If you are creating a new business or unhappy with your current business structure, you need to consider the appropriate business entity. Whether to incorporate or form a limited liability company (LLC) is not always obvious. Under the Internal Revenue Code (IRC), a corporation is either a “C Corp” or an “S Corp.” An LLC is either a sole proprietorship (single member), a partnership (two or more members), a “C Corp,” or an “S Corp (if it meets all of the requirements and files a timely election).”
Tax issues to consider when choosing an entity: Sale of the business/liquidation. Tax rate exposure. Utilization of losses by the shareholders/members. Compensation/fringe benefit packages. Payroll tax liabilities and associated complexities. And state taxes.
Non-tax issues to consider: Limited liability protection for shareholders/members. The capital structure of the entity. Buy-sell agreements. The type of business/investment activity. And the applicable state law and other corporate legal formalities.
As indicated, there are many reasons to choose one structure over another. With that in mind, here is a brief description of these business entities
Sole Proprietorship
The simplest and least expensive structure. Works best if you are on your own, in a low risk business. No double taxation on profits, such as under a “C Corp.” Profits/losses reflected on Form Schedule C of the Form 1040. Unlimited liability for the owner and all income subject to the onerous “self-employment” tax.
Partnership
An unincorporated business that has two or more partners. There are two types: general and limited. In a general, partners share in management and are each 100% responsible for the partnership obligations. In a limited, there are general and limited partners. The general partners manage the business and are personally liable for obligations. The limited partners cannot participate in management, but share in the profits. Their liability is limited to the amount of their capital contributions. Profits are taxed only once, at the partners’ marginal tax rate.
C Corporation
They are taxed (federal and state) at the entity level and are subject to taxes on income generated by the business. Shareholders pay taxes (double taxation) on the profits distributed (dividends) to them. Liability is limited to the shareholder’s investment. They have an unlimited life and possess ease of transferability of ownership. Employment taxes can be minimized. Although, a reasonable salary must be paid.
S Corporation
Corporations with fewer than 100 shareholders can elect to be taxed under Subchapter S of the IRC. With some exceptions, the “S Corp” is not subject to federal tax at the entity level. Profits and losses flow through to the shareholders, to be reported on their tax returns at their marginal tax rates. Some states tax “S Corps” at the entity level. Employment taxes can be minimized for owners receiving a salary. Although, the amount of the salary must be reasonable compared to the profits being generated by the entity.
