Four common structures exist for business entities, and the right one for your business depends on a variety of factors. However, each entity has different requirements for accounting and record keeping as well as pros and cons when it comes to liability, taxation and fringe benefits for owners. Before making a selection, collaborate with your financial advisor, accountant and legal counsel to determine which option sets your business up for long-term success.
A single-member limited liability company (LLC) is an unincorporated trade or business owned by one individual. The structure offers complete freedom over business decisions, and the owner is entitled to 100 percent of the profits. It’s also the easiest business to organize with minimal legal restrictions and less involved accounting than partnerships or corporations. However, the owner is personally liable for all debts and lawsuits, and self-employment tax must be paid on net profits in the year earned. Income tax cannot be deferred by retaining profits, and excludable fringe benefits such as health insurance are generally not allowed for the owner. (Sole proprietors or married couples in a qualified joint venture who elect to file as two sole proprietorships are treated very similarly.)
Partnerships are made up of two or more owners, and the size of the partnership influences the accounting requirements. Small partnerships are not required to provide a balance sheet and can use the same bookkeeping system as an LLC. Larger partnerships, however, must provide a balance sheet with tax returns and must complete double-entry bookkeeping. Partnerships are fairly easy to organize and have more flexibility than corporations. They pay no income tax because partners do so individually. “General partners” are personally liable for all debts and lawsuits and are subject to self-employment tax on distributed share of profits. However, “limited partners” are only liable for their investment (plus his or her own malpractice) and aren’t subject to self-employment tax (unless in the form of guaranteed payments). Partners are eligible for some excludable fringe benefits.
Up to 100 shareholders may own stock in an S corporation, and the business profits flow through to shareholders who pay income tax at their level. Shareholders who perform services are paid as employees – with income reported on W-2s – and therefore, distributions are not subject to self-employment tax. S corporations themselves generally pay no tax. Shareholders’ liability is limited to the amount invested (plus his or her own malpractice or guarantees), and they are eligible for some excludable fringe benefits such as health plans or meals and lodging. S corporations must use a calendar year unless a business purpose is established for a fiscal year, and double-entry bookkeeping may be required.
C corporations aren’t limited to a certain number (or type) of shareholders, and typically, there are no restrictions on use of a fiscal year. Shareholders are eligible for excludable fringe benefits to the same extent as other employees, and liability is limited to the investment amount (plus his or her own malpractice). However, forming a corporation can require complex and expensive legal procedures. Corporations also have more rules to follow like holding board meetings, keeping corporate minutes, etc., and they are subject to federal and state regulations. Unlike other entity structures, losses aren’t passed through to shareholders. Shareholders are paid as W-2 employees, including the accompanying payroll taxes and reporting rules, and profits distributed as dividends are taxed on the shareholder’s return (as well as at corporate rates). Tax returns also require a balance sheet to be submitted and, thus, double-entry bookkeeping. However, the life of a corporation is perpetual because ownership can be transferred as easily as selling/inheriting stock, and additional capital can be raised simply by issuing new shares.
For more details on pros and cons of your business entity options, download our comparison chart.
Blog by Crystal Harmon, Tax Director.