There are many different ways to set up a business, but understanding which one is the best fit for your entrepreneurial situation can be overwhelming. Whether you are just starting out or looking to change the structure of your existing business, it’s important to remember that the type of entity you choose will impact your core business objectives, such as:
- Tax savings
- Limitation of liability
- Management
- Capitalization
- Ownership transition
We’ve put together a quick “cheat sheet” to look at business entity types and the high-level pros and cons related to these objectives. Remember to discuss these options with your tax professional or business advisor so you are aware of all financial and legal consequences of your choice.
Proprietorships
PROS
- Easy to form and simple to operate
- Few administrative burdens
- Income taxed at the personal level
CONS
- Limited sources of capital
- No limited liability (Exception: single-member LLC may be treated as a sole proprietorship for income tax purposes but provide liability protection)
- Net income subject to self-employment tax
General Partnerships/Limited Partnerships
PROS
- More sources of capital than proprietorships
- More management resources
- Less administrative burdens than corporations
- Income is taxed at personal level and allocations of income can be flexible
CONS
- Transfer of interests can be difficult
- Each partner is personally liable for all partnership obligations (in Limited Partnerships, there is ability to have limited liability to the extent of partner’s investment)
- Net income subject to self-employment tax
- Partnership income tax and basis rules can be complex
- Partners not entitled to all tax-deductible fringe benefits
Corporations
PROS
- More sources of capital
- Owners have limited liability
- Corporations have unlimited lives
- Easy to transfer ownership interests
- More management resources
CONS
- Double taxation
- More administrative burden
- More difficult to form and dissolution can trigger taxable income
- Borrowing can be more difficult without stockholder guarantees
S Corporations (S Corp)
PROS
- Avoid double taxation, income taxed at shareholder level
- Owners have limited liability
- Distributions to owners exempt from payroll taxes (assuming adequate compensation exists for the shareholder)
CONS
- Number of shareholders is limited
- Only have one class of stock (differences in voting rights allowed)
- Limits on types of shareholders (certain trusts, corporations, partnerships)
- Shareholders who own more than 2% must pay tax on some employee fringe benefits
- Tax basis for deductions, losses and distributions does not include corporate debt guaranteed by shareholder
Limited Liability Company (LLC)
PROS
- Members have limited liability, not personally liable for LLC’s debt, unless guarantee
- Management participation can be limited based on the LLC agreement
- Flexibility to choose to be taxed as a C Corporation or S Corporation
CONS
- Transfer of interests may be difficult
- Some industries and/or professions may not permit LLCs
- Liability protection is relatively untested compared to other entity types
Limited Liability Partnerships (LLP)
PROS
- Income passed through and taxed at personal level
- Ownership structure is flexible
CONS
- Transfer of interests may be difficult
- In some states, partners are liable for debts and obligations of LLP
Identifying your objectives and evaluating the advantages and disadvantages of various entity types before making your selection is an important part of the process when opening or changing your business. The chart above captures the main pros and cons to consider when selecting an entity type or changing entity status, but it is important to complete a full review of all factors before making such an important decision. RKL’s Tax Services Group is ready to help you through the entity type evaluation and selection process, to ensure that you find the right entity type for your specific business needs. Contact us today to get started.
