A company just starting out, needs to legally define itself. It is one of the first major decisions to make. This decision will affect company taxes, liability, ownership structuring and payments. Here is your guide to the different types of business structures.
In this article you will learn:
- About business structure types
- The pros and cons of different business structures
- How pay is organized for ownership
- Reasons to lift the corporate veil on LLCs and Corporations
- When to change your business structure
What is an entity type?
Before registering your business with the state, you will need to decide on a business entity type. An entity is a business structure with different rules for tax filing and personal liability. It also influences funding from investors, and economical standing. Customers place more trust in certain types of business entities over others.
With that in mind, what you pick should have longevity. Yes you can change your business structure later. However, it’s good to get it right the first time since the undertaking could disrupt day to day activity.
Pros and Cons of Different Business Structures
Here we show how the IRS defines each type of business entity. Along with the pros and cons of different business structures:
Someone who owns an unincorporated business by themselves. One individual is entitled to all profits. As well as responsible for all business debt, losses and liability. A sole proprietor files all business income with personal, and pays self-employment tax.
Easy to form: most businesses starting out will act in this manner
No corporate tax rates, you pay pass-thru income tax
Minimum record keeping
Easy to change the business structure
Most liability risk: Anybody you owe money to is entitled to your personal assets
Not very attractive to banks or investors
Least amount of consumer trust
A partnership is the relationship between two or more people doing trade or business. Each person contributes money, property, labor or skills. Then shares the profit and losses of the business. One partner has to manage the business at all times, no outside management allowed. Business taxes are filed under personal tax returns. There are two types of partnership business structures:
Limited Partnership (LP): One general partner has more say in the company than the others. This partner takes on unlimited liability and must pay self-employment taxes at the end of the year. The other partners have limited liability.
Limited Liability Partnership (LLP): This is a partnership where each partner has limited liability.
Ideal situation for professionals that cannot form an LLC. Usually lawyers, accountants, and medical professionals opt for this structure.
An LP offers different division of profits, per a partner agreement.
An LLP offers an even spread of liability and responsibility for business.
Partnerships pay lower tax rates than corporations
In an LP one partner has more stake than another
No outside management
Pass through self employment tax
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state regulates liability and tax responsibility. Most states do not restrict ownership for LLC organizational structures. Owners of LLCs are called members. Members may include individuals, corporations, LLCs and foreign entities. There is no maximum number of members. Each member shares a limited liability for debt or losses.
A few types of businesses generally CANNOT be LLCs, such as financial institutions, banking, trust, and insurance companies. Some states exclude licensed professionals from being LLCs. Here are the different types of LLC business structures:
Multi-member LLC: A domestic LLC with at least two members. They can classify as a partnership or corporation for federal income tax purposes.
Single-member LLC: Those having only one owner are permitted in most states. Single-member LLCs can elect to be treated as a corporation or a disregarded entity. If the LLC is a disregarded entity, the LLC’s activities are reflected on the owner’s federal tax return.
Shelters personal assets from bankruptcy or lawsuits
Members in an LLC organizational structure can vary
Division of profit follows member agreement
Can bring on investors as passive members
Can elect to be an S corp (depending on the state)
LLC pays less tax than a corporation
No corporate tax rates for a partnership or disregarded entity LLC’s
Protection laws vary from state to state
business structure not recognized in all states
Some industry restrictions
A corporation is a company or group of people legally recognized as an entity separate from its owners. Owners, called shareholders, exchange money, property, or both, for the corporation’s capital stock. This business structure offers the largest degree of protection from personal liability because the business is taxed separately from the owner.
A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders. Additionally, shareholders pay income taxes on dividends distributed to them throughout the year. If shareholders don’t receive distributions, they don’t pay taxes on corporate profit.
C Corporation business structures are subject to double taxation. This is when they are taxed before and after dividend distribution. Where both the business and the owner/shareholder pay taxes. The company pays corporate income taxes on its taxable profit. This is equal to the revenue, minus business costs and expenses.
Least liability risk: a separate business entity, with no ties to personal liability
Unlimited amount of shareholders
If they are paying a reasonable ratio of wages and dividends to shareholders, they can retain earnings for company investment, without a tax penalty
Can garner funds by selling stock
Attractive to banks and investors
Most amount of consumer trust
Subject to double taxation on dividend distributions
Difficult end of year tax return
Lots of paperwork tracking revenue, stock, and shareholders incomes
Officers of the corporation must receive W-2 salary from the corporation, unless they are passive.
Costly to form
Corporations or LLCs can make an S Corp election with the IRS. This is done to pass corporate income, losses, deductions, and credits through to shareholder taxes. Shareholders report the flow-through of income/losses on their personal tax returns and are assessed tax at individual income tax rates. To avoid double taxation, they only pay self-employment taxes on wages. Rather than the entirety of company profits.
All other income is paid to shareholders in the form of distributions that are not subject to self-employment tax. However they are responsible for tax on certain built-in gains and passive income at the business entity level. There are limits to the amount of stock that can be shared. Not all states and local governments recognize this designation
S-Corp business structure is not subject to double, so the pay less tax than a C Corp
Least amount of liability
Can reinvest company profit without being taxed
Pass through tax for shareholders
No self employment tax on income exceeding W-2 salary
Limited amount of stock to share
Limited to 100 shareholders
S Corp election must be approved by the IRS
Lots of paperwork tracking revenue, stock, and shareholders incomes
Officers of the corporation must receive W-2 salary from the corporation
Paying Owners Salaries for Different Types of Business Structures
Paying yourself is one of the great luxuries of owning a business. Each business type comes with rules on pay. Salaries with tax withholdings are okayed in some jurisdictions. Others use “owners draw,” a percentage of company profits not subject to income taxes. Here are best payment practices for each business structure:
How to Pay Salaries for Sole Proprietors and Partnerships
These business structures are flexible about personal pay structure. There are no rules on how a sole proprietor or partner takes money out of the business account. This is because the IRS is getting the max amount of tax directly from the business owner. Owners can pay themselves salaries with tax withholdings OR owner’s draw payments. Here are some tips:
- Have a consistent payment schedule. One that leaves the business in good standing but also allows you to live.
