Proprietorship. Partnership. S corporation. Limited liability company. C corporation. Which form is best for your new business? The decision can be difficult. Each business form offers you both advantages and disadvantages.
Proprietorships and Partnerships
A sole proprietorship is a simple and inexpensive way to begin operating a business. Unless you operate the business under a name other than your own, generally no legal documents or forms need to be filed other than any licenses or permits required by your state or local government. As the sole proprietor, you have complete control over the business. However, a sole proprietorship is limited to one owner. So, if you have multiple owners, or expect to in the near future, a sole proprietorship isn’t right for you.
With a sole proprietorship, business income is reported on your personal federal income-tax return and taxed at personal income-tax rates rather than corporate rates. If your business is a partnership, it must file a partnership return, but your allocable share of the business’ income, losses, deductions and credits passes through to you to be reported on your personal tax return.
One of the greatest disadvantages of a sole proprietorship or partnership is that as the owner or general partner, you are personally liable for all obligations of the business. Creditors of the business can go after your personal assets if the business assets are not sufficient to cover the business’ debt liabilities.
Incorporating your business generally limits your personal liability for business obligations, but generally involves greater start-up and operating expenses, as well as added paperwork. A corporation is a distinct legal entity that is responsible for paying its own debts and obligations. Shareholders risk only the loss of the funds they have invested.
S Corporations. With an S corporation, income, losses, deductions and credits pass through to you and other owners to be reported on your federal tax returns just as they do with a partnership. Thus, S corporation income generally is taxed only once. Businesses operating as S corporations must meet several special requirements. For example, an S corporation cannot have more than one class of stock outstanding nor more than 100 shareholders. (A husband and wife are considered one shareholder.) Additionally, a nonresident alien is prohibited from owning S corporation shares. Also, unlike other business forms, it cannot selectively allocate income and deductions.
Limited Liability Company. As an alternative to incorporation, consider operating your business as a limited liability company (LLC). For the most part, forming an LLC is simpler and involves less paperwork than incorporating your business. Like a corporation, an LLC provides owners with protection from personal liability for business debts and obligations.
However, most LLC owners can choose to have their businesses treated as partnerships for federal income-tax purposes. Partnership treatment means that income, losses, deductions and credits pass through to the individual owners (called “members”) to be reported on their individual income-tax returns, so LLC income is not subject to double taxation. Partnership tax treatment also permits an LLC to specially allocate income and expenses among its owners to the same extent that a partnership can.
Keep in mind that for tax years 2018-2025, a proprietorship, partnership, S corporation and limited liability company (not taxed as a C corporation), there may be up to a 20% deduction available for qualifying taxpayers from their “qualified business income.” Your financial advisor, working with your CPA, can determine if you are eligible for this deduction.
C Corporations. A C corporation is taxed separately from its owners at corporate tax rates. This can result in double taxation. Corporate income may be taxed once to the corporation and again to the shareholders when it is paid out as dividends or the corporation liquidates. The corporation cannot deduct these dividend payments. However, it can deduct reasonable compensation paid to you and other owners. So, small corporations often pay out all or most of their net income to the owners as compensation, especially if the owners’ top personal tax rate is lower than the corporation’s rate. (The top federal personal rate is 37% in 2021, while the corporate federal tax rate is 21% in 2021.)
Choosing the right business form for your business isn’t an easy decision. For additional information and assistance in making your choice, contact your professional financial advisor.