How to Choose Your Business Entity and Why It Matters
By Kyle D. Winey, Esq. and Robert Showers, Esq.
(SS Quarterly 2018 3rd Quarter)
You are looking to launch a business, but where do you start? There are so many options. You hear that many people use LLCs. Others suggest subchapter S corporations. But are those the best choices for you? Does it even matter?
Answer: choosing the right business entity matters. A lot.
Our discussion below provides guidance on how to minimize taxes, avoid liability, and position your business on the best legal and financial ground possible by analyzing the most commonly-used entities. Please note, however, that this is general guidance. The facts and circumstances of each business require specific legal advice. Here are some options:
Entity #1: Sole Proprietorship.
A sole proprietorship is the most basic, simple, and common business structure.[1] Under a sole proprietorship, one person serves as the sole owner and operator of a business. Upon conducting business, sole proprietorships form automatically under the law, unless the business owner takes steps to form a different business entity. While no official registration is required to form a sole proprietorship, often local business permits are necessary to lawfully operate. Common examples of sole proprietors include freelancers, consultants, authors, and other professional services.
Pros of a Sole Proprietorship:
- Easy to start with no registration required;
- No corporate formalities (e.g. meeting minutes, bylaws); and
- Easily deduct most business losses on personal tax return using a Schedule C.[2]
Cons of a Sole Proprietorship:
- The biggest downside is that sole proprietors are personally liable for all business debts and liabilities, meaning in a lawsuit, personal assets (e.g. car, bank accounts, house) are exposed;
- Since there is no real separation between a sole proprietor and the business, it’s often difficult to receive a business loan, and especially, outside investment; and
- Obviously, taking on investors or partners is more difficult, if not impossible, as the term “sole proprietorship” connotes.
Entity #2: C-Corporation.
C-corporations are structured to operate as an entity independent from the company’s owners. The owners are called “shareholders,” and the company is managed by a Board of Directors and officers. Compared to other entities, C-corporations are subject to more regulations and tax laws, which can be complicated.
Pros of a C-corporation:
- Shareholders do not have personal liability for the business’s debts or liabilities;
- C-corporations are eligible for more tax deductions than any other business entity;[3]
- C-corporations pay lower self-employment taxes;[4] and
- Investors, including venture capitalists, almost always expect an entity to be formed as a C-corporation, because LLCs and S-corporations are difficult to invest in.
Cons of a C-corporation:
· C-corporations are somewhat expensive to create relative to sole proprietorships or even LLC’s (filing fees range from $100 to $500 based on which state you’re in);
· C-corporations face double taxation, which means that the company pays taxes on profits at the company level (first tax), and then shareholders personally pay taxes on dividends (second tax);
· Shareholders cannot deduct business losses on their personal tax returns; and
· C-corporations are subject to a host of corporate formalities, including adopting bylaws, raising stock, holding initial and annual director and shareholder meetings, and keeping meeting minutes with corporate records – each requiring significant paperwork.
S-Corporation
Similar to a C-corporation, an S-corporation retains the benefit of limited liability. However, different from an C-corporation (and better), an S-corporation is a pass-through entity for tax purposes. So, just like a sole proprietorship, profits and losses pass through to the owner’s personal tax returns, which means that there’s no taxation at a company level. In other words, under an S-corporation, profits and losses are taxed only once and the business owner receives the benefit of limited liability.
Pros of an S-corporation:
· Shareholders do not have personal liability for the business’s debts and liabilities; and
· Unlike a C-corporation, there is no double taxation, as S-corporations are “pass-through” entities.[5] Pass-through taxation means that no income taxes are assessed at the business level. Instead, profits and losses are “passed-through” to the owner’s personal tax returns. That means a business owner pays taxes once, rather than twice (individual level and business level).
Cons of an S-corporation:
- Similar to C-corporations, S-corporations are more expensive to create and maintain relative to sole proprietorships (filing fees are often $500, depending on the state);
- Also similar to C-corporations, shareholders must comply with corporate formalities, including adopting bylaws, raising stock, and holding meetings; and
- The IRS prohibits more than 100 shareholders, and each shareholder must be a U.S. citizen or resident. That means, if you are raising money from investors, an S-corporation is probably not an option. Why? Most venture capitalists and outside investors invest by using a separate entity (e.g. LLC, corporation), and do not invest in their individual capacity. It is just too risky. As a result, if you have organized yourself as an S-corporation and try to raise money, you will likely encounter significant problems.
In order to organize as an S-corporation or convert your business to an S-corporation, you have to file IRS form 2553. S-corporations can be a good choice for businesses that want a corporate structure and seek the tax flexibility of a sole proprietorship or partnership.
