When starting a new business, it is important to make sure you are choosing the right legal entity. The business structure you choose will impact your taxes, exposure to liability, ability to raise capital, and the management structure of the business is likely to impact the choice of entity. Understanding the different types of entities and their implications will help you make an informed choice that aligns with your business goals. To help you navigate this crucial decision, Staff Accountant Alyson DePadre offers this guide covering key considerations for any business owner.
Which type of entity is best for your Business?
- Sole Proprietorship
A sole proprietorship is the most common and simple form of business entity. You own and operate your business yourself. There are no formal requirements to create this structure which provides an easy setup, complete control over your business and simplifies your tax filings. This includes no separate legal entities, business income can be reported on your personal tax return, minimal compliance, and fewer permits with less paperwork.
This entity is the best fit for small businesses, freelancers, and individuals starting a low-risk business. A sole proprietorship does not provide liability protection, so personal assets (such as home, car, or savings) can be at risk.
- Partnership
A partnership is a business entity made up of two or more individuals. There are two types of partnerships: General (GPs) and Limited (LPs).
- A General Partnership consists of partners who are equally responsible for managing the business and sharing profits and losses. A sole proprietorship does not provide liability protection for the partners.
- In a Limited Partnership, one or more partners have limited liability, while others are actively involved partners are not protected from potentially unlimited liability.
Some advantages of a partnership are shared responsibilities, pass-through taxation and simple structure. You can divide the workload between partners and utilize one another’s skills. Pass-through taxation is when profits are passed through partners, who report it on their personal return, and like a sole proprietorship it easier to set up.
These entities benefit businesses with multiple owners who plan to work together and share responsibilities.
- Limited Liability Company (LLC)
An LLC is a hybrid business structure that combines the benefits of a corporation with the flexibility of a partnership. It provides personal liability protection for owners, so members are generally not personally liable for the company’s debts or liabilities. It has provided tax flexibility in that the company can elect to be taxed as a sole proprietorship, partnership, or S corporation which allows profits to be passed through to individual tax returns.
Normally, an LLC is best for small to medium sized businesses like family businesses, growing operations, and small partnerships.
- Corporation (C-Corp)
A corporation is a separate legal entity from its owners (shareholders). It is the most formal and structured business entity. Shareholders’ personal assets are protected from the corporation’s debts and any legal actions. Corporations have the ability to raise capital by issuing stock and to attract investors. It has the advantage of perpetual existence as a corporation continues to exist when there are ownership changes. Double taxation of corporate profits if dividends are paid and the flat 21% federal tax rate.
The C-Corp is typically used by large businesses or startups seeking significant investment.
- S Corporation (S-Corp)
An S-Corp is a special tax status that can be elected by a corporation or LLC. It allows the business to avoid double taxation by passing income directly to shareholders, who report it on their personal tax returns. The shareholders are not personally liable for the corporation’s debts. They provide an additional tax benefit, so that shareholders can potentially reduce self-employment taxes by classifying part of their income as distributions rather than as salary. S-Corps have strict eligibility requirements: the number of shareholders is maxed out at 100, the corporation can only have one class of stock, and the shareholders must be all U.S. citizens or residents.
An S-Corp is the best fit for small businesses that want advantages of a corporation without double taxation and can meet the eligibility requirements.
- Nonprofit Organization
Nonprofits are created to serve the public good rather than personal profit. These nonprofits can be organized under several other subsections of IRS Section 501(c), which allows them to avoid paying federal income taxes. Contributions to nonprofits with Section 501(c)(3) status allows donors to receive tax deductions for contributions. Nonprofits are also eligible to apply for grants and funding that are not available to for-profit businesses.
Tax exempt status is available for organizations that are focused on social, educational, charitable, or religious purposes that can benefit from tax-exempt status.
There are many objectives to consider when choosing the right business entity type, including the nature of your business, the level of risk involved, your financial goals, and your long-term vision for growth. Each business structure should be assessed to determine which most optimally meets your needs. Our firm works with many new business owners across industries and would be happy to consult with you to help ensure you make the best choice for your new venture. Contact us to start the conversation. For more information on our business tax services, visit us here.
