A question we frequently hear from entrepreneurs and business owners is, “How should I structure my business for tax efficiency and business operations?” But one size does not fit all. The answer is dependent mostly on your goals for the company.
There are essentially four options to structure your business:
- A traditional C-Corporation
- An S-Corporation
- A Partnership/LLC
- A Sole Proprietor
Each entity has its own advantages and disadvantages regarding tax efficiency, types of owners and vulnerability of personal assets to creditors. Here’s a short rundown:
Sole Proprietorship
This is one of the simplest forms of business, but subjects you to the most risk. Owners have direct and sole control in the business making decisions. There is no separation of personal and business affairs. Raising capital may be difficult as banks typically depend on prior-year income to dictate the conditions of any loans, becoming stricter for businesses just getting started.
The tax return is filed with the business owner’s own personal return with a form Schedule C, mitigating the financial burden of filing a separate tax return for the business. Income is subject to the taxpayer’s ordinary income tax rates, with an additional 15.3% for self-employment tax (Social Security and Medicare) on the net business income. One-half of the self-employment tax is deducted to arrive at adjusted gross income on the personal income tax return.
Partnership/LLC
Partnerships can be as simple as a handshake between two entrepreneurs. A General Partnership gives all partners unlimited liabilities. A limited partnership requires at least one partner to manage the day-to-day activities, known as the General Partner, making them susceptible to unlimited liability. The remaining partners are passive investors with no part in management. Limited Partners still receive certain rights, such as voting about important issues.
An LLC requires more paperwork. You must file Articles of Incorporation and pay a fee with the state. LLCs must also file annual reports disclosing any changes in location, ownership or operations. LLCs are similar to a Limited Partnership as all partners receive limited liability.
If a member of an LLC dies or files bankruptcy, the LLC will dissolve. An advantage of a Limited Partnership is that a majority of remaining partners could vote to keep the business alive rather than terminate. Be aware that not all 50 states have a uniform treatment of an LLC. For example, some states limit the type of entities that may register as such, which can cause confusion for multi-state operations.
The form 1065 tax return is filed and partners receive form K-1 dictating their share of income or losses based on ownership percentages. Partners are provided guaranteed payments for services rendered or capital contributed rather than wages. Income is flowed through and taxed at the individual level at ordinary income tax rates.
For members active in day-to-day operations, the guaranteed payments and income from the partnership are subject to self-employment tax. General partners can use losses to offset other ordinary income. Any limited partner’s income will not be subject to self-employment tax, but is treated as passive. Passive losses may only offset passive income for tax purposes. Shareholders may take distributions in any manner partners agree.
S-Corporation
Incorporating as an S-Corporation becomes a bit more formal. Owners are required to file incorporation documents with their respective state, but not every state recognizes S-Corporation status. These states will tax the entity as a C-Corporation, meaning there will be double taxation. Shareholders are limited to 100 and they may only be U.S. citizens, U.S. residents and certain types of trusts.
S-Corporations are flow-through entities with income taxed at the individual level, but income retained by the corporation is not subject to the 15.3% self-employment tax like a sole proprietorship or partnership. Owners are required to take a “reasonable” salary based on the industry’s norm, with 2% shareholders being susceptible to taxability of various fringe benefits such as health insurance.
S-Corporations give shareholders limited liability, but also allows all shareholders to actively participate in the business. Owners are only liable for the capital they contributed into the corporation. It is important to separate personal and business assets so as to not “pierce the corporate veil” subjecting business debts to personal liability. Shareholders receive a form K-1 for their respective share of income and losses. Distributions, to the extent there are any, must be in proportion to ownership percentage to avoid termination of the S-corporation election.
C-Corporation
C-Corporations are similar to S-Corporations as the incorporation needs to be filed with their respective jurisdiction. Unlike other entities, owners’ personal assets are completely segregated from the assets of the corporation. Owners will typically take a salary as a form of payment. Form 1120 is filed and income is currently taxed at a flat 21% at the corporate level. Distributions are allocated to owners as taxable dividends. These dividends are taxed a second time at the individual level (double taxation). The tax rate depends on whether they are deemed ordinary or qualified; the maximum rate is 37% for ordinary and 20% for qualified.
With the incoming Biden administration, a new tax code change may be in the works. If implemented, the corporate tax rate of 21% will increase to a flat 28%. A minimum tax on corporations with book income over $100 million would also be incorporated. It would be structured similarly to an alternative minimum tax. This may make incorporating as an S-Corporation more favorable tax-wise depending on the threshold of income that would flow through to owners. The maximum individual tax rate would increase from 37% to 39.6%.
Weighing your options
A partnership must have at least two partners. A general partnership gives all partners unlimited liability, a limited partnership provides limited liability to all except at least one partner, and an LLC offers limited liability to all. Partnership entity type will be contingent on what capacity all partners are to be involved. Partnerships are more favorable for situations where you may not make consistent revenue, allowing you to take distributions as needed.
S-Corporations are more advantageous when revenue is more consistent. It gives owners the capability to take an annual salary, with distributions complementing any additional funds needed by the owners. A corporation provides the most division of personal and business assets as courts are able to “pierce the corporate veil” of S-Corporation, leaving shareholders susceptible to some type of limited liability.
Your choice of entity depends on your individual situation and plans moving forward. I would argue that most businesses begin as a sole proprietor — they have an idea and turn it into a profitable situation. Once they start buying assets and investing more into the business, it may be a good idea to incorporate as an S-Corporation. Soon enough, the company will be electing C-Corporation status and will be taken public with an Initial Public Offering.
All things being equal, it is important to have trusted advisors behind you at every stage of your business. At Magone & Company, our advisory services can help you select the best alternative based on your goals. We can also assist in implementing strategies to make the most tax-efficient choices.