Which entity is right for your business?
What’s a Business Entity?
A business entity means you have created an organization to do business.
You’ve heard of LLCs and Corporations, right? Those are examples of business entities. The main differences between the two, and all the other entities, is how your business is recognized legally and how it pays its taxes.
So, let’s dive into all the different types of business entities and how they affect you from a legal perspective, a tax perspective, and an overall business perspective. We’ll also give you the pros and cons for each entity!
Unlike other entities on this list, you don’t need to register or do anything special to become a sole proprietor. As soon as you launch your business, you’re all set.
If you want, you can apply for a free Employer Identification Number (EIN) from the IRS if you prefer not to use your Social Security Number, but it’s not required unless you hire employees.
Pros of Sole Props
- They’re insanely easy to set up because there is no set up. The cost to start it is also nothing or almost nothing, which is much different from an LLC or corporation.
- The cost of owning and maintaining a sole proprietor is almost nothing, if not nothing. You won’t have any annual reports due to the state or annual fees to pay like with an LLC.
- Tax filing is simple because your business’s income tax liabilities pass-through to you (a.k.a. a pass-through entity), which means you can deduct business expenses and pay your tax bill all on your personal tax return.
- Also because you’re a pass-through entity, your income is only taxed once, when it’s earned.
Cons of Sole Props
- There’s no true separation between your business and yourself, which means you’re responsible for everything. You know, liabilities, debts, lawsuits. Ouch.
- Your self-employment tax will be calculated on all of your profits. This can get really expensive and make it hard to retain wealth and scale.
A partnership is when two or more people come together to own and operate a business. Instead of having to do everything on your own and keeping 100% of the profits, partnerships allow you to team up to share the workload and profits.
When most people think of partnerships they’re really thinking of multi-member LLCs (an LLC with more than one owner) and the two are sort of one in the same. For this post, we’re going to talk about actual partnerships, not MMLLCs. (You can read more about LLCs later on in this post.)
There are two types of partnerships: General partnerships and limited partnerships.
- General partnerships: Just like a sole proprietorship, with a general partnership, you don’t need to register your business with your state, or do anything else to get started. You and your partner could technically run your business together on a handshake (but we highly recommend having a professional draft up some paperwork, anyway). In this situation it’s likely that you and your partner would register for a DBA for your partnership. Don’t forget an EIN, too!
- Limited partnerships: You must register your limited partnership with your state. With limited partnerships, you and your partner can be general partners (equally sharing all the business liabilities) or you can bring on silent partners, a.k.a. investors who are limited partners without much say in the business.
Pros of Partnerships
- For general partnerships, they’re easy to set up similar to sole proprietorships.
- For both types of partnerships, you’re taxed as a pass-through entity so your income is only taxed once, when it’s earned. Although, you are required to file your annual partnership tax return (Form 1065) to report your finances to the IRS. Form 1065 is separate from your personal taxes. The partnership will issue you a K-1 showing your portion of the partnership’s taxable income and losses that you’ll use to report the income on your personal return.
- Partnerships have a lot of flexibility in how the income, losses and distributions can be allocated. You can be 50/50 partners with someone but get 30% of any income and 80% of any loss (or whatever combination you choose as long as it has a basis other than tax avoidance).
Cons of Partnerships
- For general partnerships, it’s the same as sole proprietorships. You and your partner(s) are on the hook for everything.
- For both types of partnerships, the general owners can be liable for debt. This can even fall on the silent partners (in a limited partnership) if they get too active in the business.
- Your self-employment tax will be calculated on all of your profits.
A C-Corporation (or C-Corp) is the first of two types of corporations we’ll cover. A C-Corp is 100% its own business entity with limited liability for the owners. The owners are referred to as shareholders. Corporations have a board of directors and officers to run the business.
A Corporation is a separate entity. They are treated as people and they can sue and be sued. The only difference between corporations and people is that corporations don’t ever have to die. (emo much?) Even if the shareholders pass away or the board of directors change, a corporation can live forever. With this type of entity you will have liability protection.
Pros of C-Corps
- You can be the only shareholder or you can have multiple shareholders without being personally liable.
- Your corporation can have unlimited shareholders.
- You can sell stock and raise money for the business.
- C-Corps have more control over self-employment tax and can generally deduct more expenses than any other business entity on behalf of its shareholder-employees owning more than 2% of the business.
Cons of C-Corps
- C-Corps have lots of hands on deck (you know, the shareholders, board of directors, and officers), so you’re tasked with holding shareholder and board meetings, creating bylaws, and blah, blah, blah.
