Choosing the Right Business Entity: A Look at Tax Implications and More
Karima ElKis, CPA
There are many things to consider when starting a business. One of the most important decisions is choosing the right business structure.
The choice of business entity often depends on the specific goals of your organization and how you intend to optimize revenue through effective tax planning strategies. From sole proprietorship to corporation, each entity type brings unique tax implications and considerations.
Sole Proprietorship
A sole proprietorship is owned by one person, with no formal structure or governance required. Income is reported on Schedule C of IRS Form 1040, and there are no separate filings needed for the entity. While Schedule C simplifies tax filing, the business owner is responsible for both the employer and employee portions of self-employment taxes, totaling 15.3% (12.4% for Social Security and 2.9% for Medicare), excluding federal income taxes. Even if taxable income is zero, self-employment taxes may still apply.
This filing is ideal for small businesses with low income and high expenses but may become less advantageous as income increases, at which point an S-Corporation might offer better tax benefits. The major downside of a sole proprietorship is that the owner is personally liable for the business’s debts and legal obligations.
Partnership
A partnership is owned by two or more individuals who share in the profits and responsibilities. Partnerships typically file Schedule K-1 (IRS Form 1065) to report each partner’s share of income, deductions, and credits. They are usually not taxed at the entity level unless they elect to be treated as a C corporation. Partners generally have equal ownership and decision-making power, with major decisions requiring unanimous approval. A key disadvantage is that partners are personally liable for the business’s debts and legal obligations. Examples include small professional firms and businesses like retail stores or restaurants.
Limited Partnership (LP)
A limited partnership consists of one or more general partners who manage the business and bear unlimited liability, as well as one or more limited partners who have no management role but enjoy limited liability. In most cases, a certificate of limited partnership must be filed with the state, and each state has its own requirements for such filings. General partners are personally liable for business debts, while limited partners’ liability is restricted to their investment.
This structure is often used in high-risk ventures such as hedge funds and real estate.
Limited Liability Partnership (LLP)
An LLP is a type of partnership where partners elect limited liability status, typically through a simple filing with the state. This structure shields partners from personal liability of debts and obligations of the LLP. Examples of LLPs include large law firms, accounting firms, and other professional service firms.
Limited Liability Company (LLC)
An LLC is a hybrid entity that combines the limited liability benefits of a corporation with the pass-through taxation structure of a partnership. LLCs are formed by filing articles of organization with the state, and while they do not pay taxes at the entity level, income is passed through to the members, who report it on their personal tax returns.
Unlike corporations, LLCs have more flexibility in their governance, and the operating agreement outlines the management structure. LLCs are a popular choice for their simplicity, flexibility, and protection from personal liability.
Corporation
A corporation is a more traditional business structure where ownership is divided among stockholders. The stockholders elect a board of directors to oversee the business, and the board appoints officers to handle day-to-day operations.
Stockholders generally have limited liability, and the corporation is a separate legal entity that is taxed independently from its owners. Corporations can opt to be taxed as an “S Corporation,” which allows income to pass through to the stockholders for tax purposes, avoiding double taxation. However, an S Corporation is subject to specific restrictions, including a limit on the number of shareholders, shareholder types, and stock classes. In contrast, a “C Corporation” has no such limitations but faces double taxation: income is taxed at the corporate level, and dividends are taxed again when distributed to shareholders.
Summary
Each of these entity types offers distinct advantages and disadvantages, depending on the desired level of liability protection, tax treatment, and organizational flexibility. It’s advisable to consult with a tax professional or a business advisor to understand the tax implications and make an informed choice. To reach out to a Louis Plung & Company advisor, email [email protected].
