When you form a business, you need to initially decide what type of business entity will best suit your needs.
The following are the most common entities that you can consider for conducting your business.
- Sole proprietorship
- General Partnership
- Limited Partnership
- Limited Liability Company (LLC)
What business entity you choose depends on the relative importance of four main issues.
- Relative cost, complexity and reporting requirements
- The importance of limiting personal liability for business debts and lawsuits against your business
- Tax implications
- Whether or not you’ll need to raise outside capital
A sole proprietorship is the easiest business entity to run and set up.
A sole proprietorship might be right for you if you are a one person business, ant to avoid registering with the state and don’t want to file multiple tax returns. With this business entity, income and losses are reported on your personal tax return.
A general partnership is very similar to a sole proprietorship except it involves more than one person.
Like the sole proprietorship, partnership income and losses are passed through to the partners and reported on their personal tax return. A yearly partnership tax return is required in order to explain to the federal and state governments the income and losses generated by the partnership and how they were passed through to the partners.
Limited partnerships are not recommended for the average small business owner.
Limited partnerships are usually created by one person or company called the “general partner” who solicits investments from others called “limited partners”. The general partner manages the company and the limited partners are passive investors. Limited partnerships are costly and complicated to set up and run. They are not recommended for the average small business owner.
A limited liability company or a corporation is the best business entity for limiting your personal liability.
If personal liability is a big concern, then you do not want to set up your business as a sole proprietorship or as a general partnership. With these entities you have unlimited personal liability if someone decides to sue your business. The only way to limit your liability is to set up your business as a limited liability company (LLC) or as a corporation. In a limited partnership, limited partners have minimal control over daily business decisions and operations. As a result, they are not personally liable for business debts or claims.
A limited liability company provides the most flexibility with regards to taxes.
The next big consideration in choosing your business entity is taxes. With regards to taxes, LLC’s have the most flexibility.
If you are a single person business, you can elect to be taxed like a sole proprietorship. In this case, income and losses from the LLC are passed through to the owner and are reported on your Schedule C personal tax return.
If you have an LLC, and have more than one business owner, you can elect to be taxed like a partnership. In this case, you need to file a 1065 partnership tax return that reports how the income and losses were passed down to the individual partners.
With an LLC you can also elect to have the IRS tax you as either a C-corporation or as an S-corporation.
One major tax benefit of setting up as a C-Corporation is that fringe benefits are tax deductible.
A C-corporation is considered a separate tax entity and pays corporate taxes based on its’ income and losses. One major tax benefit of setting up as a C-Corporation is that fringe benefits, such as medical insurance premiums and direct reimbursement of medical expenses, are deductible expenses for the corporation and are not treated as taxable income to the employees.
S-corporations do not have the same benefits of tax deductibility for fringe benefits that C-corporations enjoy.
With S-Corps, fringe benefits are not tax deductible for owners that are considered key shareholders. Unfortunately, you only have to own two percent or more of the Company to be considered a key shareholder. The bad news only gets worse. IRS attribution rules also disallow tax deductions for fringe benefits given to spouses of key shareholders.
One major negative tax issue you need to consider with C-corporations is the potential for double taxation.
The potential for double taxation is especially high if a C-corp holds property or assets that are likely to increase in value. If these properties or assets are sold or if the corporation is liquidated, taxes are paid by both the corporation and the shareholders.
One way to reduce double taxation is to pay most or all of your profits out in the form of salaries. The one big drawback to this tactic, however, is that you then owe self-employment taxes, such as Social Security and Medicare taxes, on that income. These taxes can decrease your take home pay by over fifteen percent!
One way to avoid double taxes is to set up your business as an S-corporation.
Like a LLC, an S-corporation can pass-through profits and losses to the shareholders. This pass-through nature of income and losses means that the corporation’s profits are only taxed once – at the shareholder level.
S-corporations pay significantly less in self-employment taxes compared to LLC’s that elect to be taxed as a sole proprietorship or as a general partnership.
S-corporations have one major tax advantage over that of a LLC. With LLC’s, self-employment tax which includes Social Security and Medicare taxes, can be imposed on an LLC owner’s entire share of LLC profits. This can amount to 15.3% on the first $94,200 of wages and 2.9% on anything above that.
For an S corporation the rules for self-employment taxes are different. As an S-corporation shareholder, you only pay Social Security and Medicare taxes on the money you receive as compensation for services. You are not liable for self-employment taxes on profits that pass through to you as a shareholder.
It is important to note that S-corporation shareholders are required to take a salary that is equivalent to fair-market value for the services you provide the corporation. You are also required to withdraw and report quarterly payroll taxes.
Your choice of business entity can have a major impact on your ability to raise business capital.
The last thing you must consider when choosing a business entity is your need to raise capital. If you plan on having multiple investors or doing a public stock offering, you need to set up your business as a C-corporation. This is because investors will want tangible evidence of their partial ownership in your business in the form of corporate stock certificates. This is not possible with an LLC.
An S-corporation has some major limitations when it comes to raising venture capital.
- One problem is that S-corporations can only have one hundred stockholders.
- S-corporation stockholders must also be natural persons. They also have to be either US citizens or legal US residents.
It is important to note that most venture capital firms are organized as either limited partnerships or LLC’s. Both of these legal entity types are not natural persons and thus cannot be stockholders in an S corporation. This stockholder rule also prevents you from using self-directed IRA money to fund a business that is an S-corp.
- An S-corporation is also problematic when it comes to raising capital because it can only issue one class of stock.
This stock requirement that limits issuance to one class of stock is fatal to a venture capital investment. Venture capital firms will demand preferred stock in return for their investment.
A C-corporation is the only type of corporation viable for a venture capital investment.
If you intend to raise outside business capital, it is important to set your company up as a C-corporation.
Setting up your business entity.
One of the easiest and cost effective ways to set up your business entity is to use a service such as LegalZoom.com. Otherwise, you can apply directly to the Secretary of State in the state you wish to set up your business entity.
We recommend that you visit the Preferred Vendors List to get well qualified help in establishing your Business entity.