Congratulations! You just started a brand new business.
Maybe you’ve been a full-time employee most of your life and finally took the plunge into the wild world of entrepreneurship. Perhaps you’re a professional who decided to open up your own private practice. Or maybe you’re a serial entrepreneur whose job it is to plant the seeds of a new business, nurture it over a period of time, then harvest the yield you’ve been the caretaker of.
Just like the vast variety of the businesses they start and operate, the owners of these enterprises can also be very distinct from one another. And because different owners have different ideas for what they want to be when they grow up, there are different ways a business can be operated and structured.
One of the most common questions we hear from our clients at Founder’s CPA is which type of entity should my business be? The quick answer to that question is “It depends.”
We will be exploring the answer to this question in a series of upcoming articles about the different types of entities you could choose for your business. The types of entities we’ll be looking at are C-Corporations, S-Corporations, general partnerships, Limited Liability Companies and sole proprietorships.
This article introduces each of these different entities and describes at a high-level the differences and similarities between the entities.
Let’s begin our discussion with what is probably the most well-known type of business entity, at least by name – the C-Corporation.
The grandfather of business entities, the C-Corporation has come back in vogue the past 24 months thanks to the “Tax Cuts and Jobs Act of 2017,” which cut the tax rate for C-Corporations from 35% to 21%.
Famous (or rather infamous) for its double taxation of earnings, the C-Corporation is the preferred entity structure for venture capitalists and other institutional investors for two primary reasons: 1.) It’s easy to transfer ownership from an existing shareholder to a new or incoming shareholder, and 2.) The C-Corporation structure provides liability protection for the shareholders.
These significant benefits of easy ownership transfer and liability protection comes at a cost, however: Double taxation and lots and lots of paperwork.
So what, exactly, do we mean when we say a C-Corporation’s earnings are taxed twice? The first layer of taxation happens at the entity level. The business itself pays a 21% tax on any net profit.
The second layer of taxation occurs when a shareholder wants to take money out of the business. While there are tax planning strategies to minimize this layer of taxation, in general a shareholder must pay taxes on money taken from the business. The most common form of cash distribution from a C-Corporation to its shareholders is through a dividend. The maximum tax rate for dividends in 2019 is 20% (an additional 3.8% federal net investment income tax may also apply, bringing the total tax rate total to 23.8%).
To summarize, the primary drawbacks of organizing your business as a C-Corporation are double taxation, the high cost of filing the necessary paperwork to create the C-Corporation and the ongoing legal and administrative work necessary to keep a C-Corporation in compliance of local, state, Federal and international laws.
But for the right type of business, shareholder or investor, the benefits of organizing as a C-Corporation outweigh the aforementioned drawbacks.
Not every business wants to attract institutional investors or eventually go public. Owners who want the liability protection of C-Corporations but an easier way to satisfy tax filing obligations can utilize the S-Corporation.
The reason why S-Corporations are not attractive to institutional investors are the three ownership limitations: 1.) The number of S-Corporation shareholders are limited to 100 or less; 2.) S-Corporation shareholders can only be individuals, estates and certain types of tax-exempt entities and trusts (other business entities cannot be a shareholder); and 3.) S-Corporation shareholders must be U.S. citizens or permanent U.S. residents.
While these three ownership limitations cause institutional investors to shy away from S-Corporations, these ownership limitations are usually not an issue for the vast majority of business owners who are not institutional investors.
Many S-Corporation businesses, in fact, are “lifestyle” businesses that have only a handful of shareholders. These businesses will never have to worry about exceeding the 100 shareholder limit.
Another significant benefit of organizing a business as an S-Corporation is only dealing with one layer of taxation. While C-Corporation profits get taxed at the entity level, S-Corporation profits do not get taxed at the entity level. The profits from an S-Corporation flow from the business to the shareholder, and get reported on the shareholder’s individual tax return.
So while all net profits are taxable to the owners of the S-Corporation, distributions to the shareholders are (generally) not taxable, while dividend distributions from a C-Corporation are subject to tax.
