One of the most crucial decisions when starting a company is choosing which type of business entity to form. While you will get a lot of advice, it is important to consider the taxation, control, and liability issues.
This article will explain the features and pros of each type of business to help you make the best business decision.
When choosing a business type, there are several factors to consider
Consider these important factors when making a business decision.
- Complexity and cost of running the business. This includes legal fees and costs of operation.
- Ownership Control and the tradeoff between control & profits/losses
- How much the business owner or business pays taxes
- Liability of business owners for the debt of the business, for actions of other owners, and for general liability
The tax implications of choosing a business are important. This is why we have provided an explanation of two types of business for income tax purposes.
A corporation is a business that is separate from its owners, called shareholders, who buy shares of stock in the corporation. These owners receive payments from the business in the form of taxable dividends. Owners may also be employees or executives. They are paid for their duties in addition to shareholder dividends.
Pass-through businesses are named as such because the tax liability of the business is passed through to the owner as part of the owner’s personal tax return. For example, if a sole proprietor has a net income of $25,000 for the year on their Schedule C, that amount is added to all the other income of the person (and their spouse, if they have one), along with any business and personal tax credits, to calculate the person’s total tax liability for the year.
Pass-through entities include sole proprietorships, partnerships and limited liability companies (LLCs), as well as special types of corporations like S corporations.
S corporation owners can’t be considered self-employed. Self-employment taxes should be included in your tax situation when considering one of these business types.
State-specific Business Types
Limited liability companies (LLCs), partnerships, corporations, and partnerships must register in the state where they intend to do business. The state’s corporation’s or business division sets the rules and requirements for business structures. Although all states permit corporations, partnerships, LLCs, some variations of these business types may not be allowed in every state.
Check with your secretary of state’s office, usually the business division, to get more information on their registration process.
Sole Proprietorships (Sole Props)
A sole proprietorship is a type of business operated by one individual. The business isn’t considered separate from its owner, and it doesn’t need to register with any state. This feature has its pros and cons.
Pros include the fact that the sole proprietor retains full ownership and can make all decisions without having to answer to other owners or a board. This also means that the owner gets all of the business’ profits. Taxes are fairly simple, consisting of a Schedule C form included in the owner’s personal tax return.
It means that the owner is responsible for all business losses. This means the owner could be held personally responsible for any business debts, including those incurred in bankruptcy proceedings, as well as for general liability.
Sole proprietorships might be a good choice or starting a new business in a low-risk situation before forming a more formal business.
Corporations (C Corps).
A corporation is independent of its owners for tax, liability, operations and taxes. The corporation is formed with articles of incorporation under the laws of the state in which it operates. Because corporations are expensive to form, in addition state registration, they must also have a board and keep regular minutes of meetings and reports to shareholders.
The corporation pays its own taxes and the owners pay taxes on dividends as shareholders, which in some cases may be double taxation.
Two benefits to incorporating are the generally low corporate tax rates and the ease of raising funds from investors.
Professional Corporations (PCs), and Professional Service Corporationss (PSCs).
Two types of corporations have been created for professionals who practice alongside other professionals.
A professional corporation is a specific type of corporation for licensed professionals such as attorneys, doctors, architects, or accountants. Some states allow these professionals to form a corporate entity. However, in this type of business, each professional remains liable for any wrongful professional actions.2
A personal service corporation (PSC) meanwhile is restricted to providing personal services. The IRS requires that the PSC meet certain requirements, including ownership of shares and services provided by owner-employees. As a PSC, you can be a professional from many different fields.
S Corporations (S Corps).
Subchapter S corporations or S corp are corporations that have the limited liability benefits and are taxed like a pass-through company, but not as a corporation. S corp owners don’t pay double income tax, but there are some restrictions to electing S corp status. This includes a limit of 100 shareholders, and only one stock class.
S corporations are subject to complex taxes because they must file a federal income tax return and have separate schedules for tax due from owners. Some states also tax S corporations.
S corporations have to be run by a board of directors, just like corporations. They must also follow the same filing and operating procedures as corporations.
Limited Liability Companies, or LLCs (limited liability companies)
All states allow the formation of an LLC by registering articles of organization or a similar document with the state and creating an operating agreement to govern member decisions, including how they share profits and losses of the business. LLC owners are called members. A single member of an LLC is called a “singlemember LLC.”
LLCs are much easier to set up than corporations. However, they provide the same protection against liability as corporations.1
An additional benefit to creating an LLC is the availability of multiple options for taxes. This can depend on certain situations, such as those outlined below.
- A single-member LLC pays taxes on its personal tax returns (using Schedule C as a sole proprietorship).
- A multiple-member LLC usually pays taxes like a partnership.
- And both types of LLCs can elect to be taxed like a corporation or an S corporation.
A partnership is a business with two or more individuals who share the risks and benefits of the business, including the partnership profits and losses. Partnerships are easy to set up and manage. They must register with a state and create a partnership agreement. While they have certain recordkeeping requirements, these are not as complex as those for corporations.
Two types of partners can be included in a partnership:
- General partners who participate in the day-to-day management of the business and have liability for partnership debts and for actions of the partnership
- Limited partners are investors who don’t participate in the business’ day-to-day operations or take on any liability.
Partnerships file an information return to the IRS to report their business tax liability. This form does not contain tax due to the pass-through status for the partners. The income or loss are divided among the partners in accordance with their agreements. Then, each partner receives a Schedule K-1 form showing their share for the year, which is reported on their personal tax returns.
Options for Partnership
There are many types to choose from, depending on the level of liability that the partners wish to assume and the type or group of people who work in the business.
A general partnership is made up of general partners, who each make business decisions. But each partner can be held liable for the debts and decisions made by the other partners.
A limited partnership (sometimes called “LP”) includes both general partners who make business decisions as well as limited partners who invest in the company but are not involved in its daily operations. While general partners are liable for company actions and debts, limited partners are protected from such liability as long they do not become involved in business decision making.
Although limited liability partnerships (LLPs are formed with general partners, all general partners are protected from liability for the actions of employees and other general partners. The LLP operates in partnership rules and is very similar to an LLC.
Businesses that have multiple owners or groups, such as a law firm or CPA company, may use one or more of the following partnership types, depending on their particular situation.