How do I choose what entity type my business should be?
We are often approached by startups and existing small businesses with questions about what entity type they should be. Even when we are not asked, we often ask why they are the entity type they have chosen to make sure they have a reason. Choosing your entity type really crosses two disciplines, legal and tax.
The legal side of your entity type relates to your legal protection or future equity expectations for the business. The tax side, which is closer to the accounting side, relates to selecting the appropriate business type that minimizes unintended tax liabilities.
We have worked with a tax professional to outline some key considerations for what entity type you should be looking into. Before making any decisions, speak to your attorney and tax accountant to make sure you are the correct entity type at this time. Most business owners pick a type and never look back. You really should review this periodically as laws and tax code do change.
The Statistics Surrounding Business Types
Your business type determines more than just what business tax return you will file. It sets the tone for your entire business, mandates which accounting regulations you are subject to, and determines how you will be taxed. Recent studies released by the United States Census Bureau shed light on the proportion of different business types (Pomerleau, Tax Foundation). As of the last census, business makeup consisted of the following:
73.1% Sole Proprietorships
13.1% S Corporations
8% Partnerships
5.6% C Corporations
Larger companies are more likely to retain corporation status because of the added tax and accounting benefits while small businesses frequently resort to simpler setups. Despite being a few years old, these statistics can be translated into today’s business world. The ease of setting up sole proprietorships draws many small business owners and entrepreneurs in, supporting the statistics. Understanding the direction past businesses have gone is the basis for deciding on your new business structure, but as always consult with your legal and accounting team.
Analyzing the Different Business Types
According to the U.S. Small Business Administration, the three main factors to consider when choosing a business structure are the way you want to be taxed, the industry you operate in, and how much personal liability you are willing to assume (Carbajo, U.S. Small Business Administration). Certain business types pass income down to the shareholder and pay taxes at ordinary income rates. On the other hand, some businesses pay taxes at the corporate level, resulting in different tax rates. Moreover, industries set standards on which business structures are more favorable. Finally, some business types come with a higher degree of personal liability, meaning third parties can come after your personal assets in the event of a lawsuit. Keeping these three factors in mind as we go through the different business types will be the key to choosing the right one for your new business.
Sole Proprietor
Ranking as the easiest and most cost-effective setup option, many small businesses lean towards a sole proprietorship business setup. Sole proprietorships are beneficial when only one individual owns the entire business. Common examples are an Etsy shop and side job businesses. The income and expenses get reported on your individual return on Schedule C and thus are subject to ordinary income tax rates and self-employment taxes. Like any other business, you are able to take credits and deductions to reduce your taxable income; however, depending on your other income streams, the tax rates could be unfavorable compared to other business types.
Despite the ease of setting up the business, there are some drawbacks. Sole proprietors often have little to no business and personal separation of liability. This opens the door to personal asset losses if you are sued. Additionally, since you are the sole owner of the businesses, there is no guaranteed business succession. Finally, sole proprietors have difficulty raising capital since no additional partners can be brought on and they are ineligible for public offerings.
Partnership
A partnership retains the simple setup process but also comes with expanded accounting and tax reporting requirements. A partnership consists of two or more individuals who share the income and loss. A separate tax return is required to be filed as a partnership is a separate legal entity from the partners. Instead of being reported directly on your individual tax return, the partnership will pass income through in the form of a K-1, resulting in the same ordinary income tax rates being applied as with a sole proprietorship. However, partnerships have added flexibility and access to multiple streams of contributions when there are many partners. Additionally, a partnership is able to take advantage of tax incentives, such as paying taxes at the entity level.
On the downside, partnerships have to file a separate business return each year by March 15. This can be a burden to get everything in order by the deadline, which is why many partnerships turn to work with an outsourced accountant to get the financials prepared in a timely manner. In addition, partnerships are faced with expanded accounting requirements to comply with Generally Accepted Accounting Principles. Issuing financials and footnotes and selecting the proper accounting method are two main tasks associated with a partnership setup. A qualified outsourced accountant can help your partnership stay on top of bookkeeping requirements, keeping all partners and regulatory agencies appeased.
S-Corporation
Moving up the complexity scale is an S-Corporation. An S-Corporation can have between one and one hundred shareholders, giving your business added flexibility. S-Corporations are similar to partnerships where they pass the income down to the shareholder, which is then subject to individual tax rates. One benefit of choosing an S-Corporation is the ease of raising capital through shareholder contributions. In addition, there are expanded tax deductions and credits available for S-Corporation owners to take. Finally, there is a separation of business and personal assets and the ability to grow your company with ease.
