The Simple Guide to Choosing the Best Entity Structure

The entity structure you choose can greatly affect the way your business is run, how taxes are filed, how profit is shared, legal liability and who controls the company. Let’s take a look at the pros and cons of each.

Consider these questions before you choose:

  • Is this a one person operation? Will you need employees in the future? Partners? Investors?
  • How much legal protection would you like and how much is required?
  • What is your goal for the business? Will it be a side hustle, small business or a publicly traded company?
  • What type of assets do you plan to acquire and how will you raise capital for your venture?
  • What is your exit strategy? IPO? Sale?

Sole Proprietorship

The easiest type of business entity to form. Sole proprietorships are usually a one-person show because they are formed, managed and controlled by one person, the owner. The IRS also views the owner and the business as one. There is no separate legal entity so everything falls on the owner.

Pros of Sole Proprietorship

  • Easiest and cheapest entity type to form. From the time you start selling and declare yourself in business, your sole proprietorship is formed. Although your business is not registered with the state you may have to comply with local registration, business license, or permit laws to make the business legitimate.
  • No annual reports/filings. Sole proprietorships aren’t required to prepare any entity level tax returns, distribution or annual filings or submit audit reports. All activity is shown on Schedule C of the owner’s individual tax return.
  • Quicker decision making since the final decision making power is held by the owner. There is no “red tape” or bureaucracy to go through.

Cons of Sole Proprietorship

  • Unlimited liability. A sole proprietorship offers no asset protection and there is unlimited legal liability. The owner can be held personally liable for the company’s debts and legal actions. Creditors can legally pursue judgments against the owner’s personal assets (i.e. house, car, personal bank accounts). This holds true for lawsuits as well.
  • Tougher to obtain outside financing from banks and investors.
  • No ongoing business life. The death of the owner effectively ends the sole proprietorship unlike LLCs, partnerships and corps.

Ideal for: Small shops, internet-based businesses (Amazon, eBay), freelancers (Upwork, Fiverr), boutiques and owners who plan to run a small operation.

Limited Liability Company (LLC)

One of the most popular entity types because it offers the flexibility of a sole proprietorship, tax benefits of a partnership and the limited liability of a corporation. LLCs are often mistakenly called “limited liability corporations,” but they are not corporations. They are a hybrid of a partnership and a corporation and are run by members, not partners or shareholders.

Pros of LLCs

  • Limited personal liability. As the name states, LLCs offer owners limited personal liability for business debts and claims. That means creditors cannot go after or pursue judgment against an owner’s personal assets for business debts. Limited liability does not protect against fraud or illegal activity, personal torts (injury) and personal guarantees.
  • Relatively simple to form. There is very little paperwork and many companies offer affordable LLC formation services.
  • LLCs are considered “pass-through entities” for tax purposes so income passes through to the member level. Members show the income on their personal tax return and are only taxed once on that income, unlike corporations.
  • Flexible tax structure. LLCs can elect to be taxed as a single member LLC (if one owner), as a partnership with two or more owners, an S Corp for tax benefits or a C Corp.
  • Unrestricted pay structures. Members can agree on any pay structure despite their ownership percentage. Unlike C Corps and S Corps, LLCs aren’t required to pay owners which may be beneficial during unprofitable periods.

Cons of LLCs

  • More expensive to register than a sole proprietorship.
  • Additional tax filings. Co-owned LLCs must file Form 1065 with the IRS along with each member’s personal tax return. Single member LLCs do not have to file Form 1065 and instead show their income/loss on the owner member’s tax return.
  • Filing fees. Many states require annual LLC filings fees to keep the LLC current. Some states also require an LLC to have a registered agent which tacks on another fee.
  • Decision making can be slower if there are multiple members.
  • An LLC will be dissolved if one of the members leaves, unless stated otherwise in the articles of organization.

Ideal for: Business owners looking for legal protection with little upfront cost and paperwork such as shop owners, internet-based businesses, freelancers, real estate holdings and segregated products in multi-level organizations. LLCs are also good if you plan to run a company with the potential to be larger or if you are selling products/services that carry some risk (i.e. cleaning companies, ride-share businesses, food distributors).

Corporation (C Corp)

A common entity type that operates as a separate legal entity from its owners. Corporations are owned by shareholders who are responsible for electing a board of directors. They are also responsible for running daily operations, decision making, drafting the corporate by-laws, managing meetings and recording minutes.

Pros of Corporations (C Corp)

  • Limited liability and asset protection. Because corporations are separate legal entities, creditors and other parties cannot pursue judgment against any of the owners’ assets for outstanding business debt or in a lawsuit. Limited liability does not cover personal injury or torts caused by an owner, fraud or any other illegal activity.
  • Lower tax rate. With the enactment of the Tax Cuts and Jobs Act in 2017, the top corporate income tax rate was reduced from 35 percent to 21 percent.
  • More options to raise funding. Corporations can issue stock to shareholders as a method of raising capital.
  • Ownership is easily transferable unlike other entity types.
  • Corporations can “go public” by offering shares of the company to the public to raise additional funding.

