As a small business owner, there are many decisions you will need to make that will impact your company for years to come.
Among these decisions is which corporate entity is best for your business. In this blog, we will review 5 different types of business entities along with their advantages and disadvantages so you can decide which works best for your business.
Many small business owners form a sole proprietorship when they’re just starting out.
If you are a sole proprietor, this means that you own and operate your business by yourself. You have complete control. All the profits of your business are yours.
However, with a sole proprietorship, you have no liability protection, which means you are responsible for all losses and debts as well. If any legal issues arise, you will be held personally responsible and those debts will need to be paid from your personal account.
A sole proprietorship is one of the simplest and least expensive entities to form because no legal paperwork is needed. However, your city or state may require you to obtain a business license, so be sure to look into the requirements for your specific state. In addition, you will want to register your business name with your state.
When it comes to your business taxes, filing is quick and easy. You can file your business taxes with your personal taxes using a Schedule C form.
In addition, you can deduct expenses and losses from your business against any other income you might earn, which will lower your tax bill overall.
The one drawback about taxes for a sole proprietor is that you are expected to pay a 15% self-employment tax on all your net income, which covers Social Security and Medicare taxes.
You are also required to pay estimated quarterly taxes throughout the year. These payments are usually due April 15, June 15, September 15, and January 15. If you fail to pay estimated taxes quarterly, you may have to pay a penalty and interest on what you owe.
Overall, the advantages to forming a sole proprietorship are that it is the least expensive entity to form, you have complete control of your business, and tax preparation is quick and easy.
The biggest disadvantage is no liability protection.
A general partnership is simple to form. Like a sole proprietorship, your city or state may require you to obtain a business license, and you will want to register your business name with your state.
I’d also strongly recommend that you set up an operating agreement for your partnership. What are the roles and responsibilities of each partner involved? What percentage of the profits will you share? Determining this at the start will benefit your business as you get up and operating.
Like a sole proprietorship, a general partnership does not give you liability protection. This means each partner in the business is personally responsible for any debts or legal action.
General partnerships are also required to pay the 15% self-employment tax on all their net income as well as quarterly estimated taxes. However, as a partnership, you have a lot of flexibility and can deduct any losses in your business against other income to lower your taxes.
That’s where the similarities between a general partnership and a sole proprietorship end. Partnerships add more complexity because there are multiple owners involved.
In a partnership, you will file a partnership tax return every year on Form 1065. Then, each partner is given a Schedule K-1 showing their individual share of the profits and losses, based on your agreement. That means you will need to file a form as a partnership as well as the Schedule K-1 as part of your personal tax return.
A limited liability corporation, or LLC, is more expensive to form than a sole proprietorship.
An LLC must be registered in the state where it does business. Each state varies slightly, but most require you to choose a distinct name and to file articles of organization. These articles of organization include information like your business name, address, and the names of its members. Many states charge a filing fee for the articles of organization. For most states, you file with the Secretary of State; however, each state is different, so carefully check the requirements in your state.
Unlike a sole proprietorship, an LLC offers liability protection, which means your business assets are separated from your personal assets. So, if your business is sued or runs into financial trouble, the business will be responsible to pay any fees, not you personally.
In addition, with a single-member LLC, you have complete control and flexibility. All the profits of the business are yours, and you can deduct any losses in your business against other income to lower your tax bill.
However, like a sole proprietorship and partnership, you will be required to pay self-employment tax on all of your net income to cover Social Security and Medicare taxes, unless you elect to be taxed as an S corporation. You are also required to make estimated quarterly tax payments.
As a single-member LLC, you can elect to be taxed as a sole proprietorship or as an S corporation, which we will discuss in more detail below.
A multi-member LLC shares many similarities with a single-member LLC. For example, you get the same liability protection. You also go through the same formation process and file documents with your state. And you can elect to be taxed as an S corporation.
The main differences between a single-member and multi-member LLC revolve around the fact that there are multiple business owners involved. Because of this, you can not elect to be taxed as a sole proprietorship. Your LLC will need to file a business tax form and each partner will need to fill out a Schedule E on their personal tax return, unless you elect to be taxed as an S corp, which we will discuss below.
In addition, there are some complexities that arise with sharing control of the business, which is why you will want to have an operating agreement in place.
S corps have the benefits of a corporation but are taxed as a partnership. Like an LLC, an S corp separates business owners and their assets from the business. Creditors can only go after the business but can’t touch the business owner’s assets.
However, establishing an S corp takes more leg work and paperwork than an LLC. Most S corps spend a considerable amount on attorney and accounting fees.
An S corp also requires more maintenance. For example, to be an S corp, you must develop a board and bylaws, issue stock, hold board meetings, and keep records of each board meeting.
In addition, the IRS also has the following requirements for S corps: 1) shareholders must be US citizens, 2) you cannot have more than 100 shareholders (spouses count as separate shareholders), and 3) you can only have one class of stock.
The taxation of an S corp is what sets it apart from other business entities. When you have an S corp, your business is taxed through the income of the shareholders, and those taxes are taken out throughout the year.
Any shareholder who works for the company must be paid a reasonable wage. After the wages are paid, the rest of the income from the business is passed onto the shareholders as dividends. The benefit of an S corp is that dividends are taxed at a low rate if they are taxed at all. LLCs that are taxed as an S corp can also take advantage of these benefits.
To take advantage of these tax benefits, you are required to set up payroll for your owners and employees. The laws for S corps are not the same in each state, so you will want to look into individual requirements for your state.
So, which entity works best for your business?
Unfortunately, there is no simple answer. Depending on your business, industry, structure, and revenue, different benefits might outweigh some of the disadvantages.
In addition, what entity works best for your business might change as your business grows. So the best advice I can provide is to know these pros and cons. Then, as the complexity of your business increases, seek the advice of experts who can analyze what works best for your situation. Paying extra for expert insights now can have significant payoffs in the long run.
If you are looking for customized insights into your business, reach out to our team! We would love to help. We specialize in small business accounting, bookkeeping, and taxes, and we enjoy having ongoing discussions with our clients to help them make decisions that will lead to their business success.