You are going to start a new business? Starting a new business is a great adventure. You will have a lot of hard work to do but the reward of owning your own business will hopefully be worth it in the end.
When starting a new business people usually don’t think about what type of business entity their new company needs to be, other decisions seem more important. However, it is very important that the correct entity type for your business is selected and that it helps to achieve your business goals. A good lawyer will be able to draft any organizational documents you need but you should talk to your CPA to see what the tax consequences are for each business entity type you are considering. This discussion is very brief and only covers certain highlights of each entity choice.
So what are your options? While there are a wide variety of options, here is a list of the most prevalent: Proprietorships, S Corps, C Corps, LLCs, General Partnerships, Limited Partnerships, and Limited Liability Partnerships. What is the difference? Below is a brief description of each.
Proprietorships are very easy to start. There is minimal paperwork and the company information is reported on Schedule C inside the owner’s personal Form 1040, individual income tax return. All profits are taxed to the owner at the owner’s income tax rate. A proprietorship has only one owner and there is no limit to liability and risk. Other disadvantages may be that there is limited source of capital and all profits are subject to self-employment tax. The proprietorship ends with the death of the owner.
S Corporations are a pass-thru entity that avoids C Corporation double taxation. This means the shareholders report the corporate income or loss on their individual tax return and only pay tax at the individual level. The owners have limited liability and the corporation can go on forever. S Corporations can also minimize the self-employment tax for its shareholders. There are restrictions on the number of shareholders and the type of stock that can be issued. A disadvantage could be that the owner’s individual income tax bracket could be higher than what the corporate income tax bracket would be if they filed as a C Corporation.
C Corporations are able to sell stock to raise capital and the owners have limited liability. A Corporation that has not elected “S status” is called a “C Corporation.” One disadvantage is that the income is subject to “double taxation”. This means that the C Corporation pays tax on its profits each year and then any dividends paid to the owners are again taxed on the owner’s income tax return, hence the double taxation. These entities are harder to form and dissolve. In addition, there are more administrative burdens.
General partnerships are arrangements between two or more people in business together. They are very simple to start. However, the partners have unlimited liability risk. There is less administrative work and all income or loss is passed thru to the partner’s tax return similar to the S Corporation. If the partnership is an active trade or business, the net income is subject to self-employment tax.
Limited Partnerships are a type of entity that allows all but one partner to have limited liability. At least one partner must be a general partner and have unlimited liability. The limited partners are generally not subject to self-employment tax but may be subject to net investment income tax if their adjusted gross income exceeds certain thresholds.
Limited Liability Partnerships are similar to general partnerships except that one partner is not liable for certain actions of another partner or the company employees. They are only liable for their own actions. This entity allows some flexibility to structure ownership interests among partners and a pass-thru taxation method as well. It does not however protect the partner from professional malpractice.
Limited Liability Companies or LLCs, can have an unlimited number of members and all members have a limited liability. The LLC can take on the tax identity of several different types while still maintaining a legal structure as a LLC. If the LLC has one owner it is treated as a Sole Proprietorship. If the LLC has two or more owners, then for tax purposes it can be treated as a partnership, C Corporation or S Corporation. Members may participate in management but if they do then the portion of their income associated with management is subject to self-employment tax. LLCs may have a limited life and transferability of interests may be limited as well. LLCs are the most popular form of business entity at this time due to income tax advantages and the flexibility.
As you can see, making the choice can be pretty complex given so many options. The accountants at Ketel Thorstenson can help you choose the correct entity for your business, going over the pros and cons of each in more detail. Contact us today for more information.