Another advantage of S-Corporation status is not paying the 15.3% self-employment (SE) tax on 100% of the business’s profits. While shareholders must be paid a reasonable salary (which is subject to the SE tax), the remaining profits after paying shareholder salaries avoids the SE tax. As a comparison, all of a partnership’s and sole proprietor’s profits are subject to the SE tax.
If you start a business with at least one other person and don’t incorporate, by default your business is a general partnership.
A general partnership is easy to start, does not require filing any paperwork with your particular state and doesn’t require certain compliance activities such as recording minutes of meetings. Each partner can also deduct their share of business expenses on their individual tax return.
Another advantage of forming a business as a general partnership is flexibility when drafting partnership agreements. While profits of an S-Corporation must be allocated pro-rata, a general partnership can allocate a non-proportional amount of income (or expenses) to a specific partner or partners.
The biggest drawback of a general partnership is the absence of liability protection. Each partner of the business is personally liable for the business’s debts and other liabilities. In some states, each partner may also be personally liable for one of their fellow partner’s negligent actions.
As a general partnership begins to grow, it may also become difficult to qualify for a business loan, attract significant clients and build a credit history.
A general partnership may make sense to quickly get a business off the ground. Then, after a period of time, the general partnership can incorporate into either a C-Corporation or a Limited Liability Company.
Limited Liability Company
The most popular form of business entity today in the United States is the Limited Liability Company (LLC). While LLCs and S-Corporations share many of the same characteristics, such as limited liability and pass-through taxation, there are several important differences that make the LLC a very popular choice of business entity.
First, LLCs do not have the shareholder limitations that S-Corporations face. States do not enforce any limitations on the number of members an LLC can have. (Owners of an LLC are called members, not partners.)
Second, S-Corporations must allocate profits and losses pro-rata. For example, an S-Corporation with two shareholders and income of $100 for the most recent calendar year must divide the $100 equally, $50-$50, between the two shareholders.
LLCs (and all other forms of partnerships) can take that $100 of income and allocate $80 to one member and $20 to the other member, for example. This same type special allocation can be done with expenses, as well. The flexibility to allocate economic transactions is a significant advantage of forming a business as an LLC. (There are guidelines for making special allocations that will be discussed in an upcoming article.)
The flexibility to make special allocations of income and expenses, however, comes with a downside – compliance requirements can become very significant, both in terms of time and money. Many attorneys and CPAs agree that the most complex component of the U.S. tax code is the section that governs partnerships (Subchapter K).
But don’t let these potential compliance requirements scare you from organizing as an LLC. Many smaller partnerships don’t consistently encounter these more complicated tax scenarios.
If your LLC does end up encountering these more complicated tax situations, chances are the business has grown to the point that the financial resources will be available to properly meet your compliance obligations.
But what if your business isn’t a partnership? What if you’re the only owner? Can you still form your business as an LLC? To answer these questions, let’s dive in to the last type of entity we’ll be discussing, the sole proprietorship.
If you start a business, are the only owner and don’t incorporate, you are automatically a sole proprietorship.
It’s almost like an “instant” business.
If your 5-year-old creates a lemonade stand this weekend and earns $20, your 5-year-old has created a sole proprietorship business. No filing requirements necessary. (Actually, some cities have started cracking down on these dangerous, illicit food preparation businesses run by minors, requiring a food permit license to be obtained. But I digress.)
Sole proprietorships are most appropriate for smaller businesses that have only one owner, such as a freelance or side hustle business, or businesses that remain at a
These types of smaller businesses oftentimes don’t have to deal with potential lawsuits and liabilities that larger businesses may encounter. Therefore the added protection of limited liability may not be necessary.
But what if you have a sole proprietorship business that’s growing? At some point it will make sense to either incorporate your sole proprietorship (and then make the election to be treated as an S-Corporation for tax purposes) or form an LLC.
That’s our quick overview of the 5 most common types of business entities. While LLCs and S-Corporations have been the most popular choice of business entity in the U.S. over the past 20 years, C-Corporations are no longer being viewed as appropriate only for start-ups looking for institutional investors. Smaller, lifestyle businesses that may have only considered being an S-Corporation or LLC in the past are now also considering C-Corporation status.
Our next series of articles will dive into each of these types of entities in more detail.
Want help in deciding which business entity is right for you? Schedule a FREE consultation with a CPA!