When starting or growing a business, one of the most important decisions you’ll make is how to structure it. Your business structure determines how your company is taxed, how profits are distributed, and how much personal liability owners may have. It also affects how you bring in investors, manage operations, and plan for the future. There is no universal solution, and the most appropriate structure depends on the size, nature, and complexity of your business. In this article, Staff Accountant Jacob Coughlin, CPA, outlines the pros, cons and implications for the most common business structures so that you can be better equipped to tackle this critical decision.
Sole Proprietorship
This option is best for businesses with one owner or self-employed individuals. There is no separate legal entity, you are the business.
Pros:
- Easy to form with minimal to no startup costs.
- Administrative and organizational costs/burdens are low.
Cons:
- Since this is not a separate legal entity, you have unlimited personal liability for debts and legal consequences.
- You do not have partners or investors, resulting in minimal opportunity to raise additional capital.
- Tax benefits exist within the other options that are not available to sole proprietors.
Tax Effects:
- Income is reported on the owner’s personal 1040, Schedule C.
- Gross business income is offset by business expenses and deductions.
- Sole proprietors pay the employer share of self-employment taxes that W-2 wage employees do not pay.
Partnership
This is an option for a business with at least two owners. A partnership is a step up from a sole proprietor, where a legal entity is formed. Partners may be general or limited partners and are not always legally separate from the partnership entity. For tax purposes, a partnership is known as a “pass-through” entity.
Pros:
- Freedom in structuring a general or limited partnership.
- General partners are active and liable, while limited partners are passive investors with limited liability.
- Business partners can contribute additional resources to the partnership.
- Flexibility in paying partners via distributions or “guaranteed payments”, which are compensation paid to partners who perform services for the business.
Cons:
- General partners face unlimited liability, and their share of income is subject to the employee and employer share of self-employment taxes.
- Additional administrative costs are present in this entity. For example, partners must form a partnership agreement for share of income, losses, assets, and liabilities.
Tax Effects:
- Gross partnership income is offset by business expenses and deductions.
- The partnership will also file a return, but there is no tax at the partnership level.
- Each partner’s share of profits or losses are passed through the partnership, and reported and taxed on the individual partners personal 1040, Schedule E.
- General partners, like the sole proprietorship, pay the employer portion of self-employment taxes that W-2 wage employees do not.
- Limited partners may also expose themselves to self-employment taxes, should they receive guaranteed payments.
- After paying tax on share of profits, owners can take cash distributions, to the extent of their ownership basis.
C-Corporation
This is best for businesses with several owners who may want to raise large amounts of capital. These tend to have more complicated ownership structures and operating agreements. The corporation forms a legal entity that is separate from the owners, where ownership is now delineated through shares in the corporation.
Pros:
- Liability protection for shareholders, as they are separate from the legal entity that is the C-corporation.
- Flexibility in the class and number of shares issued.
- The corporation’s assets, liabilities, profits, and losses are entirely within the corporation and not passed along to shareholders.
Cons:
- Higher administrative and record keeping costs.
- Formal operating and ownership agreements are required. These are known as the “Articles of Incorporation” and are required for starting a C-corporation.
- Double taxation of profits, see below for tax consequences.
Tax Effects:
- The corporation files its own tax return separate from its shareholders.
- The corporation pays a flat tax rate of 21% on its taxable income.
- The corporation can pay shareholders through dividends, which are taxed again on the shareholder’s return. However, dividends are subject to favorable tax rates that are generally lower than other forms of taxable income.
- The corporate tax at the corporation level and the dividend tax at the shareholder level, is what makes up the “double taxation” of profits.
S-Corporation
The S-Corp can be thought of as a “hybrid” entity, meaning it has characteristics of both the Partnership and the C-corporation. Like the C-corporation, a separate legal entity with shares is formed. Like a partnership, the S-corporation is also a “pass-through” entity for tax purposes, so profits/losses are now passed onto the shareholders.
Pros:
- This option also creates a legal entity that is separate from its shareholders, thus the owners maintain limited liability. All business assets/liabilities are held within the S-corporation and separate from its shareholders.
- Tax advantages to the shareholders of the corporation as there is no dividend tax when owners take distributions. Additionally, shareholders who work for the corporation can mitigate self-employment taxes.
Cons:
- The administrative, operating, and record keeping burdens faced by a C-corporation are all applicable to the S-corporation.
- There is less flexibility in class, who can be a shareholder, and number of shares issued. Shareholders must be US citizens or residents. A C-corporation or partnership is not permitted to be a shareholder.
- Limited to one class of stock and may not have more than 100 shareholders, with some flexibility in that a husband and wife may be one shareholder.
Tax Effects:
- The S-corporation will file a corporate return but is not taxed at the corporate level.
- Share of income, like a partnership, is passed on to the shareholder’s 1040.
- After paying tax on share of income, owners may take distributions, to the extent of their shareholder basis.
- Owner-employees take a “reasonable salary” relative to their work.
- Self-employment taxes can be mitigated. Owner-employees can pay themselves in part salary, and part distributions. The distribution portion of income is not subject to self-employment taxes.
Structuring your business entity can be complex. Consulting with financial and legal professionals can help you determine the best fit for your personal situation. As business advisors, we’re here to help. Contact us for guidance and to learn more about our advisory services.
