The entity you chose for your business determines several things about the way you process payroll. There are four standard entities for businesses. There are a few others for specific and unique circumstances and businesses such as medical practices, but, the four following entity types make up the vast majority of business entities. We are going to list some of the advantages and disadvantages of each but recommend that before you commit to one or another that you may want to consult with an attorney who is conversant with business entities as well as an accountant and your tax advisor.
A corporation is an entity of the State. That is it is created under state law and is regulated and taxed by the State of formation. It can operate in other states and countries but it is formed under the law of a particular State.
A corporation is a business entity that is owned by a shareholder or shareholders, that is to say, people who own shares of stock. The shareholder or shareholders elect a board of directors to oversee the corporation’s actions and hire executives to run the day to day operation. In many cases in small business corporations, the shareholders, the board of directors, and the officers are the same people. The corporation is liable for the actions and finances of the business, the shareholders are not.
There are two standard classifications of corporations.
Subchapter C or C-Corp corporations, which pay taxes as an entity, and Subchapter S corporations or S-Corps, which are pass-through entities.
C- Corp Advantages
- Limited Liability The companies’ creditors cannot seize the owners (shareholders) personal assets to pay company debts like they can in a sole proprietorship.
- Perpetual Life: A Sole proprietorship ends with the death of the owner. A corporation continues to exist with the death of a shareholder the shares pass to whoever the shareholder has designated or is controlled by State law.
- Transfer of Ownership. A shareholder can easily sell or transfer their share without restrictions unless there is an agreement to the contrary. An LLC member has to get consent from other members to sell or transfer interest.
- C Corps are better vehicles for investment. C-Corps are better to handle outside investors providing equity investment. Some investors will be unable to invest in an S-Corp or an LLC because of their entity form. Also for an IPO, the 100 shareholder restriction with an S-Corp is not sustainable.
- Corporate Law Is Well-Established. Corporations are the oldest non-sole proprietor formal entity and the laws concerning them are well established and codified. The laws concerning LLCs are still being worked out in the various States.
- Complexity. The C-Corp has a number of requirements and laws that are in place to protect the shareholders from malfeasance including meeting notices and record-keeping requirements.
- Double Taxation. One of the ongoing complaints about the law on C-Corporations is they pay taxes as an entity and then dividends to the shareholders are taxed again at the personal level.
S corporation advantages include:
- Limited liability for the shareholders. The companies’ creditors cannot seize the owners (shareholders) personal assets to pay company debts like they can in a sole proprietorship.
- Pass-through taxation. An S corporation does not pay federal taxes at the corporate level. Business income or loss is “passed through” to shareholders who report it on their Form 1040 Federal Income Tax Return. Business losses in the S-Corp can offset other income the shareholder may have.
- Tax Advantages. The shareholder may take some of the income as distributions that are not taxed for self-employment taxes.
- Sale of Shares. A shareholder can sell his shares without the complex adjustments that may need to be made in a partnership.
- Cash method of accounting. S corporations usually can use cash basis accounting unless they have inventory.
S corporation disadvantages
- Startup Expenses. There are costs in forming a corporation. The State in which the corporation is formed will require paperwork and fees. An election will also have to be made with the IRS to obtain S-Corp status.
- Ongoing Fes and Taxes. Most States require ongoing fees and or taxes for allowing the corporation to exist.
- Tax Filings. The S-Corp must file an IRS Form 1120S Corporation Tax Return with the IRS every year. There may be additional State filings as well. Plus unlike a sole proprietorship or partnership, the shareholder who works in the corporation will be required to take compensation and file all employment tax returns
- Calendar year. An S corporation must adopt a calendar year for its tax year unless it can obtain special approval from the Commissioner of the IRS to use a fiscal year.
- Stock restrictions. An S corporation can have only one class of stock and has limits on the number and type of shareholders.
- Taxable benefits. Many of the fringe benefits provided by an S-Corp are taxable to shareholders that hold more than 2% of the stock.
The standard general partnership is an entity where two or more people combine money, assets, skills, and other resources. The partners then share the profits and/or losses in accordance with the agreement between the partners. If there is no agreement then the assumption is that the partners share equally. General partners are personally responsible for all the liabilities that the partnership incurs.
A Limited Partnership will have at least one General Partner and one or more Limited Partners. Limited Partners have no liability for liabilities of the Partnership except for what they have invested in the Partnership which is at risk.
A Partnership pays no taxes. The gains and/or losses are “passed through” to the partners. Form 1065, which is the Federal Partnership Tax Return, will have a form K1 for each partner. The K1 will be used to report the Partnership earnings/losses on the shareholder’s personal tax returns.
