Which entity type is best for your business? The answer to this question depends on your current business status, your business goals, and the best way to maximize tax savings. The answer can also change depending on where your business is at in terms of growth. For example, as you launch a new business, one entity type may be best, like an LLC. After several years of operations, however, another entity type, like a C-corporation, may be a better choice.
In this article:
- A sole proprietorship, general partnership, and LLC are all pass-through entities that allow your business to avoid corporate taxation.
- An LLC protects the personal liability of members, while a sole proprietorship and general partnership do not.
- A C-corporation is the best option for attracting outside investors. It is the most common entity type, requiring a rigid structure and corporate tax payments.
Sole Proprietorship
What is a sole proprietorship?
A sole proprietorship is a pass-through entity for a business with only one owner. Generally, contractors and freelancers choose to operate as a sole proprietorship due to its low setup costs.
How is a sole proprietorship taxed?
The business entity itself is not taxed; all profits and losses pass through to the business owner’s personal tax filings, using Schedule C of your personal tax return. Sole proprietors can, however, deduct certain business expenses in order to lessen their tax obligation.
How do you form a sole proprietorship?
Set up for a sole proprietorship requires little cost and effort.
In fact, the only requirement is to register your DBA (“doing business as”) name with your state, if operating under a business name other than your own name.
You can also apply for an EIN (Employer Identification Number, also known as a Federal Tax Identification Number) if you don’t wish to use your personal SSN on paperwork, like W9 forms. Applying for an EIN is free and can be done online through the IRS.
What are the pros and cons of a sole proprietorship?
With the least amount of paperwork and fees, a sole proprietorship is the easiest business entity to form. In fact, even if a business owner doesn’t apply for an EIN or operate under a business name other than their own, they are still considered a sole proprietorship by the IRS.
However, as a sole proprietorship, the owner has unlimited personal liability for the business. This means that all business debts are the responsibility of the business owner. The owner’s own personal assets could be at risk for seizure and sale by creditors in order to meet any business debt obligations.
General Partnership
What is a general partnership?
A general partnership is a flexible pass-through entity allowing for an unlimited number of partners. Partners have equal management rights of the business, unless they’ve listed out an alternative management structure in the General Partnership Agreement.
How is a general partnership taxed?
Like sole proprietorships, a general partnership is a pass-through entity. Each business partner will report a share of profits and losses on their individual tax returns. Certain business expenses can be deducted to reduce personal tax obligations. The business itself faces no taxation.
How do you form a general partnership?
To form a partnership, you’ll need the following:
- EIN
- DBA Name
- General Partnership Agreement
You will register your DBA name through your state. You can apply for an EIN for free online through the IRS.
The General Partnership Agreement should clearly outline the management structure and responsibilities of each partner to avoid future disputes.
What are the pros and cons of a general partnership?
Partners assume all liability and are responsible for any debts incurred. Additionally, partners each pay self-employment taxes.
Some partners choose to form a Limited Liability Partnership. This means that while all general partners remain responsible for business debts and obligations, the business can also have limited partners. These limited partners, as long as they are not actively involved in the day-to-day management of the business, are only responsible for the amount of financial investment they’ve made in the business.
Limited Liability Company (LLC)
A best-of-both-worlds approach, a Limited Liability Company (LLC) protects you from personal liability while also avoiding double taxation as a pass-through entity.
What is an LLC?
Business owners are referred to as “members” of an LLC. You can operate a sole-member or multi-member LLC, with an unlimited number of members allowed. Its relatively low-cost filing fees, flexible structure, and fewer regulations make it a great option for many small business owners.
How is an LLC taxed?
All profits and losses are passed through to the members; the business itself is not taxed. For a sole-member LLC, you are taxed like a sole proprietorship, using Schedule C of your personal tax return. A multi-member LLC is taxed like a general partnership, using Form 1065.
Since members of an LLC are taxed like a sole proprietorship or general partnership, members can deduct certain business expenses from their tax return.
In certain cases, you may wish to elect to be taxed as an S-corporation or C-corporation.
How do you form an LLC?
Depending on which state you file in, you’ll file an Articles of Organization or a Certificate of Formation. Fees vary by state. You’ll also apply for an EIN.
An operating agreement — which designates how the business will be managed — is not required by most states, but we highly advise all LLCs to create one.
What are the pros and cons of an LLC?
Unlike sole proprietorships and partnerships, an LLC protects you from business debts or lawsuits, while still offering the benefit of avoiding double taxation as a pass-through entity. This does mean, however, that you’ll pay self-employment taxes on your income since you are not a W-9 employee of the business.
An LLC does not allow for stock options and can only apply for business loans through banks. If you’re looking to attract outside investors, a C-corporation may be a better option for you.
C-Corporation (C-CORP)
What is a C-corporation?
A C-corporation is your classic corporate entity with the ability to offer stock options. Public corporations offer stock options to the general public, while private corporations do not.
How is a C-corporation taxed?
A C-corp faces double taxation. This means that the company pays corporate taxes on its earnings at both the state and federal level. A corporation reports income, gains, losses, deductions, and credits to the IRS using Form 1120, known as the U.S. Corporation Income Tax Return.
Shareholders, likewise, pay taxes on any dividends received.
A C-corp may also file to be taxed like a S-corp, allowing the corporation to avoid double taxation, though there are several limitations to this option.
How do you form a C-corporation?
Documents and filings for C-corp formation can include:
- Registered business name
- Articles of Incorporation
- EIN (filed with Form SS-4)
- Licenses and Certificates, depending on your particular business type
- Sales tax license (if selling products; not all states require this)
- Stock certificates
Filing fees vary by state. While you can form a C-corp directly with your own Secretary of State, we recommend working with lawyers to ensure your C-corp is set up properly.
What are the pros and cons of a C-corporation?
A C-corp is the best entity type to attract outside investors, allowing for an unlimited number of shareholders and no limits on stock classes. Shares can either be held privately or offered to the general public.
A C-corporation requires a rigid structure. C-corps must have a board of directors and corporate officers. The board maintains overall management responsibility, while corporate officers oversee day-to-day management.
Transparency is key with a C-corp. A meeting for shareholders and directors must be held at least once a year, with minutes kept. Voting records, as well as a list of owner names and percentages, must also be kept.
Choose the best business entity that aligns with your goals.
You don’t have to choose the best business entity on your own. Whether you’re starting a new business or have been operating for years, work with Landmark CPAs to choose the business entity that best aligns with your goals.