Choosing the right business entity is one of the most important decisions entrepreneurs make when launching or restructuring a business. The type of entity selected affects how the business is taxed, its administrative complexity, and who may be held personally liable for company debts and obligations.
Important: This article focuses on tax and regulatory compliance issues. For detailed guidance on liability protections, consult your legal advisor.
Whether you’re starting a new venture or evaluating your current structure, understanding th tax implications of each entity type can help you make informed decisions. However, every business situation is unique. Here’s a quick look at five common business structures and how they differ when it comes to taxes, paperwork and compliance.
- Sole Proprietorship: Simplicity with Personal Responsibility
A sole proprietorship is the simplest and most common form of business ownership. It’s an unincorporated business owned by one individual, requiring minimal setup and administrative effort.
Tax implications: A sole proprietorship isn’t taxed separately. Instead, the business’s profits and losses are reported on the owner’s personal tax return using Schedule C of Form 1040. This “pass-through” taxation means the business income may be subject to personal income tax rates and self-employment tax. Although the maximum ordinary income tax rate for individuals is currently 37%, owners of certain pass-through entities may be entitled to a special tax break under current law. (See “Do You Qualify for the QBI Deduction?” below.)
Paperwork and compliance: Sole proprietors may have to register a business name and secure applicable licenses. Aside from that, there’s little administrative burden. However, the owner is personally liable for all debts and legal actions, which increases financial risk.
- Partnership: Shared Responsibility and Pass-Through Taxation
As the name implies, partnerships are formed when two or more people agree to run a business together. There are several types, including general partnerships, limited partnerships and limited liability partnerships, each offering varying levels of liability protection.
Tax implications: Like sole proprietorships, partnerships don’t pay income tax at the entity level. Instead, the partnership files an informational return on Form 1065. And the partners receive Schedule K-1s showing their share of profits and losses to report on their tax returns. Taxes are based on each partner’s allocable share of the partnership’s income, whether distributed or not. Only general partners are subject to self-employment taxes.
Paperwork and compliance: Partnerships require a written agreement, and partners must coordinate to manage responsibilities, finances and legal matters. Accurate bookkeeping is essential to determine each partner’s share of income and tax liabilities. Partnerships are more administratively complex than sole proprietorships. However, converting from a sole proprietorship to a partnership is a strategic move typically driven by growth, collaboration and/or the need for more resources. With the right structure and documentation, it can position the business for greater success and resilience.
- LLC: Flexibility and Liability Protection
A limited liability company (LLC) blends the administrative simplicity of a sole proprietorship or partnership with the liability protection of a corporation (discussed below). Owners are known as “members,” and an LLC can be structured as a single-member or multimember entity.
Tax implications: By default, a single-member LLC is taxed like a sole proprietorship, and a multimember LLC is taxed like a partnership. Both are considered pass-through entities. However, an LLC can elect to be taxed as a C corporation or S corporation by filing Form 8832 or Form 2553, respectively, with the IRS. This flexibility allows business owners to strategize their tax treatment.
Paperwork and compliance: LLCs require articles of organization and an operating agreement. While the compliance burden is lighter than corporations, LLCs still must adhere to state-specific regulations and annual reporting requirements.
- S Corporation: Tax Savings Potential with Restrictions
An S corporation is a special tax designation available to qualifying domestic corporations and LLCs that meet certain requirements. It allows profits, and some losses, to be passed through directly to owners’ personal income tax returns without being subject to corporate-level taxes.
Tax implications: S corporations avoid double taxation. The entity itself isn’t taxed; instead, income passes through to shareholders, who report it on their individual tax returns. Similar to a partnership, taxes are based on each owner’s allocable share of the corporation’s income, whether distributed or not.
Additionally, shareholders who are employees must receive a reasonable salary, which is subject to payroll taxes. Remaining profits may be distributed to shareholders. These distributions aren’t subject to self-employment tax and can be used to pay shareholders’ tax obligations.
However, S corporations must adhere to several rules. For example, they must have 100 or fewer shareholders, all of whom must be U.S. citizens or residents, and they can issue only one class of stock.
Paperwork and compliance: S corporations require incorporation at the state level and must file Form 2553 to elect S corporation status. Ongoing compliance includes maintaining corporate formalities, such as holding shareholder meetings and maintaining meeting minutes. They must also file an annual informational return (Form 1120-S) and issue Schedule K-1s to shareholders.
- C Corporation: Best for Large Growth-Oriented Businesses
A C corporation is a legal entity separate from its owners. It offers the strongest liability protection and unlimited growth potential through stock issuance.
Tax implications: C corporations are subject to double taxation. That means the corporation pays tax on its income using Form 1120, and shareholders pay personal income tax on any dividends and capital gains. The current federal corporate tax rate is 21%, and the current maximum federal income tax rate on long-term capital gains and dividends is 20%. The 3.8% net investment income tax may also apply.
While double taxation can be a drawback, C corporations may allow for more tax-deductible benefits (such as health insurance and retirement plans) and can retain earnings for reinvestment without passing income through to owners.
In addition, C corporations are subject to complex accumulated earnings tax (AET) rules. In general, the AET rules kick in if a C corporation retains earnings beyond the reasonable needs of the business, rather than distributing them as dividends to the owners.
Paperwork and compliance: C corporations face the most rigorous requirements. They must draft bylaws, hold annual meetings, keep minutes, and comply with both state and federal reporting rules. However, the structure is ideal for businesses seeking external investment or planning to go public.
Once You Add Employees
No matter what type of entity, the tax, paperwork and compliance requirements increase once you add employees. For example, the business or owner will be required to obtain an Employer Identification Number from the IRS. Federal and state income and payroll taxes must generally be withheld from employee paychecks. And there are additional requirements attached to employee benefits.
The Right Entity for You
These are only the basic rules. Other requirements apply. When it comes to choosing an entity type, there’s no one-size-fits-all answer. The right choice depends on your business goals, growth plans, number of owners and financial circumstances. For example, a sole proprietorship may be sufficient for a freelance consultant, while a C corporation may be more appropriate for a start-up planning to raise venture capital.
Tax strategy plays a pivotal role in this decision. Electing S corporation status or forming an LLC with specific tax treatment can optimize your tax liability, but only if structured correctly. Before making changes to your business entity, contact us to analyze the tax and compliance implications. We can work with your legal advisor to determine the optimal setup for your situation.
