What's the Best Entity Type for a Business?
This is one of the most prevalent questions business owners ask themselves today. Believe it or not, tax planning starts here.
This is because entities have different tax implications.
So, for you to pay less taxes, you need to understand and identify the right business entity for you. Before we show you how to know what business entity is right for you, let’s go over the different entities recognized by the Internal Revenue Service (IRS).
Sole Proprietor
The IRS will regard you as a Sole Proprietor automatically if you materially participate and personally run a business and there is no legal entity in between the owner and the business. Married couples have the option to elect to be treated as a Sole Proprietorship if both spouses materially participate in the business (With exception of some states, the rule of thumb is that both spouses participate more than 500 hours in a given year). Sole proprietorships are not tax-paying entities. Taxes on any profits are reported on the owner’s tax return. Listed below are the Pros and Cons of a Sole Proprietorship.
Cons:
- Higher audit risk
- Personal liability
- Tendency to mix personal and business expenses on the same bank account (If ever audited, this increases your chances of an auditor disallowing any claimed deductions)
Pros:
- Opportunity to develop a personal brand
- Reduced costs of starting a business
- Simplified business ownership and profit distribution
- Flexibility
Partnership
A partnership automatically comes into existence whenever two or more people enter into business together to earn a profit and don’t incorporate or form a limited liability company (LLC). However, in most scenarios partners enter into a written agreement to form a partnership. Partnerships are not taxed at the entity level. Rather, its profits are passed through to owners and then those owners pay tax on any profits earned on their tax returns.
Cons:
- Entire partnership is responsible and liable for any given partner’s actions unless otherwise specified in the written partnership agreement
- Unless otherwise specified on a written agreement. Each partner is liable for their partnership share of debt as well as all of the partnership’s debts and obligations
- Higher legal fees in efforts of creating a complete written partnership agreement to accommodate each partner’s self-interest and conditions
- Prone to partnership conflicts
Corporation
Contrary to a partnership or a sole proprietorship, a corporation can only come into existence by filing incorporation documents with your state government. A corporation is a legal entity distinct from its owners. It can hold anything that an owner of a sole proprietor or owners of a partnership can. Examples are the capability of holding title to a property, suing and being sued, having bank accounts, borrowing money, hiring employees, and other business-related endeavors. There are two types of corporations.
C corporations/regular corporations
This type of corporation is a tax-paying entity. This means owners will be taxed on their corporation’s profits twice. First at the entity level and then when they pay themselves.
Pros:
- Lower audit risk
- Limited liability
- Open to tax-saving strategies
- Perpetual existence
- Retain earnings from being taxed to owners
Cons:
- Higher startup expenses
- Corporate formalities
- Professional record-keeping
S Corporations
This type of corporation is not a tax-paying entity. Just like the sole proprietorship and partnership, the tax treatment is passed through to owners.
Pros:
- Lower audit risk
- Limited liability
- Open to tax-saving strategies
- Perpetual existence
- Defined profit & loss allocation
Cons:
- Corporate formalities
- Professional record-keeping
Limited Liability Company (LLC)
This type of business entity can be treated either as a sole proprietorship or as a partnership depending on the number of owners (members in this case) under the LLC. However, an LLC is also like a corporation at the same time, this is because you must file incorporating documents with your state for an LLC to come into existence. It would exist as a separate legal entity.
Pros:
- Lower audit risk
- Limited liability
- Open to tax-saving strategies
- Perpetual existence
- Flexibility
Cons:
- Costs to incorporate the entity
The right business entity is the one that allows you to pay less tax. Is the one that allows you enough flexibility for you to grow your business. And is the one that protects you from external threats. Again, when planning to save money on taxes it all starts at the entity level. Nevertheless, while a tax pro can help you save on taxes it doesn’t mean that it is also the right person to advise you on asset protection. Have your tax pro help you with your entity arrangements for tax saving purposes and then validate it with an attorney who is an expert in asset protection. Triangulate these individuals so that you can save money on taxes, grow your business, and protect your assets.