity. An alternative for a sole proprietor, is a Single Member LLC, SMLLC, that is treated as a disregarded entity, like the sole proprietor for tax purposes however it does provide some liability protection to the owner. Each of these entities is disregarded for tax purposes. That means the business is reported directly on the personal tax return of the owner on a separate schedule (Schedule C) and taxed as the owner’s individual income tax rate, plus self-employment tax imposed on the net income of the business.
Partnerships, which include General Partnerships, Limited Partnerships and Limited Liability Companies, are the second kind of entity to consider when starting a new business. General Partnerships are when two or more individuals create a business entity. Partnerships also have an ease of formation and flexibility in management; however, each partner has full personal liability for debts and obligations of the Partnership in direct proportion to their ownership in the partnership. Limited Partnerships have a formal statutory formation and organization process but are very flexible with unlimited number and types of partners, profit and losses can be allocated in any manner. The most popular is the Limited Liability Company (LLC), it’s a hybrid entity that combines some of the major legal advantages of a corporation and the tax advantages of a general partnership. The owners, called members, have limited legal liability. Partnerships file a separate tax form, but do not pay income tax at the federal level. Partners receive a K-1 from the partnership that reports each partner’s portion of income and loss and is reported on the individual tax return of the partner and taxed at the partner’s individual income tax rate.
S-corporations, like partnerships, have an ease of formation. There is separate legal protection for the shareholders and like partnerships file a separate tax form. Also, like partnerships, the income and loss from the s-corporation is reported and taxes directly on the tax return of the shareholder and taxed at the individual shareholder’s income tax rate. There are a few other tax benefits from an S-corporation in terms of dividends and salary payments.
Corporations are the fourth type of entity to consider when creating a new business.
Corporations act as separate legal structures that are separate and distinct from its owners. The C Corporation has its own tax rate schedule and pays its own corporate tax. Any distributions from the C-Corporation are picked up as income on the owner’s tax return and taxed at the individual tax rate of the owner. This is referred to as double taxation since the income is taxed at the corporate level and then again at the owner’s level.
Overall, the entity type depends on the overall objective of the business. It is recommended that the owner of a new business speak with a tax professional to determine the best entity type to create. If you have questions on starting a new business, our business consulting team is here to help. Contact us today.
by Tim Cammett