Preface: Choosing the right business entity structure is a complex task. Work with knowledgeable advisors when forming or restructuring your business
Business Structure
Your businesses legal structures is the most important tax decision your business will make. Reorganization is complex. Whether you are starting a business or buying an interest, make sure your business is appropriately advised with choosing legal structure.
The most common legal structures for business are:
- Sole proprietorship
- Limited Liability Company (LLC)
- Partnership
- Corporation
Sole Proprietorships
A sole proprietorship is the simplest business structure to setup and to liquidate. A sole proprietorship reports it tax on the Schedule C with the proprietors personal 1040 tax filing. Sole proprietorships do not have the liability protection afforded to LLC’s or corporations. So with a proprietorship, you have unlimited risk for both debts and liabilities incurred with business activity. Proprietorships while maybe functional for a roadside stand are not advisable for businesses with operation risks, i.e. the trades, or services businesses. Why? Simply because there is a lack of liability protection. Sole proprietorships will have the lowest cost tax compliance costs of any business structure, but also the most risk.
Partnerships
A partnership is business structure with two or more partners. General partnerships are similar to sole proprietorships, but the tax attributes are divided among the partnership. Limited partnerships (LP) provide limited liability, defined as partnership equity, to the limited partners. General partners have unlimited risk. Often limited partnerships are applicable to investment real estate businesses or other passive, low risk investments. Partnerships allocate i) how management decisions will be made, e.g. general partner; ii) profit, loss, capital sharing; and iii) partner interests bought or sold. Partnerships have a partnership agreement outlining these agreed to terms. Partnership taxes pass-through from the partnership tax return on a K-1 to the partners taxed on the partners’ individual tax filing.
Corporations
A corporation is a legal entity that bifurcates the legal liability from management. There are two types of corporations – C-Corporations and S-Corporations. C-Corporations are the regular form of corporate structure, but are uncommon in today’s tax environment for small businesses, because of the double taxation on profits, i.e. once on income, and again on distribution of income. In a C-Corporation officer wages cannot be excessive because it would avoid the double tax on distributions. This is the opposite of S-Corporation below market wages.
S-Corporations are the more common form of corporate structure today for small businesses, and provide the pass-through of tax earnings similar to a partnership while providing liability protection to the shareholders. S-Corporations require adequate, higher vs. lower, officer compensation because FICA tax is not assessed on earnings as in a partnership.
Limited Liability Companies
LLCs feature corporate protection with the tax structure of a sole proprietorship, partnership, and corporation. Owners of limited liability companies are called members. LLCs provide flexibility in tax structure, such as a change from partnership to corporation tax benefits with minimal overhead. Only understand that a transfer from corporation back to partnership may have prohibitively costly tax consequences.
Summary:
Business structure is important. Retain knowledgeable advisors when forming or restructuring your business to avoid costly mistakes and minimize taxes, because choosing the optimal entity structure is the most important tax decision you will make for your business.