(Not intended for a legal audience)
Congratulations! You’re about to embark upon the journey of entrepreneurship. You’re excited, but you don’t know which entity structure to select for your business. Your decision on business structure can have an immediate and significant impact on your business as well as lasting impact on your ability to raise capital. The legal structure that you select will determine everything from how you pay taxes, the amount of paperwork involved, and the impact of a lawsuit.
This post should help to clarify many of those points. After reading this post, you should be more enlightened about the advantages of the various business structures and the tax implications of those structures. Here are some key points to consider as you proceed in your journey of entrepreneurship.
Types of Business Entities and Tax Treatment
Most for profit businesses are generally formed under state law as:
For tax purposes, a business entity is treated as one of the following:
A sole proprietorship is the simplest form of business to launch. A sole proprietorship can operate under the name of its owner or it can do business under a fictitious name (commonly referred to as a “DBA” or “doing business as”). There are no formal requirements to establish this business structure. Thus, it is not necessary to file any documents with the state or the IRS. Although, some states require that you register the fictitious name with the secretary of state’s office. This particular business structure is only available to married couples or individuals. There are no partners, shares, or membership interests in a sole proprietorship, which generally makes it difficult to attract investors without first changing the business structure. The biggest disadvantage of sole proprietorships is that the owners are not legally separate from the business. Therefore, the proprietor is personally liable for all debts and obligations of the business. If the business is sued, personal assets such as your savings, house, car, etc. are at placed risk.
A sole proprietor is required to report all business income and losses on their personal income tax returns; the business entity is not taxed separately. This tax treatment is commonly referred to as "pass-through" taxation, because business profits pass through the business (avoiding corporate taxation) and are taxed on the business owner’s personal tax returns.
A sole proprietor does not have an employer to withhold income taxes from their paycheck. The proprietor must estimate how much tax will be owed at the end of each year and make quarterly estimated income tax payments to the IRS, and if required, to their state tax agency.
SOLE PROPRIETORSHIP AT A GLANCE
General Partnership (GP)
A general partnership is an unincorporated business owned and run by two or more people. General partners typically share in the day-to-day management of the business as well as the business’s profits and losses. Like sole proprietorships, a general partnership does not provide limited liability for the partners. Therefore, the partners are subject to unlimited personal liability for the debts and obligations of the business. In addition, each partner is responsible for the other partner’s liabilities, negligence, and misconduct.
General partnerships are also restricted in their ability to raise capital. Other than debt financing , partnerships often find it extremely difficult to get access to large amounts of capital. Although selling equity interests may be an option for partnerships to raise capital, it can be extremely difficult to do on a large scale because of the potential for personal liability and the limited resale market for partnership equity.
Limited Partnership (LP)
A limited partnership has two tiers of partners: at least one “general partner” who is actively involved in operating the business and is personally liable for business obligations and at least one “limited partner” who is not involved in running the business but shares in the business profits. The limited partner’s liability is limited to the amount that they invested in the business.
Limited Liability Partnership (LLP)
A limited liability partnership is similar to a general partnership, but it has no general partners. Additionally, unlike the other two partnership structures, all of the owners have limited personal liability; and therefore, are protected from the debts of the business as well as personal liability for the other partners’ negligence. LLPs are most often used by professionals such as lawyers, accountants, and physicians who want to avoid liability for their partners’ malpractice. Some states do not permit these professionals to form corporations or LLCs, so in order to protect their personal assets, these professionals are left with LLPs as a business structure.
Taxation Options for Partnerships
A business entity taxed as a partnership is regarded as a pass-through entity for tax purposes, which means it does not pay corporate taxes. The partnership's profits and losses are instead computed and allocated among the partners annually and pass-through to the partners, which include their respective share of those items on their personal income tax returns, irrespective of whether there has been a distribution of profits. It is important to note, however, that although the default taxation classification is pass-through taxation, a partnership may elect C-Corp. tax treatment by filing the appropriate entity classification election forms with the IRS.
PARTNERSHIPS AT A GLANCE
*Assuming that the partnership has not elected to be taxed as a corporation
Depending on the desired state of incorporation, corporations tend to be more cumbersome to maintain because states generally require more complex, meeting, recordkeeping, and reporting requirements from corporations than they do limited liability companies. Although the administrative requirements may be perceived as a disadvantage, corporations offer some flexible options with respect to tax classification; they may be taxed as “C-Corporations” or “S-Corporations.” In addition to the flexibility of tax treatment, corporations provide limited liability to their owners, and capital can be raised more easily through the sale of stock which may be easily transferred from one person to another - this can be important for a business that is looking to acquire outside financial support or give shares to employees. And, often, outside investors will prefer to invest in a corporation.
