(This post is part of my Small Business Startup & Survival Guide. You can catch up on the whole series here.)
When you’re getting started in business, it can be tempting to rush through to get to the good stuff. After all, you have your cool idea and your even cooler sounding name… Can’t you just tack an LLC onto the end using one of those online services?
The short answer is no. Entity selection is more important than you think. Your choice of entity can affect the number and identity of shareholders and partners, equity structure, control, and management, as well what kind of funding you might be eligible to receive.
I know what you’re thinking: why not just pick something to get started and change it if it doesn’t work? Getting it right in the beginning is crucial. While it’s true that you can make a switch later in the game, there may be tax and other consequences as a result – so slow down and get it right the first time.
When you’re making a choice about entity, remember two really important things:
- Entity choice is state specific. It doesn’t happen at the federal level. You incorporate or organize at the state level. The laws of the individual state matter: not all entity choices are respected or treated the same in every state.
- Your choice of corporate entity may be different from your tax entity. Incorporation or organization with the Department of State in your state does not constitute a tax election with the Internal Revenue Service (IRS). For example, you can incorporate as a C corporation but elect with IRS to be taxed as an S corporation. You could also organize as an LLC but opt to be taxed as a partnership, S corporation, C corporation or disregarded altogether.
See? Entity choice can get pretty complicated. There’s a lot to consider, including liability, control and taxes. Follows is a brief primer on the most common forms of entity (focusing on taxes, of course):
Sole Proprietorship. The sole proprietorship is the most simple form of business entity. There is no formal procedure to form a sole proprietorship – no forms to fill out, no agreements to sign and no documents to file with the state. Since there are few formal accounting requirements, the transferability of personal and business assets in and out of the business is easy. The downside of the lack of formal requirements is that the owner of the sole proprietorship can be personally liable for debts and obligations of the business. That means that personal assets – like your house – can be treated, for liability purposes, as business assets.
Taxpayers do not file a separate tax return for a sole proprietorship. Income and expenses from the business are reported on an individual taxpayer federal form 1040, Schedule C. That means that taxpayers are limited to personal deductions for certain expenses, such as medical expenses: in some cases, that produces a less favorable tax result.
General and Limited Partnerships. Partnerships are almost as easy to form as a sole proprietorship: it’s an association of two or more persons to carry on a business for profit. Like a sole proprietorship, in most states there are no formal procedures to form a partnership – no forms to fill out, no agreements to sign and no documents to file – though it’s certainly desirable from a business and legal perspective. In a general partnership, partners share, jointly and severally, in the liability for business obligations.
A limited partnership is a bit different in that it is typically defined as a partnership formed by one or more general partners and one or more limited partners. General partners are treated much like what we think of as “typical” partners: they have joint and several liability for the debts of the partnership and often exercise control over the partnership. In contrast, limited partners may have limited liability (this depends on state law and how much control those limited partners exercise).
For tax purposes, while a partnership does file a separate return (a federal form 1065), income and losses associated with the partnership pass through to the individual partners. Items of income or loss retain their character and are reported to each partner in proportion to their interest, as determined either by statute or partnership agreement. Each partner is then responsible for reporting that information on their individual tax returns.
Limited Liability Partnership. A Limited Liability Partnership (“LLP”) is a relatively new form of entity. An LLP is similar to a general partnership but while a general partnership can exist on an informal basis, an LLP must register with the state. The benefit of registration – a formal acknowledgment of the entity – is that the LLP takes on a form of limited liability similar to that of a corporation. Typically, that means that partners aren’t liable for the bad behavior of the other partners though the level of liability can vary from state to state. There is generally unlimited personal liability for contractual obligations of the partnership such as promissory notes and mortgages (again, this varies by state).
For federal tax purposes, an LLP is treated as a pass-through entity, similar to a general partnership.
Limited Liability Limited Partnership. No, that’s not a mistake. Some states recognize a Limited Liability Limited Partnership (“LLLP”). If you consider that a LLP is a general partnership with limited liability, think of a LLLP as a limited partnership with limited liability.
For federal tax purposes, an LLLP is treated as a pass-through entity, similar to a general partnership.
Limited Liability Company. The Limited Liability Company (“LLC”) is probably the most popular form of business entity today. It’s a hybrid entity that offers the liability protection of a corporation with the option to be taxed as a partnership or a corporation. An LLC is made up of members, as opposed to shareholders. Individual members are typically protected from liability so long as corporate formalities are observed. That means that you do need to register with the state and pay attention to state laws (like filing annual reports). On the plus side, LLCs have far fewer corporate formalities than other corporations.
