Building Your Business: The Ins and Outs of Entity Structuring
Originally published on May 12, 2016
Updated on November 1st, 2023
When you’re building or remodeling a house, you decide on its structure based on your future plans. Will you be raising a family? Accommodating guests? Including a home office? All of those factors must be considered before the foundation is even poured.
Your company is no different. The entity structure you choose affects a variety of decisions you will make down the road, such as expanding your workforce, determining your tax liability and offering stock options. So whether your business is just starting out or on the precipice of change, it is important to understand the four basic tax entity structures available and how they can impact your plans.
The simplest and most common business structure used in the United States, a sole proprietorship is a business that is owned entirely by one person. An entity of just about any size can be a sole proprietorship, from a single-person consulting firm to a large company with many employees – as long as there is only one individual owner. An LLC (limited liability company) with only one owner, known as a single member LLC, is by default a sole proprietorship unless an election is made.
Because of the simplicity of sole proprietorship, it is an ideal choice when your business is small. As the sole owner, you have complete control over decisions such as the direction of the company or whether you want to sell or transfer ownership. A sole proprietorship is also not subject to corporate taxes.
However, this simplicity has downsides. All of your trade and business earnings are subject to self-employment tax. Additionally, your ability to offer ownership to employees or bring on a partner would cause a change in business form.
Your liability risk can be mitigated by establishing your company as a single member LLC. This classification establishes your business as a separate entity from you, providing some protection from liability. Keep in mind, however, that this exemption from liability is limited; you will still have obligations regarding personal guarantees, deliberate or negligent acts and other conditions.
In a partnership, two or more individuals join together to run a business. Each person contributes money, property, labor, or skills to the venture and shares in its profits and losses. While this structure is often seen in medical practices, law firms, real estate companies and creative endeavors such as design companies, any business can be a partnership. An LLC with more than one owner (known as a multi-member LLC) is by default a partnership for tax purposes unless an election is made.
Partnership details vary greatly from business to business, because the terms of the partners’ agreement are entirely up to those involved. This flexibility makes a partnership easy to form and manage; there is less regulation regarding how the business is run, risks and profits can be distributed at whichever proportion the partners wish, it is easy to move assets in and out of the business, etc.
Whatever the terms of the partnership are, however, they should be spelled out explicitly in the written agreement. Otherwise you run the risk of ambiguity regarding each partner’s responsibilities and authority. These terms should include what happens to one partner’s share of the business if he or she suddenly dies, resigns or quits, or else you run the risk of a sudden end to the company. Forming a multi member LLC can help in this regard, since it requires an operating agreement specifying the structure of your business, responsibilities of the partners, each’s share of profits and losses, etc. This in turn protects (to a degree) the personal liability of each partner.
There are also tax disadvantages of partnerships; as with a sole proprietorship, ordinary income earnings of each partner actively involved are generally subject to self-employment tax.
C Corporations and S Corporations
Unlike a sole proprietorship or partnership, a corporation is a separate legal entity. (An LLC, which is also a separate legal entity, can also elect to be taxed as a corporation.)
The two most common ways that a corporation is taxed are C corporations and S corporations.
- S corporations are pass-through entities, meaning that taxes are only paid at the shareholder level. However, this benefit comes with several restrictions. S corporations are limited to a maximum of 100 shareholders, only certain people can be owners, and these owners are not eligible to participate in cafeteria plans. They are also subject to extremely rigid regulations that allow for just one class of stock to be offered.
- C corporations have much more freedom regarding who can own the company and the number of owners allowed, as well as the types of stock it can offer (preferred, common, etc.). However, these companies pay tax at the corporate level in addition to the taxes owners pay on dividends – a concept known as double taxation.
My business has had the same structure for years. Should I change it?
If your current entity structure is working well for you and there have been no significant changes in your business, there may be no need to switch. The U.S. Small Business Administration advises business owners to weigh the importance of five characteristics when considering such a change:
- Fees and forms
- Investment needs
- Operational continuity
Some events that could lead to a change in entity structure include significant growth, a change in ownership (such as a partner retiring or stepping down), or a nuance in tax laws that make it advantageous to change structure.
Keep in mind that it is more difficult to move from a corporation to a sole proprietorship or partnership than from a sole proprietorship or partnership to a corporation. You will first have to convince your shareholders to agree to the change (which involves a vote by shareholders and your board of directors, if you have one) and then file dissolution documents with the state and liquidate your company’s assets. Further steps are then required to file paperwork with the IRS, submit your final federal and state tax returns, and register for a new employer identification number (EIN) and fictitious business name.
The biggest hurdle, however, is the tax consequence of liquidating your company. When non-cash assets are distributed from a company (including liquidations), the tax code sees this as a sale, and gain must be recognized (along with the corresponding tax consequences) on the excess of the fair market value over the adjusted basis of each asset that is distributed.
The bottom line – no single entity structure fits every company. It’s important to evaluate your business and run all four scenarios to see which structure would provide the best balance of advantages and administrative costs. Consult your legal and tax advisers for more information.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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