One of the most common reasons that people come to me is for help understanding what the best business entity structure is best for them. My answers often come in the form of questions about what function they need the entity to perform as the issue is more complex than one a one-size-fits-all entity. I explain it like someone asking me what car to buy? I could tell them to buy a Ferrari because it’s fast and looks good, but if I know that the car needs to carry a family of 6, I am more likely to recommend a van. The same applies to a business in that entity types are built different for different purposes.
This article will explore some of the key attributes of the common business structures – Sole Proprietorship, Limited Liability Company (LLC), Partnership, S Corporation, and C Corporation – so that you can better understand and evaluate which entity is most advantageous for your needs. Keep in mind that the following information is general in nature and is not intended as specific advice for your situation. We do recommend you obtain competent legal and accounting advice for your situation.
Sole Proprietorship
Sole Proprietorships are the default entity for all business activity not structured in another entity such as an LLC, Partnership, or Corporation. A sole proprietorship is run under the individual and is indistinguishable from the person for liability and tax purposes. You should consider this entity if you are looking for simple tax filing and can accept the exposure to the business liabilities and activities. It is suggested that you not operate as a Sole Proprietorship by default, but that business activities at least be formed under a Single Member LLC for liability protections while maintaining the simplicity and other benefits of the Sole Proprietorship.
Limited Liability Company
An LLC can have a single member and be taxed as a disregarded entity or have many members and be taxed as either a Partnership or S Corporation (see the IRS’s description for more detail on these LLC distinctions and here for changing entity classification). You should consider an LLC if you are looking for pass-through taxation, need to prioritize profits or losses different from ownership percentages, and do not need to retain significant amounts of earnings within the business. Service-oriented businesses like engineering, management, real estate services, and closely held entrepreneurial businesses are ideal for the LLC’s structure. LLC’s have an advantage over limited partnerships in that they allow members to fully participate in management without losing the liability protection.
Partnership
You should consider a Partnership if you have two or more co-owners with a high degree of trust, are looking for pass-through taxation, need to prioritize profits or losses different from ownership percentages, are in a situation where LLCs, LLPs, Limited Partnerships, or S Corporations are unavailable or unworkable, and where the liability exposure can be managed with insurance. Partnerships have been used extensively with real estate investments and development activities, oil and gas exploration, venture capital investments, business start-ups expected to incur tax losses in the initial years, and professional practices. Partnerships have their place, but they have a substantial risk through the shared liability of the General Partners. Many of the benefits of a Partnership can be found through LLCs, LLPs, and Limited Partnerships, depending on your specific needs. See this link for more detailed information from the IRS.
S Corporation
S Corporations can be a great option for anyone who wants the benefits of limited liability, pass-through taxation, reduced Self-Employment taxes, and can meet the eligibility requirements for the entity and shareholders. S Corporations are not a good idea if you are looking to hold appreciated property or might have an upside-down property where the basis is greater than the fair market value. S Corporations are excellent vehicles to reduce Self Employment tax on pass-through income, although the IRS does require that S Corporation owners who actively participate in the business to take a reasonable salary (this issue is more in-depth than can be addressed in this article – stay tuned for more on this in a future article, but visit the IRS guidelines for more information now). Cash dividends paid beyond the salary amounts are considered passive income and as such are not subject to the 15.3% Self Employment tax. This benefit is one of the biggest single steps a small business owner can take to reduce the overall tax liability. See here for more information about S Corporations.
C Corporation
You should consider a C Corporation if you need more than 100 shareholders and need those shareholders to be various types restricted for other entities. The lower C Corp tax rates can also be taken advantage of if you can solve the double taxation issue by zeroing out corporate income through payments to shareholders through salary, fringe benefits, interest on loans, and rent for property owned by the shareholders. You can also bypass the double taxation if you intend to indefinitely retain earnings for growth. Capital-intensive and high-growth businesses like manufacturing and research and development companies usually operated as C Corporations to be able to retain all earnings and finance capital expenditures and growing inventory at the lower corporate tax rate. See the IRS’s guidance on forming a corporation.
Key Attributes of Business Entities
The key attributes that need to be understood in order to evaluate the different entities are: ownership size/scalability, profit allocations, tax considerations, key benefits, key drawbacks, and recommendations. The following chart outlines these attributes for each entity type.
