On most accounts, there has never been a better time to take the leap towards entrepreneurship in America. After all, there are have been several new initiatives that were part of the Tax Cut and Jobs Act of 2018 that helped introduce a single and flat corporate tax rate, new pass-through tax deduction, 100% bonus depreciation, increased automobile depreciation limits, and more. It just seems like everyone is rooting for small business owners. So, while there are numerous amounts of articles you will inevitably encounter as you search for guidance in starting a business (including several million on choosing the correct business structure), this one has one goal: helping you choose the right business entity for your new company. Keep in mind that we use the term “right” quite loosely as there may be several options for you at this point in your business that would be the best choice, and still other options that may be better as you grow, hire and earn more revenue. With that out of the way, we’ll seek to find the best match for your business and its owner(s).
Business Structure Options
It would be a disservice to jump right into which business structure to choose without first explaining each of the options a business owner in the US has when choosing the right one for their business.
The simplest business entity, or business structure, to understand both legally and financially is the sole proprietorship. A sole proprietorship offers one owner the ultimate freedom to make business decisions and does not exist legally apart from the proprietor.
For tax planning purposes, a sole proprietorship usually operates the business under their social security number without a separate tax ID/EIN. Sole proprietorships are treated as a Schedule C unincorporated business reported on their individual Form 1040 tax return.
Sole Proprietorship is most commonly utilized as a business structure early in the life of the business with owners typically transferring the business structure to an LLC or C corporation as business operations, revenue, and number of employees increases.
A partnership is like a sole proprietorship, but with more than one owner. All partners contribute capital, property, labor, or skills and, in turn, share in the profits and losses of the business. Partnerships are easy to establish but, despite having just one level of tax, come with the most complicated federal tax laws that are akin to those tax laws imposed on LLCs. The number of partners that can join a partnership is unlimited; however, partnerships don’t enjoy the corporate veil when it comes to liabilities. Any single partner can take on financial obligations on behalf of the business, for which all partners are professionally and personally liable.
The LLC creates a separate legal entity which is formed by filing articles of organization with your secretary of state. The LLC receives its own tax ID/EIN which therefore limits the owner’s liability to the extent of the assets that the business holds. Past that, an owner cannot be sued for anything they own personally unless they have co-signed a lease, loan, or contract.
Aside from protecting taxpayers from judgments against a business owner’s assets, an LLC also offers specific state law and tax characteristics of corporations, including one level of income tax.
The SMLLC, or single-member LLC, operates similar to a sole proprietorship and is also treated as a Schedule C business, but with the limited liability of an LLC or corporation. It’s common for a single business owner to set up multiple LLCs to compartmentalize assets to protect them from creditors attempting to satisfy a judgment.
An SMLLC is a business entity which the IRS treats as a sole proprietorship for tax purposes, meaning that the SMLLC doesn’t pay taxes, but instead will be included on a Schedule C with a standard 1040 tax return. An LLC that retains significant amounts of profit every year can elect corporation status for an entity and have the LLC taxed, but this is indeed rare, and one in which you should discuss with your accountant before doing so.
The MMLLC, or multi-member LLC (sometimes also referred to as multi-owner LLC), have several benefits, including, the tax features of a partnership, limited liability, and one level of income tax. The MMLLC is also treated as a partnership by the Internal Revenue Services. Instead of the MMLLC paying taxes, each LLC owner pays their fair share of taxes based on personal income tax returns on a Schedule E. The share of each member’s profits and losses, also known as a distributive share, as outlined in the LLC operating agreement that is an integral part of setting up the LLC.
MMLLCs fall into two distinct categories, manager or member managed. With manager-managed, the business functions as a limited partnership with management authority granted to only a select few individuals, as outlined in the LLC operating agreement. Member-managed LLCs, alternatively, vest management authority to all members of the organization.
MMLLCs bind this initially authority of ownership from the offset of the LLC’s “life,” and that authority typically can’t be transferred to another individual without the unanimous written consent of the rest of the members. However, an MMLLC can be dissolved if a fixed duration of time outlined in the operating agreement has lapsed, all member agrees to terminate the business, or one of the members dies, retires, or files bankruptcy, and the other members do not agree to continue the business.
