Tax Tip Tuesday: Business Entity Structuring

Tax Tip Tuesday

No matter where you are in the lifecycle of your business, launching, growing, maturing or declining, it is important to consider your business entity structure.  Every entity structure has both legal and tax implications that should be re-evaluated periodically.

The business structure you choose doesn’t have a lot of impact on the day-to-day operation of your business, but it is extremely important in defining ownership, limiting personal liability, managing business taxes, and preparing for future growth. As your business grows and situations change, it is imperative to reassess the structuring that makes the most sense.

For some very small businesses, working under your own name may be okay, but if you plan to earn a full-time income from the business, sign contracts, or hire employees, it’s likely in your best interest to choose a business structure and register with your state.

Let’s consider the differences between business entity types and their respective pros and cons.

Sole Proprietorship – This is the simplest business entity type to understand and is possibly the easiest way to start your business. With a sole proprietorship, you have complete control over the entire business operation. Plus, there are very few forms to file with state agencies, so your legal fees will be lower. When you pay taxes on your sole proprietorship, it’ll be done through your personal tax return. However, the one notable drawback is the unlimited personal liability. You’ll be personally liable for all business activities, debts, and liabilities in this legal structure. If something goes wrong, your personal assets and reputation will be on the line. In addition, you eliminate one way of raising funds for the business through issuing equity (i.e., stock options). This financing option isn’t available to sole proprietors.

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Pros:    No cost to start — You are a sole proprietor by default.

Easy to maintain — No ongoing registration or legal requirements to start, maintain, or shut down a sole proprietorship.

Cons:   You are personally liable for anything that goes wrong related to the business.

No tax benefits – You pay self-employment tax on all earnings and include business earnings on your personal tax return using Schedule C.

Less professional – Customer perception of being unprofessional without a legally registered business. You may also struggle to get business financing.

Partnership – If you want to go into business with someone else, there are two types of partnerships – a general partnership or a limited partnership. Both create a legal entity for the business where the interest is transferrable to other parties. A general partnership is easier to establish because it requires less form filling. Also, like sole proprietors, the partners remain liable for business activities and debt. On the other hand, limited partnerships include general partners and limited partners. Limited partners will have limited liability proportional to their investment in the business.  In addition, they are less involved in the company’s day-to-day operations. All parties must sign written agreements with limited partnerships, and certificates should be filed with the relevant authorities. Before forming a business partnership, it’s crucial that you fully understand and are satisfied with the partnership agreement because it will protect you in the future and ensure that the partnership is fair.

Pros:    Relatively easy to create.

May offer personal financial and legal liability protection.

Cons:   May not protect from all liabilities depending on the specific business structure and operations.

More complex tax requirements – Partnerships must file their own tax returns and supply additional forms to partners for personal taxes.

Corporation – A corporation is a complete legal entity, separate from its owners. You own shares in the business, which will allow you to transfer ownership or raise additional money by issuing stock. In addition, this protects you from liability. The drawbacks are that double taxation will occur, first on the business profits and then on dividends paid on shares or earnings you draw from the company.

Pros:    Extensive liability protection for owners aka shareholders who receive more legal protection.

Corporation acts as a legal person and can enter contracts and transact as its own legal entity.

Can have unlimited shareholders.

Cons:   Typically require more work and higher fees to establish and maintain.

Detailed ongoing requirements such as annual meetings, appointing a board of directors, and other state-imposed regulations.

S-Corporation – The primary benefit is that you won’t be subject to double taxation. In an S-Corp, you report your profit and loss in the company on your personal tax returns. In this structure, you must complete the same formalities as those who operate a standard corporation. Plus, you’ll be limited to the number and type of shareholders. There will also be limits on who can own the shares, restricting your fundraising capabilities.

Pros:   S Corp owners are shareholders and receive more extensive legal protection.

Corporation acts as a legal person and can enter contracts and transact as its own legal entity.

Can have up to 100 shareholders.

Cons:   More costly to establish and maintain.

Detailed ongoing requirements such as annual meetings, appointing a board of directors, and other state-imposed regulations.

Limited Liability Company (LLC) – This is a hybrid business structure between a corporation and a partnership. The business will be a separate legal entity, providing liability protection to the owners. It also allows taxes to be paid similarly to general partnerships through the business owner’s personal tax returns. In addition, there’s no limit to the number of owners, and you aren’t required to hold meetings. However, forming an LLC can be complex, requiring significant legal fees and numerous documents that you must draft and sign. This level of complexity can make it challenging to attract funding from venture capitalists. In addition, the granting of share options or convertible notes can be difficult.

Pros:    Liability protection for one or more owners when established and operated correctly.

Choice between two taxation methods – Pass-through taxation or S Corp taxation depending on which is more beneficial to owner finances.

Potential for major tax savings on self-employment taxes.

Cons:  Costs to establish and maintain due to government forms and fees to establish and maintain.

More complex tax requirements.

According to the National Small Business Association (NSBA), the following constitutes the number of each type of business structure:

  • Sole Proprietorship – 14%
  • Partnership – 3%
  • Corporation – 18%
  • S Corporation – 33%
  • Limited Liability Company – 33%

The best business structure for your company depends on your long-term goals, ownership, plans to hire employees, and legal risk. While some very small businesses and side hustles may operate safely as a sole proprietorship, most businesses are better off registering a business with their state.

Because of the important tax and legal implications, it is recommended to consult with an attorney or tax professional for advice on the best business structure for your situation.  If you would like to schedule a consult with me, contact us at 301-714-2071 or at www.SaundersTax.com.  We have been helping business owners of all entity structures experience a Less Taxing Life and More Prosperous Solutions. 

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Richard Lee Kissel obituary 1944~2023

Mr. Kissel retired from US Department of Commerce, National Institutes of Science & Technology (NIST) after 31 years of service with the Federal Government.

Mabel V Mooney obituary 1926~2023

Mabel was a homemaker throughout her life. In her free time she enjoyed bowling (in younger years), watching game shows, and playing cards.