Entrepreneurs have several options when deciding on a corporate structure for their business activities. For example, many owners begin as sole proprietors and, as business and income grow, they later form a limited liability company (LLC) or subchapter S corporation (S-Corp). The goal when deciding on the best structure is often tax minimization and liability protection. There certainly isn’t a one-size-fits-all solution, but there are pros and cons to consider when evaluating the different types of entities.
Sole proprietorship
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Individuals who start a small business often begin as single employees and report their income on their individual tax returns (Form 1040, Schedule C). Because the business structure only requires a Social Security number, sole proprietorship is considered the easiest and simplest to establish. Another advantage is the ability to make deductions for self-employed health insurance premiums paid and contributions to SEP individual retirement account (IRA) plans.
An important downside to operating as a sole proprietor is business assets are tied to personal assets, which can be a problem if the business is sued or fails. Legal liability also raises concerns when hiring employees because their actions could potentially come back and hurt the business owner. Hiring employees also means the employer needs an Employer Identification Number (EIN) for payroll tax reporting. Lastly, sole proprietors face Medicare and Social Security taxes on net income over $400.
Partnership
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When two or more individuals or entities join to operate a business and share profits (or losses) the structure is sometimes called a partnership. The default type is a general partnership and allows like-minded entrepreneurs to pool resources, skills, and expertise with one or more partners.
Like a sole proprietorship, however, the partner’s business and personal assets are often tied together, which can be problematic from a liability perspective. That’s why some professionals (think doctors, lawyers, or accountants) operate under limited liability partnerships (LLPs), which can help shield them from any actions of the other partners. However, limited liability doesn’t mean their assets are protected from their own actions.
LLP vs. LLC
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The limited liability company has many of the same characteristics as an LLP, but also some notable differences. Both are considered pass-through entities and profits (or losses) are reported on the owner’s income tax returns. Both LLCs and LLPs offer limited liability protection to their owners (called members in an LLC and partners in an LLP) and owners generally aren’t personally liable for the debts and obligations of the business beyond their investment in the company.
LLCs and LLPs have a lot of other things in common:
- An EIN is required.
- Partners or members can’t be on the payroll, but the company can have employees.
- LLCs and LLPs can be more costly than sole proprietorships because of separate return requirements.
- Partners and members receive Form K-1 to report their pro-rata share of income, deductions, and credits regardless of whether distributions are made.
- Ordinary income for general and managing partners is subject to ordinary and self-employment taxes.
- Limited partners and members shares aren’t subject to self-employment taxes.
- Losses are limited to basis (the amount invested), including share of partnership’s liabilities.
An LLC differs from an LLP in that it’s created by filing articles of organization with the state and the LLC operates as a separate business. By creating a financial barrier between the owner and the company, business creditors can’t go after an owners’ personal assets. Think of an LLC as a hybrid between a partnership and a corporation; it provides many of the same protections as a corporate structure but requires less paperwork and fees to create compared to corporation.
Corporation
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While the idea of incorporating might seem daunting, subchapter C (C-Corp) and S-Corps are quite common structures for small businesses and often make sense for those consistently generating income of $75,000 or more per year. A key difference with the corporation (compared to a partnership) is the liability protection and tax treatment. Because a corporation is considered a separate entity, the shareholders’ (owners’) personal assets are generally shielded from company liabilities. Also, corporations are subject to double taxation, meaning income is taxed at the corporate level and distributions at the owner level.
Electing to be treated as a C-Corp involves filing specific forms and obtaining an EIN. Owners have discretion over payroll arrangements but face the corporate tax rate of 21% on net income. Alternatively, the second election is forming an S-Corp. Owners benefit from pass-through taxation and receive K-1 forms detailing their share of income, deductions, and credits, regardless of whether distributions are made. While ordinary income after salary is taxed at individual rates, it isn’t subject to self-employment tax for Social Security and Medicare.
While forming an S-Corp can help overcome some of the problems of double taxation, certain guidelines must be followed:
- Owners’ payroll is mandatory for profitable companies.
- Owners can’t be foreign.
- The number of owners is limited to 100.
- Losses are constrained to basis, including only direct shareholder loans to the company.
The bottom line
Entrepreneurs face a myriad of options when considering the most suitable corporate structure for their businesses. From the simplicity and ease of establishing a sole proprietorship to the complexities and protections offered by corporations, each entity type presents its own set of advantages and challenges. Finding the optimal structure often depends on the owner’s individual assets, long-term goals, and tax situation. Mercer Advisors has business planning specialists to help you make the right choice for your business.
