There are many of us that want to start a small business of some sort. It can be an online retail store or a hair salon. Unfortunately, there are very few people that are set up correctly as far business entities are concerned. The purpose of this article is to provide you with some of the advantages and disadvantages of the various business entities there are. These entities include a sole proprietorship, partnership, Limited Liability Company (LLC), S Corporation, and C Corporation. Hope you enjoy the show.
A sole proprietorship, other than its difficult spelling, is arguably the worst type of business entity there is. It provides you with no asset protection whatsoever, which is the main reason you should form an entity to begin with. In other words, someone can sue you and if they win, they can get a hold of all your personal assets/things you own, including your shoes. You are also subject to self-employment taxes (i.e. FICA aka the nastiest acronym on the planet; just take a look at your most recent paycheck if you work a W-2 job). Self-employment/social security tax is around 15%! Yikes! That means for every $100 you make, $15 will go to your “social security fund,” which there’s a strong likelihood the money won’t be there when it’s time for you to “retire.” In other words, that money is probably funding someone else’s account who may be a lot older than you. On a more positive note, sole proprietorships are easy and simple to set up, although, some states require you to pay a fee for one. Also, that 15% FICA is ½ tax deductible on your tax return. Overall advice: Stay away from sole proprietorships.
A partnership is basically a sole proprietorship, but has more than one person. It also provides no liability protection for general partners, but luckily, there’s no FICA on distributions! This is because you’re no longer considered self-employed when you’re in a partnership (according to the IRS) and instead, you’re employed by your company. Your tax return will be a little more complicated as you’ll now be required to file a separate business tax return (Form 1065) that will end up on your personal tax return via a Schedule K-1 unlike a sole proprietorship (1040 Schedule C). It’s also pretty easy to set up. Overall advice: Stay away from partnerships.
Limited Liability Company (LLC)
This is by far my favorite type of entity and what we’ll be focusing most of our attention on today. An LLC is simply the best type of entity to have. It provides liability protection. In other words, if a tenant sues you and all you own is that building, the most the tenant can take is that building as long as you follow the rules of LLC’s (i.e. not comingling business and personal affairs).
LLC’s are extremely flexible meaning you can choose to be taxed as a sole proprietorship, partnership, S Corporation, or C Corporation. You can also grow your business by issuing units to investors (i.e. unitholders) and these owners can be from a foreign country, unlike S Corporations. There are very minimal maintenance costs of running an LLC, which is a huge plus. Maintenance costs can include stockholder certificates, bylaws, board minutes (you can go to Vegas to have your meetings), and certain other records. You don’t really need much of this stuff with an LLC. Furthermore, it’s very easy to set up. I would highly recommend an LLC for your business entity structure and you should elect to be taxed as an S Corp if you run a business that produces active income (i.e. accounting, law, etc.). This will help get rid of FICA on distributions. Lastly, real estate is best owned by an LLC to avoid any unnecessary taxes from what’s known as built-in gains. If you own multiple properties, you should consider a series LLC and have each property owned by a different cell within the series.
S Corporation (S Corp)
S Corps are very similar to LLC’s, but require a lot more paperwork and formalities. You still get liability protection. You pay no FICA just like a partnership, an LLC taxed as a partnership, and an LLC taxed as an S Corp or C Corp. Unfortunately, it’s not as flexible as an LLC since you can only be taxed one way (i.e. as an S Corp, although you can always re-elect to be taxed as a C Corp). One thing to note is that to form an S Corp, you first have to form a C Corp then make an election via the Form 2553 to let the IRS know you want to be taxed as an S Corp. Also, an S Corp, an LLC taxed as an S Corp, Partnership, and an LLC taxed as a partnership are known as pass-through entities by definition. This means that the income and expenses from the business tax return will “pass-through” and end up on your personal tax return. They couldn’t have made the word simpler to understand.
The drawbacks of an S Corp include the high maintenance costs you can incur from all the formalities. You can’t have foreign owners, nor can you have more than 100 shareholders. You can however issue shares to investors. Overall, an S Corp is not a bad entity choice at all. It just requires more paperwork than an LLC. Please do not use S Corps for real estate holdings as they can incur unnecessary taxes (put them in an LLC instead).
C Corporation (C Corp)
C Corps provide you with liability protection and there’s no FICA on distributions. However, the thing that makes C Corps so unattractive is that you must pay capital gains taxes on any distributions that’s not done through payroll. This is what’s known as double taxation. You’re taxed at both the corporate level (i.e. on your net profits) and at the personal level (i.e. on your distributions/dividends). You also incur very high maintenance costs.
The only reason you should maintain a C Corp is if you want to go big. Companies such as Apple, Microsoft, AT&T, etc. are all C Corps because in order to become a public company, you must be a C Corp (SEC rules). There is no 100 shareholder or foreign shareholder limit like S Corps so C Corps are very attractive for big companies.
So there you have it. These are the five main types of business entities you can have. I prefer LLC’s over any entity type due to the flexibility, ease of maintenance/management, and liability protection. You also have the ability to escape FICA on distributions which allows you to get the best of both worlds. Always consult with a competent CPA and attorney before making any of these decisions. Financial freedom is not too far away so go out there and start a business today!
P.S. I can help you set up any of these entities for a very small fee.