The Business Structure
How you structure your small business will determine how you run the operations, employ workers, and pay state and federal
income taxes.
There are many different types of business entities: sole proprietorship, general partnership, C Corporation, S Corporation and
LLC (Limited Liability Companies). Learn more about each of these options and see which is the best choice for your business.
Sole Proprietorships
A sole proprietor is an individual operating a small business as a self-employed person. The owner is
liable for all business debts and actions and receives all the profits and losses from the
business. If the proprietor's net self-employment income is $400 or more, he or she also pays
self-employment tax.
Advantages
- A sole proprietorship is an easy start-up business to organize.
- There are few legal restrictions.
- The proprietor has total decision-making control.
- Recordkeeping and accounting are relatively easy.
- If the owner wishes to dissolve the small business, he or she can do so easily and with minimal federal income
tax consequences.
Disadvantages
- The proprietor (and spouse, if a joint return is filed) bear(s) the total legal and
financial risk for the small business.
- The owner's liability extends beyond the business property to his or her personal property.
- The owner may have trouble raising needed capital.
- Business skills are limited to the owner's (and his or her employees') ability.
- Personal federal income tax cannot be deferred by retaining profits.
Partnerships
A partnership, either general or limited, is a contractual association of 2 or more persons
carrying on a business. Each partner contributes property or services and shares in the profits.
Partnership formation can be informal and inexpensive.
Limited partnerships differ in that a limited partner has only a limited amount of liability in
the company. That limited liability is equal to the amount that the partner has invested into the
company.
Advantages
- A partnership is an easy start-up business to organize. It provides a vehicle under which spouses can be
considered equal owners in a business.
- Because children may be partners, some income may be taxed at lower rates than if it were
all reported on the parents' federal income tax return(s).
- A partnership offers better financial strength than a sole proprietorship, and more than
1 person's skills and judgments are available.
- A partnership has legal status.
- Each partner has an interest in the small business, and active partners may use losses to
offset other income.
- The partnership may or may not dissolve on the death of a partner, and partnership
interests may be sold to others.
Disadvantages
- The partners generally take all the risks in a partnership, and general partners are
liable to the extent of both business and personal property.
- Limited partners' losses are subject to the passive loss rules. For purposes of the
passive loss rules, income must be divided into 3 categories: active income, passive
income and portfolio income. Passive income is income for assets such as real estate.
General partners must be able to show material participation to avoid passive loss
limitations.
- Shared decision-making may create problems among the small business decision-makers.
- General partners must pay self-employment tax on the partnership's trade or business
income.
- Federal income tax cannot be deferred by retaining profits at the partnership level; partners pay
tax on partnership income whether it is distributed or not.
- Disagreements among partners may be difficult or impossible to resolve.
- State and federal reporting requirements apply.
- The business terminates if more than 50% of the ownership changes.
Taxable (C) Corporations
A corporation is a business entity with its own legal identity, rights and liabilities.
Characteristics of a corporation include continuity of life, central management, limited
liability of the owners (stockholders or shareholders), and free transferability of ownership. In
general, a corporation is formed by incorporating under state law by filing articles of
organization and paying the state's incorporation fees.
Advantages
- A corporation exists until it is dissolved; it does not dissolve at the death of a
shareholder.
- A corporation may have 1 or many shareholders.
- Ownership transfers through stock sales have no tax effect on the company and are easy to
accomplish.
- Capital can be raised through stock sales.
- Management duties are shared.
- A corporation offers limited liability; in general, a shareholder is liable only to the
extent of his or her investment in the corporation and for debts he or she personally
guarantees.
- A corporation can offer tax-sheltered fringe benefits to its employees, including
shareholder-employees.
- Corporate tax rates may be lower than individual rates.
- Children can own stock.
Disadvantages
- Corporate income is taxed twice, once at the corporate level and again at the shareholder
level as dividends. Although the Jobs and Growth Act of 2003 has reduced the federal income tax paid on
qualified dividends, the double tax still applies.
- Personal service corporations are taxed at a rate of 35%.
- Corporations can be difficult and expensive to organize, and the corporate charter
restricts the types of business activities a corporation can pursue.
- Corporations can have complex legal and accounting requirements, which is not bad unless
the stock is publicly traded.
- Shared decision-making may create problems among the decision-makers.
- A corporation cannot simply stop doing business but must liquidate, and liquidations and
distributions of corporate assets are taxable events.
- The corporation's losses can only offset corporate income. Corporate losses are not
passed through to shareholders but instead are carried to years when the corporation has
profits.
S Corporations
An S corporation is a "pass-through" entity formed by filing Form 2553 with the IRS. S-corporation
income and losses are passed through to the shareholders; income is taxed at the individual level.
An S corporation must meet certain restrictions regarding its shareholders and cannot be included
on a consolidated return. However, an S corporation can be a partner in a partnership or own all
or part of other corporations. S corporations must satisfy state incorporation requirements.
Advantages
- S corporations offer limited liability. In general, a shareholder is liable only to the
extent of his or her investment or debt he or she personally guarantees.
- Net S corporation income is not taxed at the corporate level.
- It is possible to shift income by giving children shares of S corporation stock.
- The business does not dissolve at the death of a shareholder. Some or all beneficiaries
in a family S corporation can actively carry on the business.
- Materially participating shareholders can offset other income with S corporation losses.
- Shareholder-employees are not subject to self-employment tax on S corporation profits,
and income is taxed only at the shareholder level (unless the S corporation has
accumulated C-corporation earnings and profits).
Disadvantages
- An S corporation can have no more than 100 shareholders and cannot have nonresident alien
shareholders. The S corporation can have only individuals, estates and certain trusts as
shareholders.
- An S corporation only has limited flexibility in choosing a tax year.
- Shareholders are taxed on S corporation profits, whether the profits are distributed or
not.
- Children are employees of the corporation, so the FICA/FUTA exemptions for children
employed by their parents do not apply.
- Shareholder-employees who perform services and are paid little or no wages are likely to
have distributions reclassified as wages.
- Fringe benefits provided to more-than-2% shareholders are subject to tax.
Qualified retirement plan contributions are based on the employee shareholder's wages,
not on the overall profits of the company.
LLCs
A limited liability company (LLC) is a hybrid organization combining the pass-through ability of
a partnership with the limited liability features of a corporation. LLCs are organized under
state law; there are filing fees associated with the organization of the LLC. LLCs with 2 or
more members are taxed as partnerships unless they elect to be taxed as corporations. A
single-member LLC is taxed as a sole proprietorship unless it elects to be taxed as a corporation.
Advantages
- An LLC can have more than 100 owners. It can be owned by a corporation or be part of an
affiliated group.
- LLCs need not make a special IRS election to receive LLC treatment (unlike S corporations
with Form 2553).
- Gains, losses and other tax attributes are not taxed at the entity level but pass through
to the LLC members.
- In general, no gain is recognized on the transfer of property to the LLC by from its
members or on distributions of property other than cash to a member until the member
disposes of property.
Disadvantages
- LLC managers are subject to self-employment tax on the entity's trade or business income.
- Members must pay income tax on LLC profits even if the profits are retained by the LLC.
- LLCs must set termination dates and must terminate if their ownership changes by 50% or more
in a 12-month period.
- An LLC may need to file as a tax shelter if it has members who are treated as limited
partners or "limited entrepreneurs" (persons who are not limited partners and do not
actively participate in the LLC's management).
