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50% of new businesses fail in the first 5 years according to the Small Business Administration (SBA). One of the main reasons – failing to plan and set up the RIGHT way. So what entity is right for you? Entity selection is an imperative part of setting up a business. Don’t take a short cut and try to save a quick buck if you want your business to succeed. Today, we will highlight some of the most popular business structures.
Simplest business entity with no protections or tax efficiencies. There are no forms to fill out or state organizations to register with. Transferring assets in and out of the business is easy with no formal accounting requirements. This simplicity comes with a hefty price. The owner is held personally liable for the debts and obligations of the business—meaning personal assets (think your house, car, checking account) can be treated as business assets.
No separate tax return is filed for a sole proprietorship. Rather, your income and expenses are reported on your 1040, schedule C. This limits you to personal deductions for certain expenses that create a far less favorable tax environment for you and your business.
2 types of Corporations exist with very different tax and legal boundaries: C-Corporations and S-Corporations.
When most people think of businesses, they think of C-corporations (corporations with stock offerings). C-corporations are owned by shareholders who own stock in the corporation – called shares. Although the shareholders may vote on certain actions, the corporation is guided by a board of directors, who are usually elected by the shareholders. The day to day management is then governed by the officers of the corporations, think CEO and COO. One of the benefits of a Corporation is that the shareholders are not liable for the debts and obligations of the corporation. This protection comes at a price. C-Corporations face “double taxation”. The Corporation is a separate entity and pays taxes on the profits earned and then the individual shareholders pay taxes again on the dividends they receive. C-corporations have their place, but there are few situations where this tax hit makes sense.
S-Corporations refer more to a tax designation then a legal entity. Corporations and LLCs may elect S-Corporation status at the federal level even though they set up at the state level in another entity type. S-Corporations have a number of limitations: there is a cap on the number of shareholders, there can be only one class of stock, and there cannot be any foreign shareholders. S-Corporations are the small business saviors when it comes to tax efficiency. S-Corporations have pass through taxation and the entity does not pay taxes on the income, but the shareholders do pay taxes on distributions. This allows small businesses a way to avoid employment taxes (social security and Medicare) on distributions. However, they will still pay these taxes on compensation. The split between distributions and compensation in a S-Corporation is tricky and while it can save a significant amount of money, it can also trigger an audit risk and penalties if not done properly. Key takeaway—don’t be greedy. S-corporations can also lose their s-election if they are not managed properly and fail to follow all of the rules. This results in c-corporation treatment, which can have devastating financial consequences for the business.
Perhaps the most popular entity today is the LLC due to its flexibility and hybrid nature. You get the legal and liability advantages of a corporations, with the tax efficiency of a S-corporation or partnership. Unlike corporations, LLCs are owned by the Members who own units in the Company. Provided the Company is run properly and adheres to the required formalities, then the Members are not liable for any debts and obligations. Further, the formalities required with an LLC are often far less than that of a corporation.
So what is the right fit for you? Discuss your business plan and finances with your CPA and your attorney and together (yes they need to work together on this one), they can recommend the best entity for your business that provides you tax efficiency and liability protection. Choosing the right entity is the first step. Protecting the owners and the business is the second. Learn more about the risk a divorce, creditor, bankruptcy, sale, disability, or death of any one owner can have on your business without the right plan in place. Schedule a complimentary initial consultation to learn more about how to ensure the success of your business from day 1.
For help determining which entity is right for your business, please contact us.
This is not what you do every day. It is what we do. Let us help provide the resources you need to make an informed decision.
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