C corporations sometimes called “regular corporations” are owned by shareholders whose liability equals the amount of capital invested in the business. As with LLCs, the protection afforded to owners of smaller businesses could be considered limited to tort since lenders and creditors typical ask for owners for a personal guarantee on debt agreements.
For tax planning purposes, C corporations have become a more attractive business entity courtesy of the Tax Cuts and Jobs Act. Under these new rules, corporations pay tax on their entire taxable income at a rate of 21%. Additionally, there is no longer a corporate alternative minimum tax.
Unless given any specific rights and powers in the corporate charter, minority shareholders will have little, if any decision-making power. Instead, the majority shareholder (the one who owns most of the stocks issued) has complete control over the business decision-making process.
S corporations have been touted as a highly desirable business structure for small business due to the ability to reduce Social Security taxes on the income of shareholders and employees. Shareholders’ liability is, again, limited to capital contributed. Although, as with other business entities that don’t have a long track record of business activity, lenders may ask for personal guarantees on new loans.
Outside of having input to the initial corporate charter, minority shareholders don’t hold much sway on the direction of the company or day-to-day business functions. S corporations are limited to 100 shareholders, while all members of an extended family can be treated as one shareholder through an election.
Professional Corporation (PC)
A professional corporation is an entity formed by licensed professionals such as architects, attorneys, engineers, accountants, and physicians. The reason that these types of professionals generally choose this kind of structure is that it limits an owner from personal liability of the negligence or malpractice of other owners.
Qualified Personal Service Corporation (PSC)
The qualified personal service corporation is a type of C-corporation where 95% of all stock in the company is owned by the individuals who provide professional services for the corporation. These stocks can be held by retired employees or any estate of an employee or retiree. Because of the nature of the PSC, they are typically relegated to the health, legal, engineering, architecture, accounting, actuarial science, performance arts, or consulting industries. Qualified personal service corporations are afforded a flat tax rate of 21% and offer shareholders more control.
Which business structure is right for me?
As we mentioned before, choosing the right business structure is a tricky subject that many experts have attempted to tackle. There are several key considerations when choosing a business structure including governance, legal structure, and taxes. Choosing a business structure has a significant impact on liability, self-employment tax, how much you can earn and deduct, and administrative costs needed to set-up and run certain business entities.
Ask any accountant about which business structure is the correct one for your business and they will most likely tell you to study the tax considerations of each type of business structure to determine which is best for your new business. Businesses are structured in ways to minimize taxation, and therefore, tax considerations are among the top concerns for business owners.
Tax considerations for sole proprietorships are simple: the business income and taxes are not separate from the owners. Sole proprietors file self-employment and employment taxes themselves and enjoy one of the lowest tax rates among the different business structures. Taxes fall into the personal income tax brackets, so entrepreneurs choosing a sole proprietorship can look at the IRS tax brackets to get an idea of what percentage of taxes they will pay. Likewise, partnerships are like sole proprietorships when it comes to paying taxes. The income of the partnership is reported as passing through to the partners who are then taxed on their personal tax returns.
Unless you elect to create a corporation, single member and multi-member LLCs are also treated as “pass-through” entities. Like sole proprietorships and partnerships, profits and losses for an LLC are paid on the owner’s income tax return using the Schedule C form. LLCs are treated as partnerships by the IRS, so these businesses also do not pay taxes but instead make each owner pay taxes for their share of the profits and losses on their personal income tax returns. The percentage of gains and losses that each member must pay is usually outlined in the LLC’s operating agreement.
So, we’ve established that for taxation purposes, sole proprietorships, single member LLCs, general partnerships, LLCs are all taxed through the individual owners’ returns. This fact makes these types of business entities the right choice for individuals who want to avoid paying taxes at the business level and may be suitable in situations where your personal tax return bracket might be lower than that of the corporations.
With regards to corporations, C corporations or “regular” corporations are taxed differently than the pass-through business entities and pay a flat federal tax rate as a business. The new Tax Cuts and Jobs Act of 2017 effectively lowered the corporate tax rate from 35% to 21%, C corporations face a second layer of tax which owners must pay on the income passed to shareholders as dividends. This “double taxation” means that owners will effectively pay between 32 and 37% total when tax time comes.