Advantages of a Partnership
- Partners bring different skill sets enhancing the ability to bring knowledge to bear on the business situations.
- Multiple partners may well have access to investable money that one partner might not. Also, multiple partners have advantages borrowing money as lenders have more than one person to look to.
- Business opportunities. Multiple partners may well have access to opportunities and channels of distribution to a greater extent than a single person would have.
- Having a partner(s) to share the responsibilities, labor, decision making, and other business activities as well as being able to handle the business when another partner is on vacation or sick can have a positive impact on stress.
- Having a partner brings different points of view to a business situation allowing blind spots to be reduced and different outlooks to be included in the business. Hopefully resulting in greater success.
- A general partnership does not pay taxes the income or loss is passed through to the partner’s individual Form 1040 Federal Tax Return. This allows for a single point of taxation as opposed to C-Corps double taxation and allows business losses to offset other personal reportable income for the partners.
Disadvantages of a Partnership
- Liabilities The partners are personally responsible for the liabilities the partnership creates. This could result in losing your bank accounts, assets, and even your home from liabilities created in the partnership even if you did not make the decisions.
- You have partners who are also owners and who may want to, have a right to, have a say in the business, and how it is operated. This is vastly different than be a sole proprietor and running the whole show. If you are a control freak this might be a real problem
- Getting out. If your partner does not want to sell the whole business you may not be able to. There may be clauses in the partnership agreement that restrict when and to whom you can sell. You may also find if your partner sells his interest with a new partner that may not be someone you can or want to work with.
The sole proprietorship is the simplest entity in which to operate a business. A sole proprietorship is not a separate legal entity. It just denotes an individual who owns and operates a business. A sole proprietor is personally responsible for all of the liabilities of the business they operate. The sole proprietorship is a popular entity in that it is simple, cheap, and easy to setup. Simply go into business in many cases without anything other than doing business.
Since a sole proprietorship is just its owner, taxation is simple. The sole proprietor reports all of their income and expense on a Schedule C of their Form 1040. Self-employment taxes are calculated on any gain and are equivalent to employment taxes that they would pay, if on the payroll.
Advantages of a Sole Proprietorship
- A sole proprietor has sole and complete control over every legal aspect of their business
- A sole proprietor can sell or transfer ownership of his business at his sole discretion at any time for any remuneration he wants
- Reduced paperwork. A sole proprietor has no corporate or other documents to file. No separate tax return for the business
- The cost of forming a sole proprietorship may be as little as zero depending on the business and the State where it is formed.
- Many of the formalities, paperwork, forms, and other details are not required of a sole proprietorship.
Disadvantages of a Sole Proprietorship
- The sole proprietor is personally responsible for all of the liabilities that the business creates. As well as any liabilities that an employer may create.
- The sole proprietor makes every decision and has complete responsibility for all aspects of the business.
- Investors usually won’t and in fact, may not be able to invest in a sole proprietorship.
An LLC is a hybrid entity. If you do nothing, the LLC is treated as a disregarded entity for general tax purposes. If there is one member (owner), it is treated as a sole proprietor for tax and payroll purposes. If there is more than one member it is generally treated as a partnership for tax and payroll purposes.
An LLC can elect to be treated as an S-Corp or a C-Corp for tax and payroll purposes. The election is made on IRS Form 8832 — Entity Classification Election.
LLC advantages include:
- Creditor protection. Members are not personally liable for the LLC’s liabilities
- Flexibility in organizational control, The LLC offers the ability to structure distributions in a fashion that is not lockstep with ownership. For instance, a member who brings cash to the formation may be entitled to a greater share of the profits until the investment is paid back.
- Fewer documents and fewer formalities. The LLC is not currently burdened with the regulations and laws governing C-Corps in particular for shareholder protection.
- Built-in transfer restrictions. The LLC agreement will many times spell out when and possibly to whom ownership may be transferred protecting the rest of the members from unwanted outsiders.
LLC disadvantages include
- Additional transaction costs to create. The LLC is a creature of the State and the State will want paperwork and fees both at the origination and ongoing to maintain the protected status of the LLC
- Built-in transfer restrictions. These restrictions are an advantage in some situations and may well be a disadvantage in others preventing a member from freely selling his interest to a willing buyer.
- Usually additional costs of creation. LLCs are in many cases more expensive to set up. An agreement has to be crafted to that all originating member s will sign. A corporation runs for a standard set of rules
Your legal and financial advisors can walk you through all of the complexities and help you select the best entity for your needs. But you need to make the decision and not let someone talk you into a particular entity based on their wants, needs, and fees; and not yours.