One of the biggest advantages to working at Accounting Solutions Ltd. is that we get to help out small businesses and small business owners. From the moment that they choose to open their enterprise, to the day that they retire, we are always ready to provide our Chicago clients with hands on accounting advice. For those seeking to start a new business, there is an important step that must be taken – choosing an entity.
For those who don’t know, entities are essentially formal classifications used to encapsulate what each business does. It is important that all budding entrepreneurs have a firm grasp of what choosing an entity entails – each of the three different types bears distinct advantages, disadvantages, and nuances that can affect how the organization is taxed. The three main categories of entity include partnerships, corporations, and limited liability companies. It is also possible to run a business as a ‘sole proprietorship’. Let’s start the proceedings by discussing the latter:
Sole Proprietorship
This is widely acknowledged as being the most simple way to structure a business entity. If an individual were to open a new store, and list themselves as the ‘sole proprietor’, then they would essentially be integrating the financial responsibilities of their company within their own personal finances.
While this is a simple concept, it can have big consequences. For example, if business is poor, then your personal assets may be on the line. A sole proprietorship that goes bankrupt could feasibly bankrupt the owner, as they will have to accept all debts.
When it comes to taxes, these entities are not subject to corporate income tax. All federal income tax reports much include business income, gains, deductions, or losses, which are filled out on a Form 1040. It is important to proceed with caution when filing, as deductions for corporate businesses may not always be applicable to this type of entity.
Partnerships
As if the name didn’t speak for itself – a partnership refers to an entity where two or more people officially own the business. With this structure, the primary incentive behind forming the business revolves around personal financial gain for these owners. Since they are ‘partners’, they are able to make decisions on behalf of one another. This is a two way street, as they are also responsible for the outcomes of their decisions as a group (or shall we say, entity).
Regardless of how each partner contributes towards the business, both will share an equal amount of the profits. Even if one individual contributes their income, while the other only performs business development exercises, each will walk away with the same sized piece of pie.
Since it is considered an entity, partnerships are able to apply for credit, file for bankruptcy, transfer property, and more. In conjunction with sole proprietorships, however, partnerships are not generally subject to federal income taxes. In most of these entities, the gains, deductions, and other monetary movements of the business are reported on each partners’ federal income tax return. Since this can potentially open the floodgates for uneven wealth distribution, the ramifications of what is reported by who are generally decided upon with the signing of a partnership agreement.
Limited Partnership
When business owners form partnerships, it is generally required that each individual contributes towards the well-being of the organization in some way or other. Since everyone earns an equal share of the wealth, this is to be expected.
Limited partnerships allow more flexibility within these arrangements. If new business owners choose this entity, they permit the entity to exist with different ‘classes’ of partners overseeing them.
What this means is that certain individuals can still actively be listed as ‘partners’, but only perform marginal duties while earning a smaller percentage of income (which is determined within a partnership agreement). In many situations, these limited partners do not participate within the day-to-day business operation, any may have limited overall liability. In exchange, they only walk home with profits that align with their contributions (in most cases).
Limited Liability Partnership
Certain states permit entities known as limited liability partnerships. These entities share similarities with corporations (see below) in the sense that partners can be protected against being personally liable for the business’ actions. The scope of what one can be protected from is dependent on the law of that state, and can differ depending on a variety of jurisdictional circumstances. If you are planning on determining whether your business is eligible for this entity status, you should always check with your CPA first.
Corporations:
One of the primary incentives that many small business owners choose to incorporate revolves around the important fact that this entity helps shield owners from personal liability. In addition, this structure makes it easier for organizations to raise capital, or transfer funds as needed. Two types exist:
C Corporations
Throughout contemporary business history, the majority of corporations have been classified as C Corporations. These entities are not subject to the same federal income taxes as S Corporations (see below), and, as a result, they are more flexible in terms of equity structuring and the ownership of shares.
One of the biggest advantages of C Corporations is that they are able to deduct that which is considered a reasonable employee benefit cost. On the flip side, they are subject to income tax. This can mean that distributed earnings are taxable as both corporate and individual income, which can influence owners’ decisions when choosing which entity works best for them.
S Corporations
In order to be treated as an S Corporation for federal income tax purposes, a company has to meet a number of eligibility requirements. The IRS oversees the application process, which can sometimes involve limitations on the number and type of shareholders who own stock within the corporation.
If these requirements are met, then the entity gains a benefit that does not apply to C Corporations – income, gains, deductions, and losses are passed on to the shareholders. This alleviates the potential for dual taxation on corporate earnings, which, as we mentioned previously, is a trait of C Corporations.
Some of the employee benefit deductions available to the sister entity are not available here – for example, 2% shareholders within S Corporations would not be eligible, nor have any financial incentive, to provide a cafeteria as a benefit to their employees.
Limited Liability Company
Last, but not least, limited liability companies (LLC) are entities that limit the amount of liability that investors or shareholders face as the owners of a business. This limitation, which draws immediate comparison to the structure of a corporation, differs due to the fact that there is much more leniency regarding the structuring and governance of LLCs. In addition, these entities are treated as partnerships for federal income tax purposes, which allows members to have pass-through tax treatment.
Deciding which form of ownership best suits your business is a task that requires much thought and context. While each entity type does have its pitfalls, many of them come coupled with shortcuts that ease financial losses (if any). As an example, sole proprietors can purchase insurance that reduces the risk of liability exposure.
Despite the array of tough choices, Accounting Solutions Ltd is here to help. With our expertise, and your entrepreneurial vision, we can work towards choosing the entity that suits the vision of yourself and your company.