by Michael Whitacre, tax partner at BDO USA, LLP
Closely-held businesses seem to thrive off of entrepreneurship, and according to a recent Forbes article, the five personality traits that define most entrepreneurs are passion, resilience, a strong sense of self, flexibility and vision.
Unfortunately, knowing how to properly structure a business entity is more closely linked to pragmatism than the next big idea. If you’re struggling to navigate through the alphabet soup of corporate entity options, here is a brief introduction to how Limited Liability Companies (LLCs), C and S Corporations work.
Sole Proprietorships and General Partnerships
The two most common default business structures are sole proprietorships and general partnerships. In a sole proprietorship, there is only one owner, while a general partnership consists of two or more owners. From a tax perspective, both entity types are considered pass-through, meaning that the net income generated from the business is allocated to the owner or owners and then taxed as individual income.
Many startups may be tempted to go this route as a result of how simple and easy it is to create these types of business entities. However, with simplicity comes high risk to the individual owners.
C and S Corporations, as well as LLCs, on the other hand, are more formal ways of structuring a business entity. Similar to a sole proprietorship or general partnership, an S Corporation is taxed as a pass-through entity, but allows the owners’ personal assets to be protected against business liabilities.
However, protection comes at a price, as S Corporations are subject to additional regulatory rigor. For example, these entities are required to file an Article of Incorporation or a Certificate of Incorporation with the state of incorporation. Additionally, the IRS requires a Form 2553 be filed in order to elect S Corporation status. The S Corporation is then responsible for paying all filing fees annually. There are also ownership restrictions and compliance rules that must be adhered to, or else the corporation runs the risk of losing its designation for legal purposes.
C Corporation business structures are attractive to larger companies. They offer a great deal of protection and ownership flexibility but must contend with the issue of double taxation: C Corporations must pay taxes on their profits at whatever the corporate tax rate is (the current range is between 15-35 percent), while dividends distributed to shareholders are also taxed on personal income tax returns.
Limited Liability Companies
LLCs look and feel like corporations: they face similar filing fees and regulations. However, they are unique in that they can choose to be taxed as a corporation or a pass-through entity and have ownership flexibility.
Forming your business entity comes with many real-life implications, and it is important to understand how the different entity structures will impact your tax obligations, personal liability and overall business conduct. Putting time and resources against making an informed decision doesn’t sound like such a bad idea, especially when it could mean the difference between success and failure.
Material discussed is meant to provide general information and should not be acted on without professional advice tailored to your firm’s individual needs.
Photo Credit: John Patrick Robichaud via Flickr