Tax Options for Corporations
The most common corporate form is the C-corporation. The C-corporation is generally subject to two levels of tax on their income:
An S-corporation is a pass-through entity for tax purposes, which means it generally does not pay a corporate income tax. The S-corporation's profits and losses instead generally pass-through to its stockholders, which then include their respective share of those items on their income tax returns (irrespective of whether there has been a distribution).
S-corporations are useful for individual entrepreneurs that have not yet secured venture capital. However, a startup company should carefully consider the significant limitations placed on the number, types, and residency of stockholders that can own an interest in an S-corporation.
CORPORATIONS AT A GLANCE
LIMITED LIABILITY COMPANY (LLC)
As the name suggests, a limited liability company, or LLC, shields its owners (known as members) with protection against liability from the company’s debts and obligations. Therefore, if your LLC in unable to pay its debts or is unable to meet its obligations, only the business assets, not the your personal assets, are placed at risk in a lawsuit. However, it is important to note that the owners or members still remain liable for their own personal negligence or intentional misconduct.
LLCs generally offer fewer administrative, meeting, and reporting requirements than corporations. They also provide more flexibility than other business structures in that they offer many alternatives for tax classification and less rigid restrictions/requirements for management structure. LLCs may be taxed in the same way as a sole proprietorship or partnership, or they may elect to be taxed as a corporation (C-Corp or S-Corp). LLCs can be managed by their owners, by a select group designated as managers. And, an LLC can have one member or many members. Because of this flexibility and limited personal liability, LLCs are a popular choice for many small businesses.
However, if you plan to seek venture capital or angel investors, or if you plan to become a publicly traded company, the LLC may not be a good choice. For a variety of reasons, which will be discussed in a later post, investors generally prefer to invest businesses structured as a corporation .
TAX OPTIONS FOR LLCs
Tax Classification of a Single-Member LLC
Under the default classification rules, a single-member LLC is treated as a disregarded entity (pass-through tax treatment like the sole proprietor) for tax purposes unless it elects C-corporation tax status. A single-member LLC meeting the requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status). The primary difference between the taxation of the single-member LLC taxed as a sole proprietor and the single-member LLC taxed as an S-Corp is the difference in how Medicare and Social Security taxes (i.e. self-employment taxes) are paid. By electing S-corp. tax treatment, many LLC owners can save on their taxes.
LLC Taxed as Sole Proprietor. The member is considered self-employed, and therefore is responsible for paying Social Security and Medicare taxes on all of the company profits. Any business expenses and income are reported on the member’s personal income tax return. In addition, the owner is responsible for paying personal income tax on all company profits.
LLC Taxed as S-Corp. The member owner-employee must be paid a reasonable salary. The LLC will report the salary as a business expense, and the owner will report both the salary and any remaining business profit on his or her personal tax return. However, member owner-employee will only pay Social Security and Medicare taxes on the owner's salary. The remainder of the profits are not subject to these taxes.
In Real Life - Crunching The Numbers
SCENARIO 1: Suppose you are a single-member LLC taxed as a sole proprietor. If your business generates $100,000 in profits, you will be required to report $100,000 of income, and you will pay Social Security tax and Medicare tax on the entire $100,000.
SCENARIO 2: You have elected to be taxed as an S-corp. Your business generates $100,000 in profits. You have determined that your reasonable salary is $40,000. Your salary is a business expense, so the business now has a $60,000 profit. You will still report $100,000 of income ($40,000 of salary plus $60,000 of profit), but you and the business will only pay Social Security and Medicare taxes on your $40,000 salary.
If a single-member LLC taxed as a sole proprietor adds another member, the LLC automatically converts to a partnership for tax purposes. Alternatively, members may elect S-Corp taxation which is discussed in more details in the section immediately below (see Tax Classification of a Multiple-Member LLC).
Tax Classification of a Multiple-Member LLC
Under the default classification rules, a multiple-member LLC is treated as a partnership for tax purposes unless the business elects C-corporation tax status. Alternatively, a multiple-member LLC meeting the eligibility requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status. If a multiple-member LLC taxed as a partnership reduces its membership to a single member, the LLC automatically converts to a disregarded entity for tax purposes.
LIMITED LIABILITY COMPANY AT A GLANCE
* Assuming the LLC has not elected to be taxed as a corporation
In sum, each business structure comes with its share of advantages and disadvantages. And, the decision to select any particular structure depends on your long-term goals for your company. It is strongly encouraged to consult with legal counsel to determine which structure is best suited for your business model and long-term goals for the business. In addition, we strongly encourage our clients to consult with an accountant for advice about which entity structure best addresses their unique tax situation.
For a more detailed discussion about the appropriate business entity for your business, contact Cooper Legal.
This blawg is provided by the firm for informational purposes only and may not be relied on as legal advice. If you have any questions related to your specific business needs, schedule a legal consultation today.