When you first launch your business, there is a lot riding on the entity type that you choose. How you structure your business affects your legal liability, tax obligations, the potential for growth, and compliance rules and regulations that you need to follow. To make it just a tad more complex, the business entity that you choose when you start your business, may not be the correct choice to continue with as the company changes and grows.
You should always consult a licensed attorney and accountant or tax advisor for professional and personalized guidance on how best to structure your business. Every business is unique so it’s important to have expert advice before both setting up your business or making any entity changes.
Below are the most common business entity types and when they are used.
Sole proprietorship or general partnership – Many small businesses start off as a sole proprietorship if there is just 1 owner or a married couple OR a general partnership if multiple owners. If you don’t formally register your business with the state, you also default to one of these business types. This entity does not provide a legal or financial separation between the business and the owners.
- It’s inexpensive and simple to set up and maintain from a paperwork perspective and has fewer compliance guidelines
- Uses a pass-through tax structure – business profit and loss flow through to the owner’s individual tax returns
- The owners are directly responsible for business financial obligations or if the business is sued – personal assets can be used to satisfy debts and lawsuits.
- All taxable business income is subject to Social Security and Medicare taxes.
- No ability to sell stocks and most investors will not fund this type of business. Since it’s an extension of the owners, the business cannot be sold, although assets can be.
Limited liability company (LLC) – Often thought of as a hybrid between the sole proprietorship and a corporation. From a tax perspective, an LLC is considered the same tax-paying entity as its members, however, it’s a separate legal entity from its members requiring Articles of Organization to be filed with the state.
- Personal assets are protected if the business has legal or financial issues.
- Pass-through taxation – business incomes and losses are reported on personal tax returns unless you elect to be taxed as an S Corporation.
- Like a sole proprietor or general partnership, self-employment taxes (social security and Medicare) are applied to all business profits.
- An LLC can add new members to bring in funds to the business, but it cannot issue stock.
- An LLC ceases to exist if a member departs an LLC unless stated in the LLC’s operating agreement.
C Corporation – Regarded as a separate taxpayer and legal entity than its owners. Business income and expenses are linked to the business and not the owners, and the business reports and pays taxes. Ownership is designated by purchasing shares of stocks. You must file Articles of Incorporation with the state in addition to meeting other requirements.
- Provides the highest degree of liability protection for business owners, shareholders, directors, and employees.
- There can be an unlimited number of shareholders and multiple classes of stock. Investors are more likely to be interested in funding corporations vs. other entity types.
- Some corporations may be eligible to be taxed as an S corporation, and they are eligible for more tax deductions than other options.
- Ownership can be transferred to others and shareholders can sell, gift, or will company stock shares
- It can be complex and costly to form vs. other types as there are more internal and external rules (bylaws, initial reports, a board of directors, annual reports, etc.)
- Double taxation – C Corporation profits are taxed at the federal corporate income tax rate and taxed again when profits are distributed to shareholders via dividends. Shareholders cannot deduct any loss of the corporation on personal tax returns.
S Corporation – This is a tax election for qualifying LLCs and corporations. For an LLC, this election can reduce the self-employment tax that the business owner must pay. It’s still treated as a pass-through tax, but only wages and salaries of the business owner via payroll are subject to Social Security and Medicare taxes. Profits distributed to owners are not taxed.
For a C corporation, electing to file as an S Corp can allow them to avoid double taxation. The corporation’s profits and losses could flow through to shareholders’ personal tax return preventing the corporation from paying income tax. The shareholders who are employed by the company would pay Social Security and Medicare taxes on their salaries, but dividend income would not be subject to those taxes. Only Corporations with 100 or less are eligible for the S Corp election.
When should I assess my business entity type?
If you have already started your business and feel like you are outgrowing the limitations of your current entity, it may be time to consider changing your business entity type. Some instances that may drive change are:
- Adding employees
- Bringing in a new owner or partner
- Looking for funds from investors
- Wanting to reduce self-employment tax payment
- Considering selling the business or retiring
Changing your entity type from one to another will vary based on the business structure and the state that you are operating in. An attorney or an accountant can look at your situation and help you determine which entity type will be the most beneficial for your short-term and long-term needs and advise you on the next steps. For more information on business entities and the legal and tax considerations, please consult the IRS – you can learn more here. Litchfield Bancorp – a Division of Northwest Community Bank works with businesses of all sizes and offers Treasury Management Services to cover all your business banking needs.
Senior Vice President, Commercial Team Leader