What is the Best Business Entity Type For You?

Taxpayers who start or own a business have several choices available for the legal structure of their activity. The chosen entity will provide a framework for the conduct and reporting of business activities.

Some entities provide protection against personal liability for business debts, while others are tailored to provide flexibility and tax savings.

Over the years, new types of business entities have been created by government entities, as states devised unique solutions.

The most common business entities used in the U.S. are:

• Sole proprietorship
• Partnerships
• C corporations
• S corporations
• Limited liability companies (LLCs)
• Tax-exempt organizations

Sole Proprietorships

A sole proprietorship is defined as someone who owns an unincorporated business by himself or herself. It is an unincorporated business owned and run by one individual, and there is no distinction between the business and the owner. The owner is entitled to all profits and also responsible for all debts, losses, and liabilities of the business.

Forming a sole proprietorship does not require any formal action. As long as the individual is the only owner, this status automatically flows from the activities of the business.

Taxpayers who choose to operate the business under a name different from their own will likely have to file a DBA name (short for doing business as).

Taxes

Because the taxpayer and his or her business are one and the same, the business itself is not taxed separately; the sole proprietorship income is the taxpayer’s income. The taxpayer reports income, losses, and expenses with a Schedule C and the standard Form 1040. The bottom line amount from Schedule C transfers to the taxpayer’s personal tax return, and it is the taxpayer’s responsibility to withhold and pay all income taxes, including self-employment and estimated taxes.

Advantages

• Straightforward to establish
• Provides complete control to the owner
• Uncomplicated tax preparation

Disadvantages

• Unlimited personal liability to the owner
• Difficult to raise investor money

Partnerships

A partnership is defined as a single business where two or more people share ownership. Each partner contributes to some or all aspects of the business, including money, property, labor, or skill. In return, each partner shares in the profits and losses of the business.

There are three primary types of partnerships:

1. General partnerships
2. Limited partnerships
3. Joint ventures

Taxes

A partnership must file an annual information return to report the income, deductions, gains, and losses from the business’s operations. However, the business itself does not pay income tax. Instead, the business passes through any profits or losses to its partners. Partners include their respective share of the partnership’s income or loss on their personal tax returns. Most partnerships will need to register with the IRS, as well as state and local revenue agencies, to obtain a tax ID number or permit.

Advantages

• Straightforward and inexpensive to establish
• Shared financial commitment
• Partners can draw upon complementary skills
• Can provide incentives for employees

Disadvantages

• Joint and individual liability
• Disagreements among partners can affect the direction and even the viability of the partnership
• Profits are shared among partners

C Corporation

A corporation is an independent legal entity owned by shareholders. The two categories of corporations are C corporations and S corporations. In both cases, the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts of the business.

C corporations are more complex than other business structures because they tend to have costly administrative fees and complex tax and legal requirements. Because of these issues, corporations are generally used for established, larger companies with multiple employees. For businesses in this position, corporations offer the ability to sell ownership shares in the business through stock offerings. Going public through an initial public offering (IPO) is a major selling point in attracting investment capital and high-quality employees.

Taxes

Corporations are required to pay federal, state, and in some cases local taxes. When a corporation is formed, a separate tax-paying entity is created. For that reason, most corporations must register with the IRS, as well as state and local revenue agencies, to receive a tax ID number. Unlike sole proprietors and partnerships, corporations pay income tax on their profits. In some cases, corporations are taxed twice: when the company makes a profit and again when dividends are paid to shareholders on their personal tax returns.

Advantages

• Limit liability
• Have the ability to generate capital
• Receive corporate tax treatment
• Attractive to potential employees

Disadvantages

• Typically more expensive to run, as well as more time consuming
• Potential for double taxation and additional paperwork

S Corporations

A corporation is an independent legal entity owned by shareholders. The two categories of corporations are C corporations and S corporations. In both cases, the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts of the business.

An S corporation is created through an IRS tax election (Form 2553 must be filed). An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be taxed as an S corporation.

S corporations are considered by law to be a unique entity, separate and apart from those who own it. This limits the financial liability for which the owners or shareholders are responsible.

What makes the S corporation different from a traditional C corporation is that profits and losses can pass through to the taxpayer’s personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. However, any shareholder who works for the company must pay himself or herself reasonable compensation (a fair market value) or the IRS might reclassify any additional corporate earnings as wages.

Taxes

Similar to other entities, most S corporations need to register with the IRS, as well as state and local revenue agencies, to obtain a tax ID number.