For federal tax purposes, an LLC is generally treated as a pass-through entity. While most LLCs are taxed as a partnership because it’s typically more advantageous, there may be situations when corporate tax treatment might be preferred (for example, when the individual members of an LLC are foreign). An LLC can also opt to be taxed as a S corporation (more on that in a bit).
While this primer is meant to focus on federal tax laws, it’s worth noting that under the laws of some states, LLCs may be subject to additional corporate taxes even if they are otherwise treated as a partnership. This can bump the costs associated with being an LLC considerably. Be sure to check with the laws in your state.
Single Member Limited Liability Company. A Single Member Limited Liability Company (SMLLC) is what it sounds like on the tin: a formally organized LLC with a single member. The advantage of a SMLLC is that it may be treated as a “disregarded entity” for federal tax purposes. That means that the taxpayer does not file a separate tax form for the business; rather, income and expenses are reported on an individual taxpayer federal form 1040, Schedule C, just like a sole proprietor.
C Corporation. A C corporation is what most people think of when we think of a business. In a typical C corporation, the business is owned by individual shareholders who hold stock certificates or shares (yes, we still call them certificates even though it’s rare that you have a piece of paper evidencing your ownership). The shareholders vote on policy issues but the decisions on company policy are left to the Board of Directors. The catch? The Board of Directors are typically elected by the shareholders. The day to day work of running the company is performed by the officers of the corporation (think CEOs and COOs). The general appeal of a C corporation is limited liability: individual shareholders are not usually responsible for the debts, obligations and actions of the company.
For federal tax purposes, a C corporation is a separate taxable entity that figures income or loss each year and pays tax on taxable income using a form 1120. C corporations are taxed at the federal level using graduated tax rates ranging from 15% to 39%. Shareholders also pay tax at their individual income tax rates for any dividends or other distributions paid out during the year. Since tax is already paid on the profits from the company, this is where the term “double taxation” comes from.
S Corporation. An S Corporation is a bit tricky because the term actually refers to a tax election. That means that another entity (a corporation, LLC or PC) is created at the state level and an election is made to be taxed as an S corporation. By federal law, S corporations have a number of restrictions: they must have only one class of stock and have a limited number of domestic (no foreign) shareholders.
S corporations are treated as pass-through entities for purposes of taxation – but not exactly like a partnership. There is a separate tax return called a federal form 1120-S which reflects some differences in the way that income or losses are treated compared to a partnership. However, like a partnership, most items of income or loss retain most of their character and are reported to shareholders in proportion to their interest, as determined either by statute or Shareholder Agreement.
Accountants and other tax professionals love S corporations when it comes to compensation for small business owners. S corporations may opt to pay out reasonable compensation to small business owners and treat the remainder that passes through as a distribution. The catch? Distributions aren’t subject to payroll taxes (Social Security and Medicare) while compensation is subject to payroll taxes. To the extent that money paid out can be characterized as distribution, the tax savings can be significant since, in a small business, the employer and employee side payroll taxes often comes from the same pot of money. But be careful: the IRS hates this arrangement and it can be an audit trigger. Compensation must be reasonable. Being greedy can land you in hot water.
There’s one more very important point: if a corporation that has elected to be treated as an S corporation doesn’t follow all of the rules, the corporation will lose its S corporation status and will be treated as a C corporation. When it comes to small businesses, in particular, this can have significant consequences.
Professional Corporation. Professional Corporations (PC) are corporations for certain occupations – typically, service professions like lawyers, doctors, architects and the like. A professional corporation isn’t allowed to branch out beyond the services for which it was specifically incorporated with the state. This means, for example, a PC for law can’t offer design services. Typically, those not licensed in the profession may not be shareholders in a PC. This rule not only applies employees but also to potential investors and family members.
While PCs may elect to be taxed as C or an S corporation, a company deemed a personal service corporation by IRS for federal purpose would be subject to a flat tax rate of 35%.
Corporation Sole. Don’t bite on this one. While promoters boast that it’s the next best thing, the IRS isn’t a fan. While there is a legitimate corporation sole organized for religious purposes in some states, scammers are selling Corporation Sole packages as a way to escape paying federal income taxes and debts. There is no such magic bullet.
There may be other corporate entity forms available for small businesses but these are the big ones. Remember that these are just the basics: some states may have variations on a theme. The best advice that I can give you is to consult with a professional before jumping in with both feet. Keep reading… figuring out your professional team is next in the series!