A business entity refers to an organization created to conduct and engage in trade or similar activities. Each type of business entity dictates the structure of an organization, the paperwork needed to file as well as how the company is taxed.
The first step to starting a business is choosing the structure of your company – choosing a business entity type. The decision is made before registering your company with the state.
Most businesses may also need to get a tax ID number and file for the essential licenses and permits. Choose wisely as there may be restrictions based on your location while converting to a different business structure in the future. Seeking the professional assistance of attorneys, counselors and accountants can be helpful.
State governments in the United States recognize over a dozen different types of business entities. However, average small business owners can choose between these – sole proprietorship, general partnership, limited partnership, limited liability companies, C-corporation, and S-corporation.
This guide will provide the in-depth information you need to determine what’s best for your company.
A sole proprietorship is the most basic business structure in the United States, with one person or a married couple as the sole owner and operator of the company. If you’re the only owner when launching a new business, you’ll automatically be a sole proprietorship under the law. However, the business terminates upon the proprietor’s death.
There would be no need to register a sole proprietorship with the state. You may, however, need local business licenses or permits depending on the industry.
Service professionals such as consultants and freelancers commonly work as sole proprietors. But for more established businesses, such as retail stores, having one person at the helm would be another viable option.
When running a sole proprietorship, you’re accountable for everything the business is liable for. Thus, if someone sues your business, they’re suing you, the business owner.
Taxes for Sole Proprietorship
When running a sole proprietorship, both the business and business owner are identical for tax purposes. This means that the business owner reports business income or loss on their personal tax return. But the business itself isn’t taxed separately. According to the IRS, this type of taxation is called “pass-through taxation,” as the tax liability belongs to the business owner.
The sole proprietorship is taxed on Form 1040 while the business profit is calculated and presented on Schedule C, profits or loss from small business. Completing Schedule C requires calculating the business income, including all expenses as well as the cost of goods sold and costs for a home-based business.
The Benefits of Running a Sole Proprietorship
- Total Ownership
Having a sole proprietorship means that you’re the sole owner of the business. While you’re liable for the business debts and taxes, you’re also entitled to all the income. And, when making a business decision, there is no legal requirement for you to consult with shareholders or partners.
- Easy Setup
Establishing and operating a sole proprietorship under your name is generally an easy and inexpensive process that varies according to your state or province of residence. However, you must ensure to file all your taxes correctly. It requires very little paperwork and minimum fees in all cases.
- Few Government Requirements
Unlike corporations, sole proprietor entities don’t need to comply with various government regulations such as financial information reporting to the general public.
- Tax Benefits
Unlike corporation shareholders, the owner of a sole proprietorship is taxed just once. They pay only the personal income tax on the profits gained by the entity. The entity itself isn’t liable to pay income tax.
The Disadvantages of Sole Proprietorship
- Unlimited Liability of the Owner
A sole proprietorship doesn’t establish a separate legal entity, so the business owner deals with unlimited personal liability for debts incurred by the entity. If the business fails to meet its financial obligations, creditors will demand repayment from the entity’s owner. They must use their personal assets to repay the outstanding debts.
- Capital Raising Limitations
Unlike corporations and partnerships, sole proprietorships have fewer options to raise capital. For instance, the owner can’t sell an equity stake to acquire new funds. Moreover, approval of loans depends on the owner’s personal credit history.
- Lifespan Uncertainty
If the sole proprietor decides to leave the business, the company will dissolve. This makes it difficult to maintain long-term continuity. Other business entities let you bring a co-owner or business partner before you exit.
A general partnership is an unincorporated business entity with two or more owners sharing business responsibilities. Every partner has unlimited personal liability for the business obligations and debts. They also report their share of the business profits and losses on the personal tax return.
General partnerships are found among various types of business entities as they’re simple in terms of getting started and filing taxes.
When it comes to a general partnership, you don’t need to register your business with the state to operate legally. Moreover, when two or more individuals run a business together, a general partnership exists by default.
Features of a General Partnership
To have a general partnership, the company must have two or more owners, and all partners must agree on personal responsibility for debts or any legal liabilities incurred.
Every partner can participate in contracts or business deals binding on every other partner. It’s important to be careful when choosing a partner or partners because their actions or mistakes can affect you legally and financially.
To prevent any disagreements in the future, owners create a founder’s agreement or partnership agreement that outlines the governing structure of the business as well as every owner’s rights and responsibilities. The agreement also addresses the partner voting rights and division of profits.
General partnerships dissolve without a partnership agreement if one of the partners becomes disabled, leaves the partnership, or passes away. The agreement specifies what should happen in such circumstances.
Why Choose a General Partnership
People opt for general partnerships because they’re easy to establish with a simple verbal agreement. Moreover, it can also help reduce your tax bill. Any profits you make as a general partner will become personal assets. These profits are taxed by the IRS at the standard income tax rate. When filing your tax return, you’re likely to end up with a lower tax bill than the one received if you incorporated it.