At the state level, states do not tax S corporations equally. In Florida, newly filed S corporation must file the informational part of the F-1120, the Florida Corporate Income/Franchise Tax Return, in the first year after filing for S corporation treatment. In subsequent years, the S corporation does not need to file this return. Florida S corporations do not pay the 5.5% corporate tax that is levied on C corporations.

At the federal level, Florida S corporations (like all S corporations in the U.S.) are not subject to corporate tax. This is because they are flow-through entities. However, depending on its structure and line of business, an S corporation might be called upon to pay the following taxes:

• Payroll taxes: These include Medicare and Social Security taxes. They were established by the FICA Act and are typically equal to about 15.3% of an employee’s wages. The S corporation must withhold about half of this amount from the employee and contribute the other half.
• Federal Unemployment Tax Act (FUTA) tax: This tax is levied on corporations that spend at least $1,500 on wages in any quarter or hire at least one employee for part of a day for 20 weeks or more in any quarter.
• Personal income tax: Florida S corporation shareholders are required to pay income tax for their share of the earnings from the corporation. They must pay these taxes even if the earnings were not actually distributed in a certain year. The rates range from 10-37%, depending on the income of the shareholder.
• Net investment tax: Non-active shareholders who earn at least $200,000 individually, or $250,000 if they file jointly as a couple, are subject to the net investment income tax.

Advantages

• Tax savings
• Business expenses tax credits
• Business can have an independent life separate from its shareholders

Disadvantages

• Stricter operational processes
• Shareholder compensation requirements

Limited Liability Companies (LLCs)

A limited liability company (LLC) is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The owners of an LLC are referred to as members. Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations, or other LLCs.

Unlike shareholders in a corporation, LLCs are not taxed as a separate entity. Instead, all profits and losses are passed through the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just as the owners of a partnership would.

When forming an LLC, the LLC must have a name that is different from any existing LLC in the state in which it is to be registered. LLCs must file articles of organization, which is a simple document that legitimizes the LLC and includes information about the business and names its members. For most states, the filing takes place with the Secretary of State. Many states do not require an Operating Agreement. However, such an agreement is highly recommended for multi-member LLCs because this document structures the LLC’s finances and organization, as well as provides rules and regulations for smooth operation. The Operating Agreement usually includes percentage of interests, allocation of profits and losses, member’s rights and responsibilities, and other provisions.

Taxes

Since the federal government does not recognize an LLC as a business entity for tax purposes, all LLCs must file a corporation, partnership, or sole proprietorship tax return. LLCs are not automatically classified as corporations. They can choose their business entity classification. To elect a classification, an LLC must file Form 8832.

Advantages

• Limited liability
• Less record keeping
• Shared profits

Disadvantages

• Limited life
• Pay self-employment taxes

Tax-Exempt Organizations

Organizations that meet the requirements of Internal Revenue Code section 501(a) are exempt from federal income taxation. In addition, charitable contributions made to some section 501(a) organizations by individuals and corporations are deductible under Code section 170.

A number of different categories of organizations can qualify for tax-exempt status, each governed by a different subsection of the tax code. Some examples include:

• Corporations organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes,
• Corporations organized and operated to foster national or international amateur sports or prevention of cruelty to animals
• Cooperative hospital service organizations
• Cooperative education organizations
• Certain organizations providing child care
• Charitable risk pools
• Credit counseling organizations

There are numerous types of organizations that can qualify for tax-exempt status. The exact details of formation will vary according the subsection of the code that applies in each case, but there are several underlying principles common to forming tax-exempt organizations:

• Must create the organization under state law, acquire an employer identification number, and identify the appropriate federal tax classification according to the nature and purpose of the organization
• Applying for tax exemption requires the filing of the correct application forms

Taxes

Most organization exempt from federal income tax under IRC section 501(a) must file an annual information return, with some exceptions for organizations that include, among others:

• A church
• A school below college level affiliated with a church or operated by a religious order
• A political organization that is a state or local committee of a political party
• A political committee of a state or local candidate
• A caucus or association of state or local officials

Organizations that are not specifically excluded from the filing requirement must file an annual information return using the appropriate 990 family of forms.

Advantages

• Tax exemptions and deductions
• Eligibility for public and private grants
• Limited liability for founders, directors, members, and employees

Disadvantages

• Personal control is limited for the people who create the organization
• Finances are open to public inspection

Recent Changes

Under the terms of the Tax Cuts and Jobs Act of 2017, an individual taxpayer generally may deduct 20% of qualified business income from a partnership, S corporation, sole proprietorship, or LLC in addition to 20% of aggregate qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income. In the case of a partnership or S corporation, the deduction applies at the partner or shareholder level.