However, there are disadvantages to setting up an S-Corporation entity that should be considered. The first disadvantage is the high cost to set up and maintain S-Corporation status. Legal fees and annual tax return requirements can add up. In addition, the IRS closely monitors S-Corporations to ensure full compliance with all accounting and tax regulations. Moreover, there is less flexibility when it comes time to allocate profit and loss. The allocation needs to be done based on ownership percentage unless there is another agreement in place.
C-Corporation
C-Corporations are similar in the setup and functioning to an S-Corporation, however, there are a few key differences. The first difference is that a C-Corporation will pay taxes at the entity level, meaning no income will be reported on the individual return. This can be favorable, especially with the current corporate income tax rate hovering at 21% whereas individual tax rates can reach 37%. Furthermore, corporations have a complete separation of business and personal assets and are able to raise capital with greater ease. This can be an advantage for larger businesses or those expecting rapid growth.
Despite the advantages, C-Corporations can be subject to double taxation when income is taxed at the corporate rate and dividends are taxed at the individual rate. Moreover, corporate losses are unable to be taken as a deduction since no income is passed through to the shareholders. Instead, the losses will offset future gains or be utilized when you sell your shares. In addition, regulatory agencies closely monitor C-Corporations in a similar manner to S-Corporations.
What are Common Strategies Based on My Entity Type?
Tax planning is a key component of running a successful business in order to reduce either your corporate or individual tax liability. Since all entities are taxed differently, effective tax planning will vary based on your business structure. As always, consulting with your tax professional is needed to ensure you are implementing the proper strategies for your business.
Sole Proprietorships
Sole proprietorships are able to take a wide variety of credits and deductions to reduce taxable income. One common tax deduction is the home office deduction for small businesses and entrepreneurs running a business out of their homes. Rent, mortgage, utilities, home insurance, and certain repairs are all prorated based on your home office area. Additionally, the Qualified Business Income deduction lowers your taxable income by 20%. Both of these deductions rely on your accounting information being tracked throughout the year, making it beneficial to work with an outsourced accountant to take the burden off your plate.
Partnerships and S-Corporations
Since partnerships and S-Corporations both file a business return, the tax planning items will be similar. For more specific tax planning strategies based on your entity and financial position, contact your tax accountant. Like sole proprietorships, partnerships and S-Corporations are able to take the Qualified Business Income deduction to reduce the income the shareholder pays tax on.
Another popular tax planning item for partnerships and S-corporations is deciding on whether to take a salary or a distribution. A salary taken by a partner or shareholder is subject to payroll taxes, results in a qualified business expense, and is taxed at ordinary income rates. On the contrary, a distribution is subject to payroll taxes, is not reported on the business return or subject to ordinary income tax rates, but it does take away from your basis in the company.
C-Corporations
C-Corporation also have tax planning strategies to reduce the income that is taxed at the corporate level. One such planning strategy is the Section 179 deduction, which allows businesses to write off the entire cost of an asset placed in service during the tax year. In addition, C-Corporations can time issuing debt based on their needs.
Next Steps
All business entities will need to be considered to find the right one for your new venture. From personal liability and tax reporting to accounting regulations and tax planning strategies, all business entities have differences. Once you get your business up and running, it is critical to stay in compliance with all accounting policies and procedures through regular bookkeeping and financial reporting. An outsourced accountant, like Basis 365, specializes in assisting clients run the backend of their business to promote business growth and accurate reporting. For more information on how Basis 365 can help your new venture, reach out to one of our team members today.
Basis 365 Accounting is not a CPA firm and does not give tax advice. Please consult with your tax accountant for guidance that fits your needs.
Sources
Carbajo, Marco. “Choosing the Right Business Structure: Three Factors to Consider.” U.S. Small Business Administration, 18 July 2018, https://www.sba.gov/blog/choosing-right-business-structure-three-factors-consider. Accessed 2 April 2022.
Pomerleau, Kyle. “An Overview of Pass-through businesses in the United States.” Tax Foundation, 21 January 2015, https://taxfoundation.org/overview-pass-through-businesses-united-states/#:~:text=According%20to%20Census%20data%2C%2073.1,partnerships%20(2.2%20million%20firms). Accessed 2 April 2022.