Limited Liability Company (LLC)
In general, LLCs blend together positive attributes from the other business entities. Similar to corporations, LLCs offer limited liability protection. Similar to S-corporations, LLCs are pass-through entities. That means LLC owners receive the favorable pass-through treatment and limited liability – just like an S-corporation. But there is one more benefit: LLCs also have less paperwork and ongoing requirements, and in that sense, they are more like sole proprietorships and partnerships.
Pros of an LLC:
· Owners do not have personal liability for business debts or liabilities;
· There are not the corporate formalities that accompany S-corporations and C-corporations, which means that LLCs are relatively easier and cheaper to operate; and
· Unlike an S-corporation, an LLC can issue different classes of securities, which can be held and invested in by people or entities who are not U.S. citizens.
Cons of an LLC
· Compared to sole proprietorships, LLCs are more expensive to create and maintain (but less expensive than S-corporations and C-corporations);
· It is much harder to grant equity in LLCs relative to S-corporations or C-corporations, so many investors will not invest in LLCs;
· Converting an LLC into a C-corporation can be complicated and expensive (usually a merger or complete dissolution and creation of a new entity is required).
Implications of the Trump Tax Plan
Congress, under The Tax Cuts and Jobs Act—which you might know as the Trump Tax Plan—made two main changes that impact legal entities:
- C-corporations are subject to a flat 21% corporate tax rate, a significant cut from the previous 35% corporate tax rate.
- Owners of pass-through entities can deduct 20% of business income on their personal income tax returns. These include owners of sole proprietorships, S-corps, and LLCs that have elected pass-through tax status.
In light of these changes, many wonder if they should convert their businesses to an LLC or a C-corporation. The answer: it can be a tradeoff. Choosing the 21% flat tax rate of a C-corporation may be lower than your personal tax rate, but choosing this option means that you lose the 20% deduction of the pass-through entities (e.g. LLCs, S-corporations). In many cases, when solely comparing these tax advantages, one entity is often not necessarily better than the other.
Bottom Line:
For virtually all business owners, we recommend that you choose some business entity, rather than operate as a sole proprietor. Choosing between an LLC and an S-corporation is typically the first place to begin. However, depending on your needs, a C-corporation may make the most sense, especially if you have many employees with benefits. What is certain is that there is no one best business entity for everyone. But there is a best business entity for you based on your unique situation. Call us to figure out what that is and we can help you optimize your business strategy from a legal and tax perspective.
Sources:
Adamczyk, Alicia. “What Is a ‘pass-Through’ Business and Why Is It Favored in the Tax Bill?.” December 19, 2017. https://twocents.lifehacker.com/what-is-a-pass-through-business-and-why-is-it-favored-i-1821422829.
Berkman Solutions. “Trends in New Business Entities: 30 Years of Data.” March 08, 2018. https://www.berkmansolutions.com/trends-in-new-business-entities-30-years-of-data.
Cohen, D. (2014). Do More Faster: TechStars Lessons to Accelerate Your Startup. Wiley & Sons Canada, Limited, John.
Guidant Financial. “10 Tax Benefits of C Corporations.” June 6, 2018. https://www.guidantfinancial.com/blog/10-tax-benefits-of-c-corporations/.
Incorporate.com. “Self Employment Taxes.” Accessed July 25, 2018. https://www.incorporate.com/self_employment_taxes.html.
IRS. “Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship).” Accessed July 25, 2018. https://www.irs.gov/forms-pubs/schedule-c-form-1040-profit-or-loss-from-business.
Prakash, Priyanka. “Types of Business Entities: Pros, Cons, and How to Choose.” June 19, 2018. https://www.fundera.com/blog/business-entity.
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Disclaimer: This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers, LLP expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum. Please contact H. Robert Showers, Esq. or Kyle Winey, Esq. at kdwiney@simmsshowerslaw.com for legal advice for nonprofits and businesses that will meet your specific needs.
[1] “Trends in New Business Entities: 30 Years of Data,” Berkman Solutions, March 8, 2018, https://www.berkmansolutions.com/trends-in-new-business-entities-30-years-of-data.
[2] “Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship),” IRS, accessed July 25, 2018, https://www.irs.gov/forms-pubs/schedule-c-form-1040-profit-or-loss-from-business.
[3] “10 Tax Benefits of C Corporations,” Guidant Financial, June 6, 2018, https://www.guidantfinancial.com/blog/10-tax-benefits-of-c-corporations/.
[4] “Self Employment Taxes,” Incorporate.com, accessed July 25, 2018, https://www.incorporate.com/self_employment_taxes.html.
[5] Alicia Adamczyk, “What Is a ‘pass-Through’ Business and Why Is It Favored in the Tax Bill?” December 19, 2017, https://twocents.lifehacker.com/what-is-a-pass-through-business-and-why-is-it-favored-i-1821422829.
