Welcome to the Business Entity Guide presented by TRUE NORTH BOOKKEEPING. One of the most critical steps you can take to set your business up for success is selecting the right type of business entity. This guide will help you understand the pros and cons of the most common business structures. However, always consult with your tax accountant to determine the best structure for your business, considering factors like the type of business, your long-term goals, desired shareholders, and any state or local laws.
A sole proprietorship is an unincorporated business with a single owner. If you start a business by yourself and do not register as a different business entity, you are generally considered a sole proprietorship. The pros of this entity type include low setup cost, easy dissolution, and less paperwork than other entities. It also offers pass-through taxation and no annual filings aside from a personal tax return. However, this structure does not offer personal liability protection (unlimited liability for owner’s assets), and earnings are subject to self-employment taxes. Moreover, all debt will be personally guaranteed.
A partnership is formed when two or more people agree to perform a trade or business, divide the profits and losses, and do not incorporate. The pros of this entity type include pass-through taxation for partners and limited liability protection (depending on the partner type and the partnership structure). A partnership agreement can also offer flexibility in how partners split profits and losses. On the downside, partners in a general partnership have unlimited personal liability, and critical business decisions must be agreed upon with other partners. It is also recommended to have a partnership agreement reviewed by legal counsel. Lastly, an annual information report must be filed.
LLC (Limited Liability Company)
An LLC is a structure that generally offers limited liability protection paired with pass-through taxation. Pros include limited liability protection for owners’ personal assets and pass-through taxation for owners (depending on how the LLC elects to be taxed). This entity type also offers flexible options to elect how the business will be treated for tax purposes. However, piercing the corporate veil can lead to a loss of liability protection. The formation of an LLC has higher costs than a sole proprietorship, and states may have annual reporting requirements or franchise taxes. Lastly, transferring ownership might be difficult.
An S corporation is a tax classification for a business that has elected to pass-through income, losses, deductions, and credits to a shareholder’s tax return. Pros include avoiding double taxation on corporate income, offering limited liability protection, and reducing owners’ self-employment taxes. This entity type also allows the use of the cash method of accounting. On the downside, to be taxed as an S-Corporation, one must file with the IRS. Other cons include a limit of 100 shareholders, only one class of stocks, and ineligibility for certain corporations. Annual tax return filing is necessary, and states may have annual reporting requirements or franchise taxes. Reasonable compensation for shareholder-employees must be considered, and some states do not recognize this structure.
A C corporation is a tax classification for an entity that elects (or defaults) to be taxed under Subchapter C. The income of a C corporation is subject to tax at both the corporate and personal level. Pros include limited liability protection for shareholders, raising funding through stocks, no limit on the number of shareholders or who can own shares, and easy transfer of ownership through stock sales. However, this entity type is subject to double taxation (first at the corporate level on income, then at the shareholder level on dividends). It must also file an annual tax return and adhere to stricter regulatory requirements based on their state.
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