This article is for individual who are considering opening a business or changing their business entity and are looking for a basic overview of the major types of business entities. To find the best fit for your situation, however, we recommend talking with your financial planner, lawyer and CPA.
When you own and operate your own company, selecting a business entity to establish it under is an important step to ensure your personal assets are protected and your tax advantages are maximized. Identifying the right entity for you requires you to evaluate your future goals for your business as well as its current and projected financial health. To start the conversation, we’re going to go briefly cover four entity types and discuss some common advantages and disadvantages to help you consider your options.
This is the go-to for many self-contained business owners. Since they have no employees and hold the power to make all business decisions, sole proprietors are required to follow very few formalities including mixing business and personal assets. There’s very little in the way of setting up a business as a sole proprietorship and owners do not have to pay unemployment tax on themselves. The laid-back entity does have its drawbacks though. Because personal and business assets can be co-mingled, owners face unlimited personal liability for their business. Business profit is paid as personal taxable income. There are also limitations on sole proprietorships for future growth. Interest cannot be sold to investors and sole proprietorships rarely successfully change hands. While this may be the most simplest of entities, sole proprietors should consider the risks and limitations to ensure their futures are protected.
Ideal for service businesses with low-overhead and start-up costs, S Corporations offer limited liability for its owners and income splitting potential. For small business owners filing as an S Corporation, they have the opportunity to save thousands of dollars in taxes and the ability to deduct losses on personal tax returns. However, it is important to note that for top earners, distributions will be taxed at a higher rate on the personal level. Growth is also capped at 100 shareholders. While this is more robust than a sole proprietorship, S Corporations are not suited for all business types and the overall tax savings need to be considered alongside the company’s long term potential.
Unlike S Corporations, the number of shareholders is not capped which sets this entity up as a great option for business owners projecting for growth. Personal liability is also minimized by keeping the business’ legal obligations separate from the owners and individuals affiliated with the business. Taxes for C Corporations have a downside. For starters, losses cannot be deducted on personal tax returns. Net profits are distributed to shareholders as dividends and ultimately are reported as taxable income on their personal returns in addition to being taxed at the business level. That’s right, revenue is taxed twice.
Limited Liability Corporation (LLC)
This is a form of partnership where two or more owners have agreed to share in the profits and may pass on those profits (and losses) flexibly between each other without taxation. Personal liability of the owners is also protected. This formal arrangement has a fairly easy setup and only requires an informational tax return. While a business continuation agreement is required for a succession plan after a partner dies, the agreement also allows for fluid transfer of interests between owners. The overhead on a LLC is also higher compared to a sole proprietorship, often requiring owners to pay unemployment taxes for themselves and commingling of personal and business assets are not allowed.
While you may feel motivated to get the ball rolling and quickly choose a business entity, properly and thoroughly researching your options and how your company would potential evolve as such entity is worth slowing down for. Your financial planner can help you with your evaluation by discussing the individual tax advantages, protections, and limitations of each would apply to your thriving business. If you would like assistance, we welcome you to reach out to WorthPointe and continue the conversation.
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