Like C corporations, S corporations form a separate legal entity but are treated like partnerships or LLCs for tax purposes so don’t incur the double taxation of C corporations. The income or losses experienced by the business are again paid by the owners or shareholders of the S corporation.
When first starting a business, this is the time you want to think of the future of the business and where you envision it taking the owners. With a sole proprietorship, you, the owner and the company are the same legal entity. For this reason, a sole proprietorship offers you the most overall control of your business.
Obviously, individuals who form a general partnership with others will hold diminished control of the business. This fact can create several issues, and so it’s best to outline the authority from the beginning. The easiest way to do this is to form a partnership agreement that will outline how profits and losses are allocated across owners and the weight of each partner’s vote. Barring a written agreement, each member of a general partnership will have exactly one vote. In a partnership agreement, members can create senior or junior partners, designate managing and non-managing partners, and appoint management committees with specific responsibilities.
Control of an LLC is directly proportional to the amount of member interest or number of shares that a member owns. How many shares a company consists of and the amount of control each member exercises should be clearly outlined in the Limited Liability Corporation operating agreement. Typically, the operating agreement for LLCs will identify a manager for the LLC who has the authority to execute contracts, perform purchases, and make strategic decisions for the company. The operating agreement will also outline how many votes each member will have.
C corporations are controlled by the shareholders of the company who elect a board of directors to make business decisions and oversee the business. Anyone can be a shareholder in a C corporation and control of the company is typically determined by the number of shares owned. Therefore, if an individual owns 50% of a C corporation’s shares, they are entitled to 50% of the earnings, votes, and the company itself.
Cost of formation
The cost of formation is the first investment an entrepreneur makes in their business. Costs typically associated with business formation include business licenses or permits, state filing fees, tax form filings, and business checking accounts.
With a proprietorship and partnerships, the costs of forming the company can be quite cheap. In some cases, one can file for a city and county business license for as little as $20. There’s no need to register with any state office for these business types which alleviates some of the start-up costs. Alternatively, corporations and LLCs have higher costs of formation due to the state filing fee, an annual statement of information fee, and an agent of server process yearly fees, in addition to, IRS filing fees.
The cost of ongoing administration, also known as business maintenance costs are also a consideration when choosing a business structure. Again, proprietorships and partnerships offer the most savings as they have relatively no business maintenance costs. LLCs and corporations, on the other hand, must pay an annual filing fee to the state for their annual report/statement of information. Additionally, they must also pay a fee to register an agent for the company. Federal law also dictates that corporations must hold an annual meeting of shareholders which could incur additional expenses.
As a final note, keep in mind that you can switch business structures if your business experiences changes such as more owners, different capital structure, or the desire to shield wealth from business liability that make it more suitable for a different type of business entity.
In general, it’s wise to avoid forming a C corporation due to the double taxation and complexity of the business structure. The only good reason to establish one is if you plan on taking the company public. Additionally, you can always begin as one business structure and easily change to a corporation in preparation for an IPO.
Utilizing a Schedule C and forming an SMLLC to limit liability and avoid self-employment work well for many small businesses. Business owners seeking to minimize Social Security tax may choose to create an S corporation over an LLC as they reduce salary. This salary minimization could, however, also reduce the owners’ opportunity to contribute to a qualified retirement plan.
LLCs could have the most tax efficiency out of all the businesses with more than one owner and offers tax-free opportunities to contribute property to the entity and for the business entity to distribute noncash property to owners of the company.
Hire a Knoxville Accountant or CPA
Because of the long-standing financial and even personal implications of your new business venture, it’s crucial that new business owners seek seasoned advice on business entity selection early on. Some owners find themselves in trouble by year two or three of business operations because they haven’t properly thought out all the implications of the decisions they make early on.
When beginning a new business or reorganizing an existing one, you might get the advice to hire a lawyer and an accountant. Conventional wisdom has shown millions of business owners that hiring a professional CPA or accountant early on can save an enormous amount of time and money. Furthermore, hiring an accounting firm will help LLCs and corporations in navigating the more complex tax rules imposed on them. Contact Lawhorn CPA Group today to get answers about your business structure, find help with switching business entities, and to get professional assistance with tax planning and preparation.