Business entities come in several flavors but they are not all the same. You cannot just close your eyes and point. Instead, you need to take several factors into consideration when selecting a business entity. You want to get this right.
We all have to deal with the Internal Revenue Service, and your small business is no exception. Depending upon your business entity, you could personally be responsible for taxes, or you might even find yourself double taxed.
Here are some specifics:
- Sole proprietorship – since the single owner and the sole proprietorship are one and the same; the owner pays taxes on the sole proprietorship’s profits.
- Partnerships – A partnership does not have to pay income tax. Rather, the business will pass through its profits or losses straight to its partners. Then the partners will include their respective share of the partnership’s income or loss on their personal tax returns.
- Corporation – Corporations have to pay state and federal taxes, and they sometimes also have to pay local taxes. This will include paying income taxes on profits (the opposite of partnerships and sole proprietorships have to do). A corporation can end up paying taxes twice: first when it makes a profit, and the second time when dividends go to the shareholders.
- S Corporation – an S corporation is often a good choice for tax savings purposes. The members of an LLC have to pay an employment tax on the entire net income of the business. However, only the wages of any S corporation shareholder who is also an employee are subject to employment tax. Any remaining income is payment to the owner as a distribution. Distributions are taxed at a lower rate, if at all.
- LLC – an LLC is not a separate entity according to the IRS, so it isn’t taxed. Instead, the members pay individual taxes.
2. Legal Liability
If your employee gets into a car accident while on the job, does your company have to pay part of any settlement or verdict? Do you have to pay, out of your own pocket? What if your employee commits sexual harassment and your company is the subject of a lawsuit? What if your employee commits a felony, like homicide, while on the job? What if your employee breaks federal law, such as mail fraud?
The different business entities expose owners to differing degrees of legal liability. Let’s get a look at the details:
- Sole proprietorship – there are no limits at all to personal liability. If the sole proprietorship did it, then so did its one owner. You are responsible for all debts and obligations, and that includes any risks from actions of employees. Essentially, you, the sole owner, equal the company.
- Partnerships – Partnership owners retain full, shared liability. Therefore, partners are not only liable for their own actions. They are also liable for any business debts and decisions made by the other partners. Furthermore, all of the partners’ personal assets can be seized to satisfy the partnership’s debt. If you end up in a bad business partnership, and your partner doesn’t pay the rent and instead gambles away the money at the tables in Vegas, you might have to foot the bill with your own money to cover the rent.
- Corporation – Within a corporation, the shareholders’ personal assets have protection. Shareholders can usually just be held accountable for their investment in the stock of the company. However, if your employee commits fraud or a felony under your direction, the corporate ‘veil’ can be ‘pierced’, and your personal assets can be on the line. The obvious remedy against this is: don’t tell your employees to commit fraud or felonies.
- S Corporation – An S corporation shareholder’s personal assets, just like their personal bank accounts, cannot be seized for the purpose of satisfying any business liabilities, such as verdicts against the company.
- LLC – LLC members have protection from personal liability for the business decisions or actions of the LLC. Therefore if the LLC incurs debt or becomes the subject of a lawsuit, the members’ personal assets are usually exempt. But not always, hence the term ‘’limited liability’.
3. Costs and Shares
These are really up to you when it comes to selecting a business entity. No matter which business entity you choose, know the facts going into it. Here are some details:
- Sole proprietorship –you are the company. If it makes money, so do you. Of course you need to pay rents, salaries for any employees you might have, taxes, etc. But your share is 100%.
- Partnerships –partner shares vary, and they should be clearly spelled out in the partnership agreement. You do not have to split everything evenly, particularly if one partner wants to only be on the sidelines. In that instance, you might want a limited partnership, where one (or more) partner steps back and has limited liability, but also limited decision-making capabilities.
- Corporation – a corporation is run by its board of directors, which are usually (although not always) also the owners. Ownership stakes are defined by what percentage of stock everyone owns. If one person has a controlling interest (over 50% of the stock), then their decisions will generally overrule everyone else’s. If the shareholders have smaller stakes in the corporation, then sometimes shareholders will band together in order to influence decisions or even kick board members out. Profits are generally distributed per the share percentages, although board members can take a salary.
- S Corporation –In this species of corporation, a shareholder working for the company must pay him or herself reasonable compensation. The shareholder has to get fair market value, or the IRS may reclassify any additional corporate earnings as wages.
- LLC – An LLC is another type of corporation and the only real difference is liability rather than shares and costs, so it works like other corporations.
The bottom line, quite literally, is that you need to decide what is best for you. Want lower taxes? Then you probably want an S-Corporation or a partnership. Want to shield yourself from liability? Then you probably want some form of corporation. Want to have control? Then either keep a controlling interest in a corporation or partnership, or stay a sole proprietorship. Want more profits? Then it can be tossup, depending on how successful your company is.