Cons of C Corporations

  • Significantly more legal paperwork and capital required to form compared to other entity types.
  • Corporations are legal entities so they must file a tax return (Form 1120) separate from their owners.
  • Double taxation. Distributions to owners are taxed at the corporate entity level and again at the individual income tax level.
  • More work required to maintain corporate status. Corporations have to have annual shareholders’ and directors’ meetings, keep minutes of those meetings and officers must sign off on important decisions.
  • Decision making may be slower because it requires approval by several officers or directors.

Ideal for: Larger businesses, businesses raising venture capital funding or hoping to go public like startups.

S Corporation (S Corp)

A hybrid between a C corporation and an LLC, S Corps have the makeup of a corporation but enjoy the tax advantages of an LLC or partnership. One unique attribute of S Corps is they are not really an entity type for formation purposes. Instead shareholders of a corporation or members of an LLC can make an election to be taxed as an S Corp. In order for a business to qualify for the S Corp designation, they cannot have more than 100 shareholders, must be a domestic company and can only issue one class of stock.

Pros of S Corp

  • No double taxation. A major benefit of an S Corp is avoiding double taxation. Unlike C Corps, an S Corp is treated as a “pass-through entity” and is therefore not taxed at the entity level. Income is passed through to its shareholders, much like partnerships and LLCs. C Corps pay taxes at the entity and individual levels.
  • Limited liability protection. S Corp shareholders are considered separate from the entity so a party cannot seek judgment against their personal assets.
  • Separate roles. Shareholders can separate their roles between owner and employee with both roles being taxed differently. An owner can be listed as an employee and be paid a reasonable salary. By doing so, the individual will be taxed as an employee and avoid paying the 12.4% social security tax and 2.9% medicare tax that employers and self-employed individuals are required to pay.
  • S Corps generally allow you to take home the most money from your business compared to the other entity types. Of course there are many factors that can alter that.
  • Relatively easy to change ownership without unfavorable tax consequences.

Cons of S Corp

  • More rules. S Corps have to hold periodic shareholders’ and directors’ meetings, keep minutes of those meetings and maintain stock transfer and record maintenance.
  • Increased scrutiny from the IRS. It is believed that the IRS keeps a closer eye on the wages of shareholders and the records of S corps.
  • S Corps are required to pay salaries to officers and owners even when the company is unprofitable.
  • Less attractive to outside investors. Investors like to invest in companies with multiple classes of stock and those with the ability to take on multiple shareholders. S Corps only have one class of stock and a 100 shareholder cap.

Ideal for: U.S. Citizens looking to run a small to medium sized business. S Corps don’t fit larger companies because of the 100 shareholder cap. Companies can include most businesses such as service companies, workshops, retailers, restaurants, and agencies.

General Partnership (GP)

There are two types of partnerships, general partnership and limited liability partnership. A general partnership is formed when two or more individuals decide to become partners in a venture without filing paperwork to be recognized as an LLC or corporation.

Pros of General Partnerships

  • GPs are the simplest and most cost effective partnership and co-owner entity structure to form and maintain.
  • Less initial capital required to start-up. Since all partners make contributions to raise capital for the business, less upfront capital is required from each partner.
  • GPs are “pass-through entities”, much like LLCs, so the partnership income passes through to each partner’s individual tax return.

Cons of General Partnerships

  • Unlimited liability. GPs do not offer any asset protection or limited liability. All partners have unlimited legal liability so credits can seek judgment or collection against their personal assets.
  • Joint Authority. Any individual partner can bind the partnership to a contract. This may be a problem if one partner signs a contract that the business cannot afford leaving each partner personally liable for the contract.
  • Joint and Several Liability. This means a party can bring a claim against the partnership as a whole or hold one or more partners personally liable for partnership debt.

Ideal for: Family members or associates looking to open a small business together like a small shop, restaurant, bakery, laundromat, roofing business etc.

Limited Liability Partnership (LLP)

Similar to a GP, an LLP is a venture between two or more individuals but unlike a GP, an LLP’s partners register with the secretary of state granting them limited liability.

Pros of Limited Liability Partnership

  • Limited personal liability. Each partner is held separately liable for their actions. Furthermore, a party cannot seek judgment against non-managing partners or their personal assets.
  • Forming an LLP only requires an agreement between partners and approval from the secretary of state.
  • An LLP is also considered a “pass-through entity” for tax purposes so income passes through to the partner level and is shown on the individual’s tax return.

Cons of Limited Liability Partnership

  • Unlimited liability still exists for managerial partners.
  • More time consuming and expensive to form compared to general partnerships.

Ideal for: Personal service companies like accountants and law firms.

If you have questions or would like to discuss tax or accounting matters with us, please email us at colin@horsfordcpa.com or call us at (347) 201-2045.

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