By: Kurt K. Ohliger, Jr. CPA
For anyone with an entrepreneurial spirit, the thought of starting your own business is both an exciting and frightening venture. They embrace the challenge with visions of becoming the next Donald Trump, while reserving a requisite amount of fear that their business dreams may never come to fruition. After developing the conceptual framework for the new business, one of the first, and most critical, decisions the owner must make is choosing the optimal form of legal entity to conduct the business operations.
Generally, there are five "forms" of business entities to choose from:
- Sole Proprietorship
- Subchapter S Corporation
- Partnership
- Subchapter C Corporation
- Limited Liability Company
Many factors need to be considered before deciding on the appropriate entity formation for your business. Ease of formation, number of owners, management structure, legal liability protection, transferability of ownership interests and of course taxation are all items to consider when making an entity choice. The ultimate choice will be based on all the facts and circumstances related to the nature of the new business. There is no one "perfect entity" as each form has its own set of advantages and disadvantages. The table below summarizes some of those distinctions.
| Entity |
Advantages |
Disadvantages |
|---|
| Sole Proprietorship |
- Formation—no formal filings and registrations.
- Management—easy to operate since no layers of management.
- No corporate formalities to conduct and document.
- Business income is reported on the owner's individual tax return.
|
- Limited source of capital because there is only one owner.
- No limited liability for owner.
- No business continuity—the entity ceases when the owner dies.
- Business income is subject to self-employment (SE) tax.
- Health insurance premiums are not a direct deduction against business income.
|
| S Corporation |
- Generally, one-layer of tax: S corporation files its own tax return but items of income, gain, loss and deduction "pass-through" to the shareholder(s).
- Owners have limited liability.
- Election required to be filed to claim S Corporation status.
- Individual tax rates may be lower than the applicable corporate rates.
- Distributions from the S corporation are generally exempt from payroll taxes.
|
- Number of shareholders limited to 100; limitations as to the types of shareholders;
- Only one class of stock permitted.
- Generally the taxable year must be the calendar year.
- Lack of tax-free fringe benefits to greater-than-2% shareholder-employees.
- Individual tax rates on the pass-through income may be higher than applicable corporate rates.
- Corporate formalities must be followed—all transactions conducted through the business, stock issued, state incorporation filings, annual board meetings held and documented.
- Shareholders must directly invest to have basis to claim losses; guarantee of entity debt is insufficient.
- Borrowing money may require shareholder loan guarantees.
|
| Partnership |
- More sources of capital because there are two or more partners (owners).
- Management resources spread between two or more partners (owners).
- Pass-through taxation; special allocations allowed.
- Limited partners have limited liability and net income not subject to self-employment (SE) tax.
|
- Transfer of interests is more difficult than stock or limited liability units.
- Each general partner is personally liable for the partnership's debts, business activities, etc.
- General partners' net income is subject to self-employment (SE) tax.
- A comprehensive partnership agreement is required.
- Health insurance premiums are not a direct deduction against business income.
|
| C Corporation |
- Can raise capital with stock sales.
- Owners have limited liability.
- Ease of transferability of stock.
- More management resources due to the potentially greater number of people involved in the business.
- Health insurance premiums are a direct deduction against corporate income.
|
- Earnings subject to corporate level tax and then individual level tax when distributed.
- Somewhat difficult to form and to dissolve.
- Borrowing money may require shareholder loan guarantees.
- Corporate formalities must be followed—all transactions conducted through the business, stock issued, state incorporation filings, annual board meetings held and documented.
|
| Limited Liability Company (LLC) |
- All members have limited liability.
- No limit on number or types of members.
- Pass-through taxation under partnership rules.
- Member distributions can include special allocations.
- Members may participate in management.
- Different classes of ownership may be permitted.
- An individual may form a single member LLC.
|
- LLC may have a limited life.
- Transferability of interests may be limited.
- LLC laws vary from state to state.
- LLC liability protection is relatively untested in the courts, especially with single member LLCs.
- Earnings allocated to members who have management authority, debt responsibility, or who materially participate may be subject to self-employment (SE) tax.
- Health insurance premiums are not a direct deduction against business income.
|
The advantages and disadvantages listed above are not intended to be all-inclusive, but rather as a concise list of some primary factors to consider when choosing the appropriate entity type for your new business venture.
As always, we encourage you to contact your Dermody, Burke & Brown tax advisor to discuss any concerns you have as you embark on your new business.
The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.
