Choosing the Right Business Entity: A Guide for Business Owners

Author: Jesse Porter, CFP®, CEPA®, Vice President & Private Wealth Advisor

Choosing the right entity structure for your business is one of the most important initial decisions you’ll make as a business owner. It has far-reaching implications for your company’s taxation, personal liability, and regulatory compliance. 

The right entity can offer considerable tax benefits, protect your personal assets, and increase your business’ credibility. On the other hand, the wrong choice can lead to risks, unnecessary complexities, and financial issues. 

This guide will explore the different entity options and help you find the entity that best suits your business's needs.

Why Entity Selection Matters

Choosing the appropriate business entity is a pivotal step when setting up your business. It directly impacts your business's taxation, the level of personal liability you assume, and regulatory compliance. 

• Different entities have distinct tax implications, affecting the amount of taxes you pay and how you report your business income.
• Some entities offer better protection for your personal assets if your business were to go into debt or face lawsuits. 
• Each entity type has its own set of legal and regulatory requirements, which can influence the complexity of your operations.

Failing to choose a suitable business entity can have severe drawbacks. 

For example, sole proprietorships or partnerships offer no separation between personal and business assets, which may put your personal assets and property at risk if your business runs into financial or legal troubles. On the other hand, setting up a corporation for a small business could lead to complex legal and tax requirements, extensive paperwork, and potentially higher taxes if not properly managed.

Understanding Your Options: Types of Business Entities

Sole Proprietorship

A sole proprietorship is the simplest and most common business structure. It’s defined as an unincorporated business owned and operated by one individual. Sole proprietorships are the easiest entity to set up, requiring minimal paperwork and lower startup costs compared to other business structures. 

However, it offers no liability protection. As a sole proprietor, you have complete control over your business, but you're also personally responsible for all debts and liabilities. The business and the owner are seen as one.

This means that if the business incurs debt or is sued, your personal property, such as your home or savings, could be used to satisfy business obligations. Despite these risks, many entrepreneurs choose sole proprietorships for their simplicity and direct control.

Partnership

A partnership is a business structure involving two or more owners. 

There are two main types of partnerships:

• General partnership: All partners equally share legal and financial responsibilities. This setup is straightforward to establish and offers flexibility in distributing profits and losses. However, partners are personally liable for the business's debts and obligations.

• Limited partnership: One partner assumes the role of a general partner, bearing full personal liability for the partnership's debts. Other partners (who could be one or more people) act as limited partners, enjoying limited liability — up to the amount of their investment—and minimal involvement in daily operations. This structure provides some protection against personal liability, but it may come with more complex tax and legal requirements.

Partnerships will file an annual tax return reporting the income, deductions, gains, and losses from its operations. However, partnerships do not pay income tax. Instead, they "pass through" profits or losses to their partners, who then report these on their personal tax returns through a Schedule K-1.

Limited Liability Company (LLC)

An LLC combines the liability protection of a corporation with the tax advantages of a partnership. Members are not personally liable for the business's debts, offering a protective shield for their personal assets. 

Just like a partnership, the LLC profits have pass-through taxation, meaning they’re only taxed on the members’ tax returns, avoiding double taxation.

Compared to a corporation, an LLC is typically easier to set up and manage, with less annual paperwork and record-keeping. However, members are considered self-employed and must pay self-employment tax on the LLC’s profits.

S Corporation

An S Corporation, or S Corp, offers the limited liability advantage of a corporation and tax advantages of a sole proprietorship or single-member LLC.

S Corporations are pass-through entities, which means the company’s profits and losses are passed through to the shareholder’s individual tax returns. 

An S Corp can minimize self-employment taxes, as only the salary paid to the owner-employee is subject to employment tax, while distributions are exempt. This can result in substantial tax savings compared to a sole proprietorship or single-member LLC.

S Corps can also be beneficial in estate planning, especially for business owners planning to transfer ownership to family members. Shares in an S Corp may qualify for valuation discounts and favorable tax treatment upon the owner's death, reducing the estate's tax burden. 

However, it's important to note that S Corps come with certain limitations, including a cap on the number of shareholders and restrictions on shareholder eligibility.

C Corporation

A C Corporation, referred to simply as a corporation, is a business entity that’s separate from its owners, or shareholders, for tax and legal purposes. This structure allows for an unlimited number of shareholders, making it an attractive option for businesses aiming to expand or go public.

