Entity selection - choosing your business type
When starting a business, you want to ensure you choose the type of entity that will serve you and your business best.
There are many factors to help you determine which business type to choose, but the two most important factors you want to look at are the legal and tax sides. Since I am not an attorney, I will talk about the tax benefits and drawbacks for each entity type. Before I get into that, let's first break down the different entity types.
There are different ways to categorize entities, a lot of the time, you will hear the term "flow-through," which means the income/loss passes through to the owner(s) of the business.
Nonprofits (honorable mention)
Limited Liability Company
Trusts & Estates (honorable mention)
Within Partnerships, there are several legal classifications:
Limited Liability Partnership
There are also additional types of corporations besides C and S, which are largely treated like C corporations unless an election is made to treat them as an S corporation:
B corporation or Benefit Corporation
PC or Professional Corporation
When people choose a business solely on the legal protection offered, more often than not, they end up going with an LLC. However, depending on what state your business is registered in, that may not be possible. Another common scenario is choosing an LLC as your business structure and then electing to file as an S corp. Also, in some states, depending on the type of business, you may not be able to form as an S corp and would instead form a Professional Corporation.
The Small Business Administration (SBA) has a lot of resources for small businesses, including a guide on selecting your business entity which includes the below chart, so I won't go into too much detail on things you can read there.
Now that you know a bit about the different types of entities, let's get into some pros and cons of each:
Sole prop: if you do not want to formally create a business, then you, by default, are a sole prop. There are a few advantages to being a sole prop:
No (or minimal) set-up fees
No minimum state tax (looking at you, California)
Easy to have multiple businesses
Do not need to dissolve the business if you decide to do something else
Ability to deduct self-employed health insurance payments
Ability to deduct a home office
There are, however, a lot of disadvantages:
Have to pay self-employment tax and income tax on your profit
No liability protection
The owner cannot take a salary
Limits on business expansion; cannot take on investors, can be harder to get a loan, etc.
Partnership: Each partnership type has different legal pros and cons, but I will focus on the tax pros and cons for partnerships in general. Here are some of the advantages:
The entity itself does not pay tax (on the federal side) the profit/loss instead flows through to the members who then pay tax on their individual tax return. Depending on what is flowing through, there could be self-employment tax.
Can be a good choice for holding real estate (depending on the business structure) - see article"Why you should not own property in an S corp."
Here are some disadvantages:
It takes two to tango; if you are a sole owner, you cannot form a partnership
Set up fees to establish the business and all required documentation
Liability protection varies depending on the type of partnership
Owners do not take a salary but can be paid guaranteed payments which are subject to self-employment tax
Under the Centralized Partnership Audit Regime, any IRS audit discrepancies require tax to be paid at the partnership level (unless an opt-out was timely filed)
Does not survive the death of a member
Limited Liability Company: when it comes to an LLC, things get a little tricky since an LLC is a business structure but not a tax entity; it gets to choose how it wants to be taxed. The default is to be taxed as a partnership, or it can elect to be taxed as an S corp. If there is only one owner of the LLC, then for federal purposes (and some states), it is filed as part of the owner's individual tax return.
S Corporation: Unlike an LLC, an S corp is a tax entity but not a business structure. So essentially, this means that you cannot form an S corporation; you form a different type of entity (C Corporation, LLC, Professional Corporation, Benefit Corporation, etc.) and elect to be taxed as an S corporation. So what are the advantages:
More tax planning options due to the ability of the owner to take payroll
Can sell shares of stock
Can exist indefinitely and do not dissolve with the death or removal of an owner
No double taxation
Here are some disadvantages:
Can only have 1 type of stock
There is a limit on the number of shareholders and type of shareholders
Reasonable compensation must be taken each year
Higher costs to operate (more admin due to required payroll)
Self-employed health insurance paid by the business is wages to the shareholder
Shareholders cannot deduct a home office on their return (must either have a reimbursement plan set up in the business or the business must pay rent to the shareholder)
Strict rules and timelines on qualifying and filing the S election
Not great if holding property - see article"Why you should not own property in an S corp."
C Corporation: Since a C corp is the most structured type of entity, I have saved this one for last. For this one, we will start with the disadvantages:
There is a high cost to form a corporation
Corporations pay income tax, and any income passed on to the shareholders is taxed, so income is subject to double taxation.
Harder to change from a corp to an S corp due to built-in gains tax
Not great if holding property - see article""Why you should not own property in an S corp."
Here are some advantages:
Different levels of stock can be offered
No restrictions on the number of shareholders or type of shareholders
Great choice if the company wants to go public one day
A completely separate entity from owners, so overs a lot of liability protection, and there is no impact if a shareholder leaves or dies.
Tax-free fringe benefits to employees, including shareholders (ex. health insurance, retirement contributions, etc.) that are fully deductible to the corp.
No required distributions to shareholders so earnings can be reinvested in the business.
The above list of advantages and disadvantages is not exhaustive for each entity type. You should always speak with a knowledgeable CPA or tax attorney when creating an entity. Although there are a lot of cheap resources out there for creating new entities, I always recommend working with professionals so you can ensure everything is set up correctly and that you know all of your filing obligations (tax and otherwise) going forward.
It is also crucial to have a good set of books for your business, and even if you don't have the resources to pay for ongoing bookkeeping, having someone help you set up your books and maybe do some training can be a lifesaver.
This article is not a substitute for professional advice, and no tax advice is provided here. This is solely for educational purposes.