Choice of Entity for Small Business Owners

Are you an entrepreneur or small business owner trying to determine which business entity is right for your business?  This article is for you.

  1. Overview of the Available Legal Entities:  “The Big Three”

    1. The three most commonly used vehicles for operating a business activity are the C corporation, the S corporation and the limited liability company (“LLC”).  

      1. C corporations 

        1. Separate taxpayers filing Form 1120.

        2. Subject to “double taxation,” meaning that corporate income is taxed first at the corporate level on Form 1120, and then, when profits are distributed to shareholders as dividends, the dividends are taxed at the shareholder level (typically on Form 1040, assuming the shareholder is an individual).  

        3. Cons: (i) double taxation; (ii) complexity and costs; (iii) complexity in profit distribution; (iv) regulatory compliance; and (v) ownership restrictions.

      2. S corporations

        1. Pass-through entities, in that the income of each business entity is generally passed through to its owners at the federal level, and also at the state level.

        2. Easy to set up.

        3. Intuitive to operate, since they require a strict pro-rata allocation of all tax items under Subchapter S and strict pro-rata distributions of all property.  

      3. LLCs

        1. Pass-through entities, in that the income of each business entity is generally passed through to its owners at the federal level and also at the state level.

        2. Easy to set up.

        3. Intuitive to operate, and additional flexibility because you can choose to be taxed as an S corporation, partnership (if more than one member), or pass-through to individual’s personal return (if a single member).

  2. LLC vs. S corporation

    1. Single Member LLC (Pass-Through Taxation)

      1. Pros:

        1. Simplicity in Taxation: LLCs offer a simplified tax process since income is reported on the owner’s personal tax return, avoiding the double taxation common in traditional corporations.

        2. Flexibility: LLCs are known for their operational flexibility and fewer compliance requirements compared to S corporations.

        3. Limited Liability Protection: Offers personal asset protection from business debts and liabilities.

        4. No Ownership Restrictions: LLCs face no restrictions on the number or type of owners.

      2. Cons:

        1. Self-Employment Taxes: Profits are subject to self-employment taxes, which can be higher than corporate tax rates.

        2. Limited Growth Potential: Investors might be less attracted to LLCs as they can’t issue stock.

        3. Limited Fringe Benefits: Tax treatment of benefits like health insurance can be less favorable than in an S corporation.

    2. Multi-Member LLC (Taxed as an S corporation)

      1. Pros:

        1. Tax Savings on Self-Employment Taxes: Only the salary paid to members is subject to self-employment taxes (Social Security and Medicare), not the entire profit distribution. This can lead to significant tax savings.

        2. Salary and Dividend Splitting: Allows for splitting income between salary and dividends, potentially lowering overall tax liability.

        3. Limited Liability Protection: Provides personal asset protection against business liabilities.

        4. Credibility: Often perceived as more structured and professional, which can be beneficial for raising capital or business dealings.

      2. Cons:

        1. Payroll Requirements: Members working in the business must receive a reasonable salary, subject to payroll taxes.

        2. Stricter Compliance Requirements: More formalities like annual filings, maintaining corporate formalities, and stricter accounting rules.

        3. Ownership and Shareholder Restrictions: Limited to 100 shareholders, who must be U.S. citizens or residents.

        4. Potentially Higher Administrative Costs: Due to increased regulatory and compliance requirements.

    3. Multi-Member LLC (Taxed as Partnership)

      1. Pros:

        1. Simplicity in Taxation: Income, deductions, and credits flow through to members’ personal tax returns, simplifying the tax filing process.

        2. Flexibility in Profit Distribution: Partnerships offer flexibility in how profits and losses are allocated among members.

        3. No Salary Requirement: Members are not required to be on payroll, avoiding the need for reasonable salary assessments.

        4. Fewer Compliance Requirements: Generally, partnerships face fewer formalities and compliance requirements than S corporations.

      2. Cons:

        1. Self-Employment Taxes on Entire Profit: All profit distributions are subject to self-employment taxes, which can be higher than the tax on corporate dividends.

        2. Limited External Funding Options: May be less attractive to investors compared to S corporations, which can issue stock.

        3. Less Structured Management: Can be seen as less formal, potentially impacting business credibility and investor confidence.

        4. Joint and Several Liability: Depending on state law, members may be personally liable for the actions of other members.

    4. S corporations 

      1. Pros:

        1. Tax Savings on Self-Employment Taxes: Only salaries (not dividends) are subject to employment tax, potentially reducing the overall tax burden.

        2. Credibility and Investment Attraction: S corporations might appear more formal to investors and can issue stock, which can attract investment.

        3. Fringe Benefits: Employees can receive benefits like health insurance tax-free, and the company can deduct these costs.

      2. Cons:

        1. Stricter Operational Requirements: S corporations have more formalities like annual meetings, stockholder meetings, and keeping minutes.

        2. Salary Requirements: You must pay yourself a “reasonable salary,” which is subject to employment taxes.

        3. Ownership Restrictions: Limited to 100 shareholders, all of whom must be U.S. citizens or residents.

        4. Tax Qualification Obligations: Failure to meet IRS regulations can lead to losing S corporation status.

  3. Key Considerations

    1. Nature of Business: Some businesses might benefit more from the corporate structure of an S corporation, especially if planning to seek investors.

    2. Income Level: High earning businesses might save on taxes as an S corporation

    3. Administrative Burden: LLCs have fewer compliance and administrative burdens.

    4. Future Goals: Consider long-term business goals, including potential investment needs and growth strategies.

Contact Logan & Logan LLP For Business Planning

Each business scenario is unique, so please consult with a tax professional or a business advisor to understand the implications fully and make an informed decision based on your specific circumstances. Contact Logan & Logan LLP for a professional opinion on what is best for your business. Fill out our form today or give us a call at (617) 209-3723.

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