Are you picturing running a modest one-person operation, or planning to build a business empire that outlives you? If it’s the former, your new business might be well suited for a sole proprietorship; if it’s the latter, forming a corporation might be the best choice. For new business owners, choosing the right entity structure largely comes down to your vision for the future, your business goals and your willingness to take on various risks. All entity structures have merits and drawbacks that new business owners should discuss with their advisors before making a choice.
Choosing an Entity Structure
While there are a lot of different ways to set up a new business, the IRS recognizes four basic entity structures.
Sole proprietorship: Considered an “informal” entity, a sole proprietorship tends to be the easiest entity structure to create. A sole proprietor owns their business alone, so they’re personally responsible for all the business’s liabilities and debts. If someone sues the business and wins, the sole proprietor could lose their personal assets. Tax preparation and tax filing are relatively straightforward, and the business’s taxes are filed as part of the owner’s personal tax return. New business owners often start out as sole proprietors to test whether the business will succeed in the marketplace before creating a more complicated structure like a corporation.
Partnership: Partnership structures are akin to sole proprietorships, but are created when two or more people own a business together. The owners are still personally liable for the business, and they report business income on their personal tax returns instead of paying corporate tax on money the business brings in.
Limited liability company: Establishing an LLC lets a business owner separate their personal liability from their business liability. An LLC is a more formal entity structure than a sole proprietorship or partnership, and forming one requires filing articles of organization with your state. LLCs are still easier to form than corporations, while providing tax advantages that C corps don’t. Like informal entity structures, an LLC allows for pass-through taxation: Instead of the business paying corporate income tax on profits, profits are passed through the LLC to its members (owners) who then report that income on their personal tax returns.
Corporations: Forming a corporation for your business creates a separate legal entity that’s responsible for its own liabilities. As with an LLC, that distinction allows business owners to protect their own assets. Corporations can also issue stock, something that’s not possible for sole proprietorships, partnerships or LLCs. Being able to sell shares allows the company to raise money and bring on investors, creating a path for growth that doesn’t exist for other kinds of entity structures. And because a corporation is its own legal entity, it can continue on even after its founder sells it or dies. However, incorporating tends to be more expensive and involves more extensive reporting requirements than informal entity structures require.
There are two common kinds of corporations, with the difference primarily involving taxes. A C corp is essentially the default type; if you decide to incorporate your business, it’ll automatically start out as a C corp. Double taxation is the primary drawback with a C corp. The company pays corporate income tax on the money it brings in, and shareholders are taxed on the dividends they receive. Business owners end up paying taxes twice on money their company earns. To avoid double taxation, a business owner may elect to file additional incorporation paperwork and convert a C corp into an S corp. Like LLCs, S corps are pass-through entities so no corporate income tax is owed. Shareholders are taxed on business income at their personal income tax rate.
Other Incorporation Considerations for New Businesses
Choosing an entity structure is just one of the first big decisions you’ll get to make as you bring your business to life. If you decide to incorporate, these are just a few of the considerations you’ll want to discuss with your business advisors and tax professionals.
- Where do you want to incorporate? Most owners will incorporate a new business in their home state, but there can be tax and legal benefits to incorporating in a different state. Generally these benefits are more significant for large corporations than for small businesses. (More than two-thirds of Fortune 500 companies are incorporated in Delaware because of its advantageous business laws!) The costs of out-of-state incorporation often outweigh the pros, but it’s worth considering.
- When do you want to incorporate? There can be a lot of timing hurdles around incorporation, especially for small business owners who are already running sole proprietorships, partnerships or LLCs and aren’t sure when to make the leap to incorporation. If you’re starting a brand-new business and know you want to start out as a corporation, your advisors may suggest that you file for incorporation before doing anything else. Being incorporated may help you secure financing, and protects your assets before your business starts accumulating liabilities. If you hire your first employee before incorporating, and the employee injures someone in the course of doing their job, you may be personally liable for any costs.
- Will you be an S corp or C corp? While your corporation will start as a C corp, consider whether you’re a good candidate to convert to S corp status. Only an entity that has fewer than 100 shareholders and issues a single class of stock is eligible to become an S corp. The IRS is especially strict with S corps, so business owners who choose this kind of entity structure have to be diligent about meticulous record-keeping and tax reporting.
Sachetta Callahan’s advisors work with new business owners on a range of issues, from choosing an entity structure to tax planning and business consulting. If you’re thinking about starting a new business, we want to help you make it a reality. Contact me today!
Stephen Sachetta, CPA, MST is a Certified Public Accountant and holds a Master’s Degree in Taxation. He has a diverse background of experience in the public accounting field over the past 40 years, ranging from the former Big 8 to being one of the founding partners of our firm. He specializes in the Restaurant and Food Service Industry and works with individuals and small businesses at developing them into flourishing companies while helping them to save tax dollars along the way.