Consultant’s Corner: Business Entity Selection
Question: “How should I go about choosing a business entity type?”
Many small businesses are structured as unincorporated sole proprietorships and General Partnerships due to their formation and maintenance simplicity and costs; however, the primary disadvantage with a sole proprietorship or General Partnership is that it is not a separate legal entity, even when it uses a trade name (also known as an assumed, fictitious business or Doing Business As (DBA) name), and the business obligations and claims of creditors are the personal obligation of the business owner. In contrast, a business entity (i.e. LLC, corporation, etc) is more difficult and costly to establish and maintain, but does offer the business owner(s) limited liability protection from the business obligations and claims of creditors.
Despite the protection a business entity can provide, many small business owners feel that there is little reason to form a business entity and operate as unincorporated sole proprietorships or general partnerships because the risks arising from the business activities are either remote or are insured with auto and homeowner’s coverage or separate policies. Though some operations may not create numerous business risks, lawsuit claims can be devastating and unpredictable; therefore, your risk assessment should include not just the business assets; but also, the amount of your personal assets.
Basically, there are no standard sales, profit, asset value, or other financial thresholds, employee headcount, or a time in business threshold when forming a business entity becomes necessary. Often a business entity is desirable when the business commences; however, if you start your business as a sole proprietorship then deciding whether to form a business entity basically comes down to assessing the level of risk the business poses to your personal assets and your personal financial situation(s) and goals. While your personal financial situation(s) and goals are a consideration and there can be an added administrative burden with a business entity, you should form an entity to house the business when you do envision possible risks to your personal assets.
LLCs and S corporations are suitable for small business owners looking for personal asset protection from business risks, but there is no one business entity that is the most advantageous in every conceivable situation. Ultimately, your long-term plans for the business and personal financial situation and goals will dictate whether an LLC, S corp, C corp or other form of business entity is the most appropriate for your business. From a tax perspective, an S corp can offer certain employment tax benefits as business income rises compared to other entity structures; however, assessing the tax benefits associated with a particular form of entity typically involves performing some “what if” scenarios with the help of a tax advisor to determine which form of entity will be the most advantageous in a particular situation. To develop a better understanding of business ownership structures and the advantages and disadvantages of different structures, see articles like these:
As discussed in the information above, the primary benefit of forming a corporation, LLC or other business entity is the limited liability protection that a business entity provides the business owners. This limited liability protection, which is also known as the corporate veil, protects a business owner’s personal assets, like a house or car, from the claims of the business creditors; however, corporate veil protection is not absolute. Under certain circumstances, the corporate veil can be pierced and business owners can be held personally liable for the business obligations. For example, third parties have shown personal wrongful conduct on the part of a corporation’s or LLC’s owners, officers, or directors and held them personally responsible by piercing the corporate veil. Personal guarantees on business debts, fraudulent, harmful or illegal actions by the business owners, business capitalization, operations and governance, and other factors can affect the corporate veil protection under certain circumstances and in certain legal matters. However, unlike a C or S corporation, an LLC cannot be pierced like a corporation and the members cannot be named in a lawsuit for failure to follow any formalities. Every business owner should be aware of the corporate veil risks so that they can structure and operate their business in a manner that preserves the personal asset protection. You can review articles on some of the advantages of incorporating at the following websites:
You can also review discussions on corporate veil protection at the following websites:
In terms of selecting a business entity, the benefits of a particular form of business entity vary based on the business ownership, operations, and long-term goals; however, when evaluating the most appropriate legal structure for a particular business, a business owner’s three main considerations are protection of personal assets, income tax liabilities, and long-term capital requirements. As to asset protection, both an LLC and a corporation (C or sub-chapter S type) are legal entities separate from the business owners that are organized and formed under state law. An S corp is basically a C corp that has elected pass-through tax treatment by filing Form 2553 with the IRS. However, an LLC is a hybrid entity that combines the limited liability protection of a corporation with the tax attributes of a partnership (multi-member) or sole proprietorship (single member). Corporations and LLCs differ in terms of legal structure, governance and tax treatment, but both S corps and LLCs offer personal asset protection and, in small companies, similar access to capital and partners; therefore, taxation is often the main difference and a deciding factor when choosing a business entity.