- C-Corps are expensive to establish, plus you have to keep in mind the maintenance bills like legal, filing, and license fees.
- The dreaded double taxation. C-Corps are not flow-through entites like the others we’ve looked at so far. The income is taxed once at the corporation level and then again if/when the profits are distributed to the shareholders. This is the main reason why most small businesses are not C-Corps.
S-Corp (short for S-Corporations) are the second type of corporation and our personal favorite. It gets its name because the tax law governing S-Corps is from subchapter S in the Internal Revenue Code (yawwnnn). So, technically, your S-Corp is a C-Corp…the only difference is how S-Corps are taxed.
Like, C-Corps, S-Corps are their own business entity, which means you and/or your shareholders have limited liability for the business’s debts and shit. The best part? No double taxation, either!
Pros of S-Corporations
- S-Corps have the potential to save big during tax season compared to Sole Proprietors and Partnerships because they allow you more control over your self-employment taxes, and this tends to result in a lower tax bill.
- No double taxation!!! The S-Corp is taxed as a pass-through entity so your income is only taxed once, when it’s earned. Although you are required to file a separate tax return for the S-Corporation (Form 1120S and this is separate from your personal taxes. The S-Corp will issue you a K-1 showing your portion of the corporations taxable income and losses that you’ll use to report the income on your personal return.
Cons of S-Corporations
- S-Corps, like C-Corps, come with more red tape and are a bit more serious. If you don’t keep up with your bookkeeping, you’re probably not going to be happy as an S-Corp. They take time and effort to maintain. Pro Tip: Hire someone to do it for you.
- Maintaining your S-Corp can get expensive.
- You’ll need to pay yourself a reasonable salary via payroll…which also increases the cost of your compliance.
- S-Corps can be complicated to dissolve because you need the approval of every shareholder or director on the board to do so.
- You can only have 100 shareholders.
Limited Liability Company (LLC)
LLCs are a hybrid business entity. That’s because when you form an LLC, you (and any owners, a.k.a. members of your LLC) get to choose how you want to be taxed. You can be taxed as a corporation or as a pass-through entity.
To be frank, the act of forming an LLC doesn’t give you any extra abilities or deductions. The main perk of LLCs is if shit hits the fan, your personal stuff might be safe. This is why most people jump to form an LLC over anything else—and we don’t blame them!
Members of an LLC will have limited personal liability for the debts and liabilities of the business.
LLCs can be considered as the “check-the-box” entity. That means LLCs don’t actually have their own identity. LLCs take on whatever form you give it when it comes to taxes and you don’t give it a form, it defaults depending on how many members there are in the LLC.
If it’s just you, the default tax treatment is sole proprietor and if there’s at least two owners, then the default tax treatment is a partnership.
Pros of LLCs
- They’re fairly easy to setup and simple to dissolve.
- They have a lot of flexibility in the sense that they have various ways they can elect to be taxed.
Cons of LLCs
- If you don’t elect to have your LLC taxed as a corporation, the self-employment tax can possibly be higher than with S-corps or C-Corps.
What is Limited Liability?
One of the major differences between the entities above is how they handle liability. An exception to the limited liability rules above is if you “pierce the corporate veil.” This means if you’re…
- Commingling funds (a.k.a. using your business checking account for personal expenses and vice-versa)
- Not actually running a legitimate business (the LLC is a sham, you don’t have a business account, you don’t create invoices, and you don’t act like a business in any which way besides having an “LLC”)
- Or you’re taking on debt knowing that you’re just going to use it for personal reasons before you try to get off scot-free
…you will be liable. No number of LLCs or corporations in the world can save you.
What if You Don’t Choose a Business Entity?
You might not need to right now. Check out this post we wrote forever ago: Do I Need an LLC Right Away?
If you’re forming an LLC or an S-Corp because you think you need to in order to be eligible for tax deductions, it’s not true. You are still eligible for the same deductions whether or not you create an LLC or a corporation.
When you don’t incorporate your business into a business entity at all, you’re essentially operating as a sole proprietor. You’re on the line, personally, for everything. And you’re in the same tax situation as if you were a sole proprietor or LLC.
If you choose not to form a business entity, everything gets easier. You don’t need to invest any money into forming an entity. You don’t need to open a separate business account in order to stay compliant (although you should keep your personal and business funds separate, anyway).
How you choose to do business will affect your financial situation. If you aren’t sure where to start, definitely speak with an attorney or an accountant.
Please reach out, we’d love to help!
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Countless assumes no liability for actions taken in reliance upon the information contained herein.