Business Entity Types, Liability, and Taxation

The choice of business entity types has become more and more complex. Should you use an LLC, S-corporation, C-corporation, Sole Proprietorship, or partnership? The differences mostly revolve around liability protection and taxation. The IRS has an excellent site that explains some of the regulations (https://www.irs.gov/businesses/small-businesses-self-employed/business-structures)

Some business entities are treated as a fictional "Legal Person" and are entities created by law to act as a person. They are often corporations, but not always. Legal Persons are distinct and separate from the natural person that owns the business. Because of their status, they have certain legal responsibilities and privileges.

Business Entity Taxation

Some business entities are taxed at the level of the entity (since they are legal persons) and some pass the business profits, losses, and deductions down to the owners to be taxed at an individual level. In general, C-corporations are taxed at the level of the entity and pay taxes on the profits they generate. A C-corporation files its taxes using IRS form 1120. If they pay out profits to their owners, these are referred to as dividends and are taxable to the owner who receives them. This results in "double taxation" of these profits.

Other business entity types including sole-proprietorships, partnerships, and subchapter S-corporations pass through the taxation of gains and losses. This means that the profits, losses, and deductions are considered personal, so no corporate-level tax or tax credit is owed. In a partnership or sole proprietorship, all of the tax treatment of the gains or losses is passed to the owner. Limited Liability Corporations (LLC's) may elect to be taxed as partnerships and single-member LLC's are usually disregarded entities for tax purposes and the business is typically taxed as a sole proprietorship. A single-member LLC and a sole proprietor both file the schedule C to report income. An LLC has the option to be taxed as an S-corporation.

An S-corporation is a hybrid and offers the owner a choice to consider some amount of the distributions to be treated as regular wages and some as distributions with pass-through tax treatment. S-corporations file IRS form 1120s to report its income.

Sole proprietors, LLC owners, and partners in partnerships are considered self-employed, and they must pay self-employment tax on the net income from their business.

Business Entity Types and Characteristics

C-corporation

A C-corporation is the most common business structure for large companies. Most of the stocks listed on the stock exchanges are C-corporations. The stock is easily bought and sold and the gains and losses from trading the stock in the companies are treated as capital gains and losses. There is no maximum number of shares and an owner of a share of stock is a partial owner of the company. Different classes of stock are allowed with different voting, dividend and liquidation preferences. A C-corporation is a legal entity. The owners of a C-corporation have limited liability and their liability is limited to their investment in the business. In other words, they can only lose what they paid for the stock even if the business goes bankrupt with debts and have no personal liability for the corporation.

S-corporation

Many small businesses are formed as S-corporations. One of the unique characteristics of an S-corporation is the ability for an owner to receive compensation both as an employee by getting W-2 wages and as an owner by getting S-corporation distributions. S-corporation distributions are not considered wages and no FICA taxes are due on these distributions. These distributions can not be used to calculate Social Security or as the basis for 401(k) or other retirement plans. The maximum number of shareholders that can own an S-corporation is 100. The owners of an S-corporation have limited liability like the owners of a C-corporation.

Any corporation can elect S corp IRS status if it has between 1 and 100 shareholders. In order to elect to be taxed as an S corporation, a corporation must meet eligibility requirements and notify the IRS of this election. The two requirements which need to be met are a limit of 100 shareholders and the consent of all of the shareholders.

Limited Liability Company (LLC)

A Limited Liability Company is formed by filing Articles of Organization with the state instead of filing Articles of Incorporation as in the case of a subchapter C or S-corporation. The owners of an LLC are referred to as members instead of shareholders because an LLC is classified as a partnership. The members of an LLC have limited liability for the actions of the organization. Because of this, the LLC has some of the characteristics of the partnership and some characteristics of a corporation.

Partnership

A partnership is a business with two or more individuals who share the risks and benefits of the business, including the profits and losses of the partnership. Partnerships must register with a state and create a partnership agreement. They have some recordkeeping requirements but are not as complicated as those of a corporation. If one of the partners leaves a partnership it is dissolved and must be reformed with the remaining partners.

A partnership may include two types of partners. General partners who participate in the day-to-day management of the business and have personal liability for partnership debts and for actions of the partnership and Limited partners who are merely investors and don't share in the day-to-day operations of the business or in liability and are just investors in the business.

A limited partnership (sometimes called an "LP") has both general partners who participate in business decisions and limited partners who invest in the business but don't participate in daily operations. General partners have liability for company debts and actions, but limited partners are shielded from liability as long as they don't become involved with business decision making.

Sole Proprietorship

Most small businesses are sole proprietorships because they're the easiest and least expensive way to start a business. Unlike other entity types, there are few formalities for a sole proprietorship. Most sole proprietors who operate a business using a name other than their own must file a DBA certificate in the city or town where they operate. Unlike a partnership or a corporation, a sole proprietorship is not a separate legal entity from the proprietor and the owner of the business has unlimited personal liability for the actions of the business. All of the assets of a sole proprietorship belong to the owner of the business, not to the business itself.

Choosing Your Business Entity Type

Choosing a business entity type can be confusing and the decision can affect the operation of your business, the taxes you pay, and the proceeds you receive if you ever sell the business. Your first stop when starting a business should be your accountant or attorney to help you make the decision and to help with the organizational documents used to form the entity.

While you can change your mind later, the complications and potential taxes for fixing an issue are considerably more than any fees you might pay to your advisors to get the decision right in the beginning.

More information on this topic can be found on the Small Business Administration website.