As for tax considerations, an LLC is unique in that it can be taxed as a disregarded entity, partnership, C corp or an S corp. Unless an LLC elects corporate tax classification by filing Form 8832 (C corp) or Form 2553 (S corp) with the IRS when it is formed, a single member or owner LLC is taxed as a disregarded entity and a multiple member or owner LLC is taxed as a partnership. A disregarded entity is taxed as a sole proprietorship when the business is engaged in active trade or business activities.
Unfortunately, there is no one business entity structure that will routinely produce the lowest overall tax burden for a business and its owners. Overall tax burden varies depending on a number of factors, including the expected business net profit, the owner’s personal income tax situations and the constantly changing tax laws; however, most small businesses are formed as pass-through entities (sole proprietorship, partnership, S corp and similarly taxed LLCs), which are subject to one level of taxation rather than regular C corps which are subject to double taxation. Pass-through entities are not taxed on their net income but instead pass their net income or loss directly through to the business owners. Owners of pass-through entities pay income tax on their share of the business net profits regardless of whether they ever take profit distributions from the business. With the C corp structure, the business pays tax on its net income and after-tax profit distributions are taxed again, generally as dividends, at the personal level.
One significant difference between the S corp structure and the sole proprietorship and partnership structures occurs with respect to the Self-Employment Tax (SE Tax). Owners of sole proprietorships, partnerships and similarly taxed LLCs pay SE Tax on their share of the business net profit, whereas owners of S corps and similarly taxed LLCs do not. Therefore, the S corp structure can offer the advantage of less SE Tax compared to a sole proprietorship, partnership or similarly taxed LLC in situations where it is reasonable to pay a salary amount that is less than the Social Security limit ($132,900 in 2019) while distributing the remainder as profits to the owners.
While owner-employees of an S corp or similarly taxed LLC can avoid the SE Tax, they generally cannot avoid paying employment taxes altogether. Owner-employees of C and S corps or similarly taxed LLCs who hold executive officer position(s) and manage the day-to-day business of the enterprise, generally need to take a W-2 salary in order to comply with the IRS “reasonable compensation” doctrine for corporate officers. This reasonable compensation requirement tends to mitigate the SE Tax advantages because W-2 salary is subject to Social Security and Medicare tax withholding and also subject to federal and state unemployment taxes.
In terms of insurance and other fringe benefits, the C corp structure offers a greater variety of fringe benefit plans than any other type of business entity. While sole proprietors, partners, shareholder-employees owning more than 2% of an S corp and members of LLCs taxed as sole proprietorships, partnerships or S corps must pay taxes on fringe benefits (such as group-term life insurance, medical reimbursement plans and medical insurance premiums), shareholder-employees of C corps generally do not have to pay taxes on these benefits. However, provided all of the IRS qualifications for claiming the self-employed health insurance deduction are met, sole proprietors, partners, shareholder-employees of S corps, and LLC members can generally deduct 100% of the cost of their medical insurance premiums, including coverage for their spouse and dependents, as an adjustment to gross income on their personal tax return, Form 1040, which tends to mitigate some of the C corp insurance benefits advantage.
While LLCs are a newer form of business entity and have a limited record of legal cases regarding asset protection and other issues, we have found the LLC structure when taxed as a sole proprietorship or general partnership adequate for many small businesses because it provides personal asset protection, pass-through income benefits, the opportunity to contribute to self-employed retirement plans, flexible ownership and income (and cash flow) allocation, and easier administration. But, you need to make the business entity decision based on your risk exposure and personal financial situation and goals. You can review additional comparisons and registration services on following websites:
The state filings and other paperwork vary by type of business entity. Once you decide on a business structure, you can form an entity yourself, through a lawyer, or with incorporation services. The least expensive method of forming a business entity is preparing and filing the paperwork yourself; however, it is generally recommended for first time filers to form a business entity through a lawyer or with incorporation services.
Due to the various legal and tax implications when starting a new or reorganizing an existing business and forming a business entity, business owners generally use local professionals (CPA, lawyer, and business insurance agent) for help in reviewing their business plans and evaluating business entities, tax, licensing, legal, and risk management issues.