Business entities: Choosing the appropriate structure
Subscriber Benefit
As a subscriber you can listen to articles at work, in the car, or while you work out. Subscribe Now
Starting your own business isn’t for the faint of heart. One item that causes much consternation is how to structure your new business from a legal and tax standpoint. Here are some of the more common business entity types and the benefits and downsides of each.
Entity Options – What Do I Choose?
Sole-Proprietorship. The most common and least complex structure is the sole-proprietorship. The ‘sole-prop’ is tailored to companies with one owner. They are easy to set up (you can use your social security number as your business ID), carry little to no cost to establish, and do not require a separate tax return. As the single owner, you have complete control of the company and keep all profits.
Partnerships. Partnerships share similar traits to sole-props in that they are easy to administer and inexpensive to create. They also provide flexibility regarding business income as the allocation of profits does not need to be handled proportionately. This is beneficial in cases where a silent partner (one who provides capital but isn’t involved in the day-to-day) is a key company member. Both the sole prop and partnerships are deemed ‘pass-through’ structures as the net income recognized by the company is taxed on the owners’ tax return and not at a corporate level. While both entities carry pros, there are some glaring drawbacks.
For Consideration:
- Neither entity provides personal liability protection. This implies that the owners and the business are one-and-the-same. Thus, the owner(s) personal assets are not protected from creditors.
- Raising capital is also a difficult endeavor. You cannot sell stock to raise funds, and banks often are hesitant to lend to these small business types.
- Another major disadvantage is FICA taxes which are comprised of taxes for Social Security and Medicare. Net profits (less the deductible portion of self-employment taxes) will be taxed at 15.3% (12.4% for SS up to IRS limits; 2.9% for Medicare).
S-Corporation. What options are available if you desire liability protection and a single-taxation pass-through structure? Enter the S-Corp (it’s important to recognize that an S-Corp, contrary to sole-props and partnerships, is NOT a business structure, it is a tax election).
- Once you have filed as a corporation (by default, all corporations are C-Corps), you must file for S-Corp status with the IRS to establish this election.
- An S-Corp provides that protective barrier that isolates all business debts to your business itself and insulates personal assets.
- Also, as an S-Corp, you are technically an owner-employee, meaning the compensation you receive can come in two forms: a salary and distributions of net income. Why is this important? As stated above, all net income from sole props and partnerships is subject to FICA. With an S-Corp, only the salary you pay yourself is subject to FICA.
For example, Joe’s Tacos (a sole-prop) has net earnings of $100,000, which is taxable income to him. In conjunction with those taxes, his self-employment taxes will amount to $14,130 ($100,000 of net earnings less the deductible portion of self-employment tax (7.65%) x (15.3%)). Conversely, if Joe is an S-Corp, he could pay himself a salary of $60,000. As an S-Corp, Joe only has to pay FICA taxes on his salary, which amounts to $9,180. The remaining $40,000 of profits would only be subject to income taxes.
So why not just elect S-Corp status and take ALL income as distributions? Well, the IRS is keen on that strategy and determined that you must pay yourself a ‘reasonable salary’ (what one would pay if you hired someone for that same position) so as not to use the S-Corp as a tax avoidance workaround.
While the S-Corp carries many positive attributes, it does come with its share of cons:
- S-Corps require a fully legal setup, which results in increased costs as you will usually need the services of a lawyer and an accountant.
- In addition, profits and distributions must be allocated according to ownership, removing some of the partnership flexibility.
- There can be no more than 100 shareholders, all of which must be US citizens or legal residents.
- You can also only have one class of stock. Thus, there can be no preferred shareholders.
Limited Liability Company. The LLC (Limited Liability Company) is a hybrid of sorts as it provides the ease of establishment and maintenance similar to that of sole props and partnerships while providing personal liability protection comparable to an S-Corp.
- The LLC is a legal entity only, meaning it is not a taxpaying business structure, and you can choose which tax arrangement is suitable for your business. By default, single-member LLCs follow the sole-prop tax structure, while multi-member LLCs mirror partnerships.
- You can also elect to be taxed as an S-Corp for your LLC. Remember, an S-Corp is simply a tax election. This means it can provide additional flexibility on payment structure and subsequent taxability.
Summary
The decision on how to structure your business can be an arduous process. If this process becomes too cumbersome, consider speaking with your financial advisor to get their input and loop in an attorney when needed. Taking the time to work through the benefits and drawbacks of each structure can yield better results for your business.
Mathew Ryan, MBA, CFP, EA is a Financial Planning Specialist with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Mathew at mryan@bedelfinancial.com.