- Be aware of how your income affects your liability. Constantly transferring money between business and personal accounts will affect your personal assets.
- When opting for an owner’s draw make sure you set-up estimated payments. Owner’s draw does NOT exclude you from self employment tax.
How to Pay Owner’s Draw for LLC
Since owners of LLCs are considered members, they are different from employees. Technically they CANNOT receive wages from the company. They must take an owner’s draw out of their share of company profits. Here are tips on how to pay owner’s draw for LLCs:
- Single member LLC’s can write themselves a check or transfer money from a business to personal account.
- Multi-member LLC’s decide how the profits will be split. These are called “guaranteed payments” which is a contractual obligation to pay its members. These payments have a zero net tax effect.
- Members are responsible for self employment taxes during quarterly estimated filings.
How to Pay Salaries for C Corp and S Corp
S Corp and C Corp shareholder-employees (owner’s of the company) are required to pay themselves a reasonable salary. The average amount for similar services is a good benchmark for a “reasonable employee salary.” There are several factors to consider when coming up with a shareholder salary, as stated in the IRS:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Revenue and dividend history
- Payments to non-shareholder employees.
- Timing and manner of paying bonuses to key people
- Comparable pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
Salaries vs Distributions for Corporations
Some owners try to avoid payroll tax, by solely giving themselves corporate distributions. It is illegal to disguise employee salaries as corporate distributions. The IRS will re-characterize your distributions as a salary. Plus a retroactive payment of payroll taxes with penalties, as icing on the cake. Likewise, scam loans from the corporation to shareholders are illegal. If a shareholder has no plan of paying back the loan with interest, the corporation will get a hefty penalty.
If your company is not making any money, the IRS will not object to you not paying yourself. That is the only case that goes without penalty. As soon as the company starts making a profit, you need to pay yourself reasonable compensation.
Tax Advantage of S Corp election
So your business is profitable, and you want to take out some money from the company. It’s usually less expensive to do so as an S Corp business structure than a C Corp. As mentioned before, income from a C Corp is subject to double taxation. The income is first taxed at the corporate level, then taxed again when it is distributed to the shareholders as a dividend. Because the owners of the company are also shareholders, they are taxed twice.
Income at an S Corp is only taxed at the personal level. This means that when they distribute income to the shareholders, the distributions are tax-free. With the condition, the shareholder has basis to take the distribution. If a shareholder does not have basis, the distribution may be subject to additional tax as a dividend.
Reasons Courts Will Lift the Corporate Veil on Liability
Liability protection is one of the main reasons people opt for LLC and Corporation business structures. Unfortunately, in the event of company failure, paying creditor debts with personal assets is not entirely off the table. As a business owner you should be aware that the courts can legally lift the corporate veil. Making you personally liable for business debt. Then, creditors can go after your home, personal bank accounts, and investments. Here are reasons for lifting the corporate veil on liability:
- Did the LLC or Corporation engage in fraudulent behavior?
- Did the LLC or Corporation follow corporate formalities?
- Was the LLC or Corporation properly funded to be a separate entity?
- Was one person or a small group of closely related people influencing control over the LLC or Corporation?
- Was the LLC or Corporation commingling assets (sharing bank accounts, paying personal bills with money from the business, etc)?
Organizational Structure Protects Business Assets
To avoid this situation, keep business and personal separate. Even if you are a small business with a few members, maintain formalities. Abide by all rules and regulations when making decisions for the company. Hold annual meetings and record any actions taken. Contracts are a great way to protect each member and ensure everybody is on the same page. Courts will not find innocent parties personally liable for business debt.
Should I Change My Business Structure?
At some point your business structure may need to change. You can change it once with ease, a second time is more complicated. So consider why you need to make a change. Here are reasons to change different types of business structures:
- You want more business credibility and trust with consumers
- You have attained significant assets and you want to ease personal liability.
- You gained a partner or silent investor
- You want to make your business more appealing to investors
- The partnership dynamic has changed
- The managing partner wants less liability
- You no longer want to pay self employment tax
- You are doing business in another state that doesn’t recognize this designation
- You want to transfer ownership of the business
- You want to minimize self-employment tax via S Corp election
- You want to provide a stock option
- You are doing business in another state that doesn’t recognize this designation
- You don’t want to be subject to double taxation
- You want to split profits and losses amongst owners differently
- You want to avoid extensive record keeping
- The corporation is dissolving
- You want to increase the amount of shareholders
- Shareholders no longer want to pay pass thru tax
- Split profits and losses amongst owners differently
- You want to add a foreign owner not permitted by the state
Business Structure for the Future
Your business should make you happy, and provide a good living. The last thing you want is to get caught up in a litigious situation. Set your business structure with the future mind. Consider how much liability you have and the amount of taxes you want to pay. Be sure to anticipate business growth. Will you seek investors or partners? Will you share stock? Will you want less liability? All of this is easier to decide in the first year of business. Always consult a tax accountant before making the final decision.