Business Considerations for Your Start-Up
Getting a business off the ground can be stressful, and the need to decide which entity structure to use amid all the chaos can be overwhelming. There are many different factors to consider, such as ease of administration, liability protection, legal requirements and income tax implications. In this blog, we’ll take a high-level look at some of the more common entity types and discuss a few considerations for each.
Sole Proprietorship – This is someone who owns an unincorporated business by himself or herself with no other owners and without any layer of legal protection. From a legal perspective, there is no distinction between the owner and the business itself.
- Legal Considerations: Since there is no legal structure in place, no registration is required. However, since there is no separation between the business owner and the business, the owner has unlimited personal liability for the business’s debts and obligations. This structure is easiest to administer but comes with the downside of unlimited personal liability.
- Tax Considerations: Since a sole proprietorship only has one owner, the owner will report all business activity on Schedule C of their personal tax return. If income is high enough, the business owner will also have to pay self-employment tax and may have to remit estimated tax payments throughout the year to ensure taxes are paid timely.
Partnership – A partnership is an arrangement between two or more individuals who share in both the management and profits of the business. There are two main types of partnership entities – a general partnership and a limited partnership.
- Legal Considerations: While it’s possible to start a partnership without one, a written Partnership Agreement is often preferred. In a general partnership, the partners have unlimited personal liability for the debts of the business. Liability is a bit different when considering a limited partnership. In a limited partnership, there still must be at least one general partner who has unlimited liability, but the other limited partners enjoy personal liability protection from the partnership’s debts (their investment in the partnership itself is still at risk).
- Tax Considerations: Generally, partnerships themselves do not pay income taxes. Instead, the partnership’s activity is reported on a separate informational tax return (Form 1065) and flows through to the partners on a form K-1 who, report their share of income or loss on their personal tax returns. In a partnership structure, partners could still be liable for self-employment tax on their share of the partnership net income. Also, if income is high enough, partners may need to consider making estimated tax payments during the year.
Limited Liability Company (LLC) – This structure can be put in place for either a sole practitioner or multiple members. Whether the business has one owner or many, forming the business as a limited liability company will add a layer of personal liability protection for the members.
- Legal Considerations: To form an LLC, paperwork often must be filed with the secretary of state, but the process can vary by state. There could be annual reports and fees associated with keeping the LLC in good standing. Also, it is important to get an operating agreement in place for the LLC.
- Tax Considerations: The taxation is similar to that of a partnership. The LLC generally does not pay its own income taxes. Instead, the LLC activity flows through to the member(s) who report their share of income or loss on their personal tax returns. If there is only one owner, he or she will need to report all LLC activity directly on Schedule C of his or her personal tax return. However, if there is more than one owner, a Form 1065 will need to be filed. In an LLC structure, members could still be liable for self-employment tax on their share of net income. Last, if income is high enough, members may need to consider making estimated tax payments during the tax year.
S Corporation – This is a corporation that elects to pass income, losses, deductions and credits through to the shareholders for tax purposes. There are certain requirements that must be met to be an S Corporation, including domiciled in the U.S., no more than 100 shareholders, one class of stock, and a few others.
- Legal Considerations: To become an S Corporation, the corporation must submit Form 2553 signed by all shareholders. Each of the S Corporation shareholders enjoys personal liability protection. Also, articles of incorporation must be filed with the secretary of state. Last, states could require annual S Corporation reports and fees.
- Tax Considerations: Since the S Corporation passes income, losses, deductions and credits through to its shareholders, an informational tax return (Form 1120S) must be filed. S Corporations are popular because the income that is distributed to the owners escapes payroll taxes. However, the S Corporation owners must pay themselves a “reasonable salary” via a W-2, which is subject to payroll tax. As with other pass-through entities, S Corporation shareholders may need to make estimated tax payments during the tax year.
C Corporation – This is a corporation that pays its own income tax. This entity also affords its shareholders with personal liability protection from the obligations of the business. There is no limit to the number of shareholders that can own C Corporation stock, and there is great flexibility as to who can be an owner. Another key consideration is that different classes of stock can be issued.
- Legal Considerations: This structure affords each shareholder personal liability protection. In order to be properly registered, articles of incorporation must be filed with the state. At least one annual shareholder meeting must be held, and minutes must be maintained for transparency purposes. Last, the C Corporation may have to pay annual fees, must have company bylaws, and file numerous annual reports and financial statements. C Corporations can be one of the more administratively burdensome entities to maintain.
- Tax Considerations: Since a C Corporation pays its own income taxes, it must file its own tax return, Form 1120. Also, there could be double taxation that occurs when the earnings of the corporation are paid out to shareholders in the form of dividends. The shareholders must recognize the dividend payments as income on their personal tax returns. Generally, C Corporation shareholders are W-2 employees of the business and have income tax withheld from their paychecks. Last, the C Corporation is the only entity structure mentioned that does not give shareholders the potential benefit of the 20% Qualified Business Income Deduction, which is a deduction that pass-through business owners enjoy on net income passed through to their personal tax return (not including wages paid via W-2).
As you can see, there are many options to choose from when deciding on the best entity structure for your new business. If you have any questions regarding these considerations, please reach out to your BDF team for assistance.
Matt is a wealth manager at BDF. He sits on BDF's Financial Planning Committee and leads many of the firm's tax-related initiatives. Matt has a passion for building strong relationships with his clients and helping them make sound decisions. He also holds the Certified Exit Planning Advisor designation which helps him advise business owners on how to exit their business and prepare for retirement.