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Starting a Small Business

Choose the Right Business Entity Before Commencing your Start-Up

by
Frank Jenkins Jr
on
10/16/2016
Choose the Right Business Entity Before Commencing your Start-Up

Identifying the right type of business entity for your start-up is one of the most critical decisions that you are likely to make. Not only will your choice impact how you will pay taxes, it also determines your personal liability risk and how much documentation and paperwork you are going to need to provide.  Your choice needs to give consideration to the requirements and impact of both your state laws about the formation of your business and the federal tax law, as the two are independent of one another.

There are five commonly-used types of business entities.

They are:

  • Corporations (C-Corporations)
  • S-Corporations
  • Partnership
  • Limited Liability Companies (LLCs)
  • Sole Proprietorship

Deciding which is most appropriate for your business depends on a number of different things, including whether you want your business to be taxed as a pass-through entity in which only the owners are taxed, or as a business where both the owners and the business itself are subject to tax. The latter option applies strictly to C-Corporations: all of the other types of business entities listed above are pass-through entities in which only the owner or owners pay federal tax.

The other major factor in deciding on a business type revolves around protecting assets from creditors. Some business types offer greater limitations on liability for the business’ owners than others. Let’s take a look at each type of entity to determine which may be most appropriate for you and your business.

C-Corporation

As stated above, a C-Corporation is the only type of business entity in which the business itself is responsible for paying taxes on its profits. This complex business structure is formed by having shareholders provide the foundation of the company’s capital stock, which may be in the form of property, cash, or both.  Those shareholders are then provided with dividends when the corporation makes a profit, and they in turn are taxed on the dividends that they receive. This means that both the entity and its shareholders are taxed, with the shareholders paying taxes at their individual rates via their personal tax returns. There are no deductions available to the corporation for its distribution to shareholders, and shareholders are not able to take deductions if they incur a loss as a result of their contribution to the corporation.   

Generally speaking, those who set up their business as a C-Corporation have no personal liability for the company’s debts, though individual states may impose exceptions to this rule.

Sole Proprietorship

The simplest and most straightforward type of business entity is the sole proprietorship, which is owned by a single person. A sole proprietorship can be a person’s only source of income and employment or can be something that is done on a part-time basis. Examples of sole proprietorships can include home-based businesses and one-person consulting firms, retail businesses, and even farms and large companies with employees. The business is unincorporated, which means that all the liabilities that it incurs fall to the owner. They are also responsible for all of the business’ taxes on their individual tax return. If the business represents only a part of the owner’s income, then in addition to reporting revenue and deductions from the business, their tax return must also include all other forms of income and deductions. 

Unlike W-2 employees, sole proprietors do not have the taxes on their income automatically withheld from a paycheck. As a result, the business owner is required to calculate and pay quarterly estimate income tax, as well as self-employment taxes, on their profits.

It is important to make a distinction between sole proprietors and those who are sole members of domestic limited liability companies that are treated as a corporation.

Partnerships

When more than one person is the owner of a business, then all of the parties involved can form a partnership based on their contribution to the organization. This contribution may be financial, a skill, or property, and is given in expectation of being able to realize profits (as well as risk losses) in the entity. 

In deciding to establish a business as a partnership, those involved must choose between a limited partnership and a general partnership. Where both types’ taxes are treated as pass-through entities in which owners pay federal tax, the owners’ level of personal liability is more limited in a limited partnership. There are also some differences in the way that the taxes are treated. Where those who establish their partnership as a limited partnership are only responsible for self-employment tax on payments that are guaranteed (such as fees for professional services provided), general partners have to pay self-employment taxes on their share of net earnings from the partnership. This is true whether the earnings are distributed or not.

As a pass-through tax entity, the participants in a partnership pay their taxes as individuals, reporting both revenue and expenses for their share of the income and liabilities.  Similar to sole proprietorships, partners are not employees and therefore no tax is withheld on their income. They are expected to calculate and pay quarterly estimated tax payments, and to report on their income from their share of the partnership regardless of whether a distribution has been made or not.

A significant negative to a general partnership is the potential liability for the actions of other general partners.

Limited Liability Companies (LLCs)

Before deciding to form your business as a Limited Liability Company, it is important to investigate and understand all of the requirements and regulations established by the state where you will be operating your business. This is because individual states have very different statutes governing the LLC business structure. Some states allow LLCs to be created in businesses that have just one owner. 

An LLC can be formed by an individual or individuals, but its members can also include other LLCs, corporations, and even foreign companies. Much of the way that the IRS treats an LLC is determined by how many members it has as well as what elections the entity has made regarding its formation. In some cases it may be taxed as a partnership or a corporation, while in others the LLC’s income may be taxed on the individual tax return of its owner. Unless an LLC has chosen to be treated as a corporation, if it has more than one member it is usually taxed in the same way as a sole proprietorship. The profit or loss passes through the individual’s 1040.  However, LLCs generally are required fees to the state for the privilege of having the limited liability. 

S-Corporation

S-Corporations are very similar to C-Corporations in that the shareholders have limited liability, but beyond that the shareholders are required to pay taxes on the entities income regardless of whether it is distributed or not. All income, losses, credits, and deductions are passed through to the shareholders and reported on each shareholder’s individual tax return and subject to their individual tax rates. The state may tax an S-Corporation at a corporate level. Establishing a business as an S-Corporation requires that certain criteria be met, so if you are considering establishing your business as this type of entity, it is best to consult with a professional.

As you can see, there are a number of serious and complicated considerations involved in choosing which type of business entity is right for your individual situation. For professional assistance in evaluating each option, contact a tax professional.

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Frank Jenkins Jr

Frank Jenkins Jr

Frank Jenkins Jr. is the managing partner of Adams, Jenkins & Cheatham, a CPA practice based in Midlothian, VA. Frank specializes in Consulting services, tax planning, accounting, audit & assurances. "I genuinely care about our clients because I have a personal connection with them. This job requires me to multi-task and work under tight deadlines. I get great professional satisfaction from balancing firm and client commitments while building a strong team here at AJC."

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