What Structure of Business Ownership Is Best?
Small business owners have unique financial, tax, and liability concerns, which can be addressed by their form of business ownership. In particular, your choice of business structure determines your tax treatment and your liability risk. As your company grows or ownership changes hands, reassessing your initial choices can be appropriate. This article explores the characteristics of five basic business entities: sole proprietorships, partnerships, C corporations, S corporations, and limited liability companies (LLCs).
Many small businesses start out as sole proprietorships, but owners need to be aware of the personal liability risk. One individual owns a sole proprietorship and typically runs the business. Sole proprietors own all assets and profits, and income is subject to individual income tax, as well as self-employment tax. The sole proprietor assumes personal liability for all aspects of the business, including debt and legal action taken against the business.
Two or more people own a partnership, and there are several types, including general partnerships, limited partnerships, family limited partnerships, and limited liability partnerships. A legal agreement generally specifies how profits will be shared, delineates the management responsibilities, and provides guidance for resolving disputes and dissolving the partnership. General partners face unlimited personal liability, whereas limited partners assume liability no greater than the capital they contributed.
Tax treatment is similar to that of sole proprietorships. The partnership entity is not taxed; however, partners are subject to income tax on their compensation, plus self-employment tax, if applicable. Losses also pass through to partners, and restrictions on deductibility apply. Because of this “pass-through” taxation, partnerships avoid the double taxation that corporations may face.
Shareholders own a corporation, which is considered by law to be a unique entity separate from those who own and run it. The corporation pays corporate taxes, and the shareholders pay tax on the income they receive as dividends. This double taxation can be a disadvantage, particularly for owners who are not in a position to reinvest a significant portion of profits back into their business.
One advantage to this structure for businesses is the protection it offers from personal liability. Owners are personally shielded from debt liability and lawsuits against the company; only the amount of their investment is at risk.
S corporations, which limit ownership to 100 shareholders, share characteristics of C corporations and partnerships. This form of pass-through entity generally does not pay corporate income tax and permits the shareholder to treat company earnings and profits as distributions. This income depends on the shareholder’s percentage of ownership and passes through directly to his or her personal tax return, thereby avoiding double taxation and self-employment tax. Shareholders may also deduct losses, limited to their basis in the business. State tax treatment may vary.
As with C corporations, shareholders are protected from personal liability. Only their investment in the company is at risk.
Limited Liability Companies
A limited liability company (LLC) provides the limited liability benefits of a corporation and the tax efficiencies and operational flexibility of a partnership. Members of an LLC are protected from personal liability, risking only their investment in the company. Most states require LLCs to have at least two members, but there is no maximum limit.
LLCs can be taxed in a variety of different ways. “Check-the-box” regulations enacted in 1997 simplified the taxation of LLCs. Unless it chooses to be treated as a corporation for tax purposes, an LLC with two or more members will be treated as a partnership, while a single-member LLC will be treated as a sole proprietorship. If treated as a partnership, the LLC’s profits and losses pass through to the members, who then pay the tax on their individual income tax returns.
As you can see, each business structure has its advantages and disadvantages. Your choice affects the taxes you pay and your personal liability risk, so it is important to choose the right entity for your business.
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