Unlike S Corporations or LLCs, C Corporations face "double taxation", meaning profits are taxed both at the corporate level when earned and again at the individual level when distributed to shareholders as dividends. Despite this, C Corporations can reinvest profits at a lower corporate tax rate and offer liability protection to their shareholders, shielding personal assets from the company's debts and liabilities.

Companies aiming for venture capital funding, contemplating an IPO, offering stock options to employees, or planning to reinvest substantial profits back into the business may benefit from choosing a C Corporation for its tax advantages.

Choosing Your Business Entity

Once you understand the different business entities, it’s important to consider a few key factors when choosing the right one for your business. 

Factors to consider

• Personal liability: As a sole proprietor or general partner, you're personally responsible for your business's debts and liabilities. This means your personal assets, such as your home, car, and savings, could be at risk if your business is sued or unable to pay its debts. LLCs and corporations offer personal liability protection. This means that, in most cases, your personal assets are shielded from your business's debts and liabilities.
• Tax implications: Sole proprietorships, partnerships, and LLCs — including S corporations — are pass-through entities, meaning the business itself doesn't pay taxes. Instead, the business's profits and losses are passed through to the owners' individual tax returns. C corporations, on the other hand, are subject to double taxation. The company pays taxes on its profits, and shareholders pay taxes on their dividends. However, C corporations may be eligible for more tax deductions and credits than other entities.
• Ownership structure: Sole proprietorships and single-member LLCs are owned and managed by one person. Partnerships and multiple-member LLCs have multiple owners, and the management structure can be customized based on the owners' preferences. Corporations have a more formal management structure, with shareholders and a board of directors. This structure can be beneficial if you plan to raise capital from investors or eventually go public.
• Cost: Sole proprietorships and partnerships are the simplest and least expensive to set up and maintain, while LLCs and corporations involve more paperwork and higher setup and ongoing costs.
• Local laws and regulations: Each state has its own requirements for setting up and maintaining different entities, and some may offer additional benefits or restrictions.

Matching the entity to your business type 

Each entity type is suitable for different types of businesses:

• Sole Proprietorship: Best for individual owners looking for the easiest set-up and total control over the business.
• Partnership: Ideal for businesses with two or more owners looking to share responsibilities and profits.
• Limited Liability Company (LLC): Great for small to medium-sized businesses seeking liability protection, operational flexibility, and the benefits of pass-through taxation.
• S Corporation: Excellent for businesses wanting to enjoy the benefits of a corporation while avoiding double taxation.
• C Corporation: Good for bigger businesses or those planning to go public, seek venture capital funding, or offer stock options to employees.

Real-Life Scenario

Sarah established an LLC to manage her business and must choose between S corporation and partnership taxation. The business generates net earnings of $200,000. 

Scenario 1: LLC taxed as an S Corporation

If Sarah elects S Corporation taxation, she can pay herself a reasonable salary —let’s assume that’s $90,000 —and take the remaining $110,000 as a distribution that is not classified as employee wages. Neither Sarah nor her S Corporation are required to pay Social Security or Medicare taxes on this amount. This results in a total of $12,717 in self-employment taxes (15.3% x 92.35% x $90,000).

Scenario 2: LLC taxed as a partnership

If Sarah chooses partnership taxation, the entire $200,000 in net earnings is subject to self-employment taxes (with the 12.4% Social Security portion of the self-employment tax being capped at $168,000 of wages, and the 2.9% Medicare tax being assessed on the full amount of self-employment income). This results in a total of $26,632 in self-employment taxes.

The S Corporation taxation would result in significant tax savings for Sarah's LLC.

Navigating entity selection with Compound Planning

Choosing the right entity for your business is a complex decision that should be made with expert advice. At Compound Planning, we strive to be your trusted partner throughout your business journey. Our team of financial advisors and tax experts work alongside you, understanding your financial situation, your business, and your strategy.

As part of our comprehensive financial strategy, we'll assist you in choosing the optimal business entity tailored to your goals, projected cash flows, and tax circumstances. We’ll help you navigate the intricacies of each entity type, helping you set up your business for success.

Sign up for a dashboard and schedule a free consultation to hear how our advisors can help you navigate your business journey from inception to exit.

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