The cost of creating a general partnership is much less than setting up a limited liability partnership or a corporation. General partnerships also involve less paperwork, though certain permits, registration forms, and licenses may be essential at the local level. h
The Downsides of General Partnership
Like every other business entity, general partnerships also come with some disadvantages. The fact that you and your partners are responsible for all business debts can put you in an alarming situation. So if the company falls behind on payments or other financial obligations, the creditors can come after your and the partner’s personal assets.
Moreover, a general partnership is prone to getting complicated rapidly. This may be the case, especially when there are only two partners equally owning the company. Most experts recommend including a partnership agreement when establishing your business.
Limited Liability Company (LLC)
A limited liability company is a business structure combining several aspects of a corporation and a partnership. It’s attractive for business owners because it offers flexibility and protects them from personal liability created by debts. According to the U.S. Small Business Administration (SBA), the limited liability business structure is a hybrid business structure approved in most states.
It’s designed to provide the limited liability feature of a corporation and the tax efficiencies of a partnership. LLC owners can include foreign entities, multiple corporations, individuals, and other LLCs. The members of LLCs can range from one member to dozens.
Regulations for Limited Liability Company
The Limited Liability Corporation offers small businesses the features of corporations as well as sole proprietorships. When it comes to a corporation, LLC owners can’t be personally held liable for business debts.
In addition, the business can’t be held liable for personal debts. Unlike traditional corporations, LLC owners can use their companies as pass-through entities to prevent double taxation. Regulations for establishing an LLC vary depending on the state, but there are significant similarities.
Advantages of Limited Liability Corporation
- Limited Liability
The company is formed as a separate legal entity protecting its members from being personally liable for business obligations. This advantage is typically borrowed from corporations.
- Tax Advantage
According to the law, the income of a Limited Liability Company is treated as its owners’ income. As a result, the members of a limited liability company can prevent double taxation on business income.
- Income Distribution Flexibility
A limited liability company offers flexibility regarding profit distribution. So, the business earnings under this form don’t have to be distributed equally on the partner’s capital contribution ratio.
Disadvantages of Limited Liability Corporation
A limited liability company has two sources of raising funds as a corporation – debt and equity. Raising funds through the equity route leads to selling ownership stakes of the business. This means adding another member to the list who will share your profits.
Limited liability companies are registered with the states and not federal agencies. So if you intend to do business in multiple states, it may be complex to understand and comply with different requirements. That’s why an interstate business may not work well with this type of business structure.
Since S-corporation is a tax designation, both LLCs and corporations can file to be taxed as an S-corp. However, no state offers entrepreneurs the opportunity to incorporate their organization as an S-corp. Those willing to establish an S-corporation must file a form complying with the International Revenue Service (IRS).
Commonly associated with small businesses, S-corp status gives the regular benefits of incorporation while enjoying the tax-exempt privileges of a partnership.
To acquire S-corporation status, businesses have to meet certain IRS qualifications that include:
- Being incorporated domestically within the United States
- Having a single class of stock
- Not having more than 100 shareholders
- Have shareholders who meet specific eligibility requirements
Specifically, S-corporations must be trusts, estates, individuals, or particular tax-exempt organizations. Non-resident aliens, corporations, and partnerships can’t qualify as eligible shareholders.
An S-corporation may pass business income, losses, credits, and deductions directly to the shareholders without paying any federal corporate tax.
Advantages of Filing Under S-Corporation
The tax benefit is the biggest advantage of registering as an S-corporation at the entity level. Saving money on corporate taxes is beneficial, especially for business startups. S-corp status can also lower the personal income tax tab for business owners.
With the money received from the business as salary or dividends, S-corporations owners tend to lower their liability for self-employment tax. The S-corp status makes the deductions for business expenses as well as wages paid to employees.
The Disadvantages of Filing Under S-Corporation
Since S-corporations can disguise salaries as corporate distributions to avoid paying payroll taxes, the IRS analyzes how employees should be paid. Reasonable salaries must be paid to shareholder-employees for services rendered before making any distributions.
When it comes to making these distributions to shareholders, the S-corp is liable to allocate profits and losses according to the percentage of ownership or number of shares of every individual.
To help you choose the best legal structure for your business, we offer expert advice at Advance Tax Defense and Accounting in West Palm Beach. Since you won’t want to make this decision alone, consult with a specialist about the ideal corporate structure to opt for. We are ready to help you establish your company and stay compliant.
With years of experience and comprehensive knowledge in the field, our professionals also offer business tax preparation services, accounting, and bookkeeping services, financial statements compilation, and more.
To get the best tax solutions for your business structure, reach out to us today.