Choosing of the structure of your business can be complicated. There are so many financial, tax and legal considerations that the choice of an entity should be made with the assistance of a legal professional. Too often, we find that clients have rushed prematurely into starting a business without first examining their business plans and objectives and without considering important tax and financial implications of their early business decisions.
The new business owner may only realize their mistakes until the business is already underway and change in the form of ownership or remedying tax matters is difficult. Too often, the business owner has already paid unnecessary taxes.
Or the owner may have failed to apply for necessary licenses, or to observe the necessary formalities in starting or running the business, which can result in massive tax bills or even personal liability for the debts of their companies.
But how is a new owner to choose between a corporation, partnership or LLC? Are any of these options a necessity or can an entrepreneur simply begin business without any formalities? And what are the possible consequences of this decision?
Advantages of a Sole Proprietorship
- Easy and inexpensive to form: A sole proprietorship is the simplest and least expensive business structure to establish. Costs are minimal, with legal costs limited to obtaining the necessary license or permits.
- Easy tax preparation. The business is not taxed separately, so it’s easy to fulfill the tax reporting requirements for a sole proprietorship.
Disadvantages of a Proprietorship
- Unlimited personal liability. Because the sole proprietorship is not a distinct legal entity, the owner can be held personally liable for the debts and obligations of the business.
- Hard to raise money. Sole proprietors often face challenges when trying to raise money. Because you can’t sell stock in the business, investors won’t often invest. Banks are also hesitant to lend to a sole proprietorship because of a perceived lack of credibility when it comes to repayment if the business fails.
Advantages of a Partnership
- Easy and Inexpensive. Partnerships are generally an inexpensive and easily formed business structure. The majority of time spent starting a partnership often focuses on developing the partnership agreement.
- Shared Financial Commitment. . Partnerships have the advantage of pooling resources to obtain capital. This can also be beneficial in terms of securing credit.
Disadvantages of a Partnership
- Joint and Individual Liability. Similar to sole proprietorships, partnerships retain full, shared liability among the owners. Partners are not only liable for their own actions, but also for the business debts and decisions made by other partners. In addition, the personal assets of all partners can be used to satisfy the partnership’s debt.
- Disagreements Among Partners. Partners need to consult each other on all decisions, make compromises, and resolve disputes as amicably as possible.
- Shared Profits. Because partnerships are jointly owned, each partner must share the successes and profits of their business with the other partners. An unequal contribution of time, effort, or resources can cause discord among partners.
Advantages of a Corporation
- Limited Liability. When it comes to taking responsibility for business debts and actions of a corporation, shareholders’ personal assets are protected. Shareholders can generally only be held accountable for their investment in stock of the company.
- Ability to Raise Capital. Corporations have an advantage when it comes to raising capital for their business through the sale of stock.
- Corporate Tax Treatment. Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits are awarded a corporate tax rate, which is usually lower than a personal income tax rate.
Disadvantages of a Corporation
- Double Taxation. The net profits of corporations are taxed twice – first, the corporation pays tax on this net based on the corporate tax rate. And the amounts paid to shareholders as dividends are not a tax deduction for the corporation. So, these amounts are taxed again—on their individual tax returns, the shareholders pay taxes on dividends paid to them by the corporation.
- Limited Protection. In order for shareholders to have limited liability, the corporation must be properly “capitalized.” The corporation must have sufficient capital to justify its treatment as a separate entity. The amount of insurance carried by the corporation can be an important factor in this determination.
- Additional Paperwork. The corporation has additional start-up costs and must file a separate tax return each year. As a separate structure, corporations require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws.
Advantages of an S Corporation
- No Double Taxation. First there is no double taxation as there is with an ordinary corporation. The S corporation does not pay taxes—it’s net profits are passed through to shareholders who report and pay taxes on the net.
- Other Tax Savings. While a sole proprietor or members of an LLC and are subject to employment tax on the entire net income of the business, only the compensation for services paid to the S Corp shareholder are subject to employment tax. The remaining income is paid to the owner as “distributions,” which is not subject to employment tax.
- Furthermore, some expenses that shareholder/employees incur can be written off as business expenses. The tax savings achieved by S corporation owners is often more than sufficient to offset the need for additional formalities and paperwork
Disadvantages of an S Corporation
- Shareholder Compensation Requirements. A shareholder who works for the S corporation must receive “reasonable compensation” for services rendered. If the S corporation pays an artificially low salary and thus pays higher amounts as “distributions,” IRS may reclassify the distributions as wages, resulting in higher taxes.
Advantages of an LLC
- Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members’ personal assets are usually exempt.
- Operational Ease . An LLC’s operational ease is one of its greatest advantages. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity.
Disadvantages of an LLC
- Limited Life. When a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways.
- Operating Agreements. Because the structure is flexible, LLC’s need to carefully consider how they want their company to be formed and to operate. LLC’s need an “operating agreement” setting out exactly all of the various relationships and responsibilities of the members and manager. Such an agreement should be drafted by a legal professional in almost all cases.
- Self-Employment Taxes. Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.
Combining the Advantages of an LLC with an S Corp
There is always the possibility of requesting S Corp status for your LLC. Your attorney can advise you on the pros and cons. You’ll have to make a special election with the IRS to have the LLC taxed as an S corporation.