New business owners are often challenged with many decisions upon deciding to engage in a new business venture. Of those decisions none is more important than choosing the appropriate business entity. This decision will ultimately have ramifications that will dictate the business owner’s tax structure and the extent of his or her personal liability.
There are four business entity types that are available for consideration. Each has certain advantages and features that distinguish it from the other three. The types of business entities available are the Sole Proprietorship the LLC also known as the Limited Liability Company the S Corporation and the C Corporation.
The first and simplest type of business entity is the Sole Proprietorship. This type of business entity is the easiest and least expensive to form. It is essentially an extension of the individual that is why it is commonly referred to as a DBA (Doing Business As) i.e. John Smith DBA ABC Painting. The DBA is fairly simple to set up and is usually obtained through a local county courthouse for a nominal fee. Some of the limitations of the Sole Proprietorship are that all income is passive and is defined as earned income by the IRS which makes the total sum of all income earned by Sole Proprietorships subject to self- employment taxes. Another defining feature of the Sole Proprietorship is that the personal assets of the owner would be exposed to a judgment in the event of a lawsuit. This feature makes the Sole Proprietorship unattractive to individuals whose purpose is to protect their personal assets in the event of litigation being brought against the company.
The second and newest form of business entity is known as the Limited Liability Company commonly referred to as the LLC. This type of business entity is a hybrid of the Sole Proprietorship and the S-Corporation. The LLC limits the personal liability of the business owner like a corporation, while providing a simpler and more flexible structure than most other forms of business. Ownership in an LLC is expressed through percentages unlike ownership in a corporation which is expressed strictly through shares. This type of ownership structure allows members to be flexible in how they split up the company’s profits.
The tax structure of an LLC is dependent on whether the LLC is a single member LLC or a multimember LLC. A single member LLC is taxed on the federal level the same as a sole proprietor, while a multimember LLC is taxed on the federal level the same as a partnership. Because a large number of small businesses are sole proprietorships the LLC is likely to be an excellent choice for these types of businesses. It retains most of the benefits of a sole proprietorship or partnership with the added benefit of limited liability, with very little in the way of extra requirements.
The third type of business entity is known as an S Corporation. The S Corporation is a special form of corporation (Note: The “S” in S Corporation refers to subchapter S of the tax code). S Corporations are based on C Corporations but they are not treated as a separate tax entity as C Corporations are. Instead, the income of an S Corporation is “passed through” to the personal income of its owners (shareholders) in proportion to their ownership interest.
An S Corporation is created by forming a traditional C Corporation and then filing the IRS Form 2553 (The Subchapter S Election) for federal recognition of S Corporation tax status. While the S Corporation has many of the same features as a C Corporation, there are some important differences.
Note: While the S Corporation features similar pass through taxation to an LLC, in the area of self-employment taxes an S Corporation can be advantageous over an LLC. The salary portion of S Corporation shareholders is subject to self-employment taxes; however profits allocated to them as shareholders are not.
The last and most complicated form of business entity is called a C Corporation. The C Corporation is a completely separate tax and legal entity from its owners, and owners who work in the business are treated and taxed as employees of the corporation (Note: The “C” in C Corporation refers to a subchapter of the tax code; C-corporations are one of the most common forms of corporations, and they are frequently referred to generically as corporations).
The C Corporation is subject to corporate income taxes separate from the owners, where most other forms of business entity allow for the company profits to “pass-through” to the personal income tax statements of the owners. As such, C Corporations are the most formal business entity and they have greater tax reporting responsibilities than other business entities. C Corporations allow for profits to be retained in the business, if desired, and frequently these profits can be taxed at a lower rate than personal income. C Corporations can also pay out after tax profits to its owners in the form of dividends, but this can also lead to double taxation.
C Corporations are the least likely of the incorporated entities to appeal to a small business owner because of their inherent complexity and tax reporting liabilities. Owners of C Corporations are required to file quarterly tax filings as well as have extensive record keeping requirements. Unlike LLCs, C corporations are subject to corporate formalities such as bylaws, shareholder meetings and the filing of annual reports. This can be a significant time commitment for companies with few employees.