Tax Tips for the Busy and the Baffled

Choosing a Business Entity

Dec 28, 2018 2:13:49 PM / by David Fruchter

When starting a new business your first decision is choosing how that business will be organized for tax purposes. That entity choice (LLC, S-Corp, Partnership, etc.) will determine how the business is taxed, personal liability, and your ability to raise money from investors or get a small business loan.

Below are some typical options along with a few of the advantages and disadvantages of each entity.

Sole Proprietorship

A sole proprietorship is a simple business entity that is owned and run by one person. If you do not formally elect another structure, you are a Sole Proprietor by default.

Pros:  

  • No formal creation process.
  • Easy to operate and dissolve.
  • Simplified tax reporting for the business on the owner's personal tax return.

 Cons:

  • No liability protection.
  • Self-employment tax of 15.3% on business profit, in addition to ordinary income tax, is assessed on the first $132,900 (for 2019) of the net profits of the business.

A sole proprietorship may be the right choice if the company operates part-time, is expected to produce only modest income, or there is little exposure to risk.

General Partnership

A General Partnership is a business entity in which two or more people agree to share the assets, profits and risks of owning a business. If you are running a business with at least one other person (special exception if that person is your spouse) and do not formally elect another structure, you are a partnership by default.

Pros:

  • Easy to create.
  • No limits on the number or type of partners. (Partners can be a person or another business entity).
  • Flexible in the allocation of profits, losses, and distributions.
  • Profits are passed through to the individual partners and taxed only once.

Cons:

  • Requires a separate partnership tax return (Form 1160).
  • Each general partner has personal liability.
  • Requires tracking of the basis for partners, both inside and outside the partnership.
  • Requires formal bookkeeping/accounting effort.
  • Individual partner’s share of income is subject to self-employment taxes at the same rates as Sole Proprietors.
  • The partnership automatically terminates when there is a greater than 50% ownership change.

Limited Liability Company (LLC)

If you are an owner of a business, you are eligible to form a Limited Liability Company (LLC). If you are the only owner of your LLC business, until you formally choose otherwise, you will be taxed exactly as if you were a Sole Proprietor. If the company has more than one owner, the owners will be taxed as if it were a partnership until a different election is made. An LLC has the same pros and cons as the sole proprietorship or partnership except for a couple of additional benefits:

  • The name you choose for the company will generally be protected and exclusive in the state in which the LLC is formed.
  • They may offer the owner(s) liability protection if the company is sued.
  • The LLC is flexible and may change its form of tax reporting with the IRS as its circumstances evolve without creating a new business entity.
    • A single member LLC can add additional members and be treated as a partnership.
    • Can elect S Corp status to take advantage of potentially lower Self Employment taxes.
    • Can elect to be treated as a C Corp as a means of raising investment capital.

 You may benefit from choosing the LLC entity if you run a business with operations that could leave you exposed to liability claims or would like sole possession of a business name and would like the flexibility to elect a different tax status later on.

C-Corporation

If you’re launching a business with the potential need to raise a large amount of outside capital, a C-Corporation might be the right business entity for you.

Pros:

  • No restrictions on ownership.
  • No personal liability for non-active stockholders.
  • C-Corporations can issue multiple classes of stock (e.g. preferred shares vs. common shares).
  • Can offer fringe benefits for owner-officers.
  • Ownership is easily transferred through the sale of stock.
  • Raising capital can be achieved by offering stock publicly or privately.

 Cons:

  • Double taxation of profits.
    • First at the corporate level at a maximum of 21%.
    • And then at the shareholder level when profits are paid out as dividends.
  • Complicated and expensive to create and maintain.
  • Requires formal bookkeeping/accounting effort.
  • Requires regular board of directors meetings and a record of the minutes of those meetings.

A C-Corporation may be a good fit if the business is complex and has foreign owners, or owners that are not people (other businesses). Also, if you intend for your company to be sold to another business entity, particularly a public corporation, this may be the right choice for you.

S-Corporation

An S-Corporation is an election made with the IRS to tax an existing C-Corporation or LLC under a specific set of rules. The election must generally be made within 75 days of the beginning of the company’s tax year. For most companies that means the election to be taxed as an S-Corporation must be made by March 15th to be effective beginning with the first calendar year.

Pros:

  • Liability protection like C-Corporations.
  • No double taxation.
    • Profits are passed through to the share holders and taxed at their personal tax rates.
    • Depending on the industry and amount of profit, the shareholders may receive a 20% of Qualified Business Income (QBI) tax deduction on their personal tax return.
    • S-Corporation profits ARE NOT subject to the 15.3% Self Employment tax.
  • Ownership is easily transferred through the sale of stock.
  • Losses can offset shareholder’s other taxable income.

 Cons:

  • Requires tracking of basis for stockholders.
  • Ownership is limited to specific types of entities.
  • Destructibility of fringe benefits for owner-employees is limited.
  • Requires formal bookkeeping/accounting effort.
  • S Corporations may have only one class of stock.
  • Officers of the S-Corporation must pay themselves a W-2 wage that is “reasonable”.
    • 30% of company profits is generally considered “reasonable”.
    • Not required to be paid at regular intervals.

You may benefit from electing S- Corporation if your company has significant profits or requires personal liability protection for its shareholders.

 

If you’d like to learn more about how choosing the right business entity could potentially save you thousands in tax dollars, click below to request a consultation.

 

Request a Consultation

David Fruchter

Written by David Fruchter

David Fruchter, E.A. ChFC is the owner of Tax Advisors of Cary LLC. David graduated from Emory University in 1985 with a B.A. in economics. For more than 30 years he’s provided tax and accounting services services as well as financial planning* and investment guidance* to individuals and small businesses. *Services provided through Great Plans Capital Management LLC, a Registered Investment Advisor.

Subscribe to Email Updates

Lists by Topic

Posts by Topic

Recent Posts