Business Entities: Pros and Cons

Various factors should be considered when deciding what type of business entity to choose: personal liability, access to capital, profits or losses, fringe benefits, ownership, tax rates, employment taxes, restrictions on accounting periods and methods, multistate operations, and exit strategy. Some factors are more important than others, depending on the nature the business, the knowledge and expertise of the business owner, and the start-up money available.

Personal Liability

Personal liability is a major consideration since, for a sole proprietorship or a general partnership, the business owner is personally liable for business liabilities, so the owner's personal assets may be at risk if the business fails. Most businesses cover some liability with insurance, but selecting the right business entity can further limit personal liability. Entities in which the owner's assets are usually not at risk include limited liability companies, limited partnerships, and corporations.

However, personal liability can be set by contract so that the other party has some guarantee of payment or performance. For instance, lenders will require a personal guarantee for any loans extended to the business. SBA loans also require personal guarantees from all owners holding at least a 20% interest in the company.

Regardless of business entity, business owners have personal liability for trust fund taxes — Social Security and Medicare taxes that employers must withhold from employee's paychecks. The employer must also pay the employer's share of trust fund taxes for its employees.

Startup Capital

Businesses require startup capital. For many small businesses, business owners use their own funds or get funding from family and friends. If a business needs to raise more capital, that can best be achieved by forming a corporation. S corporations, however, are limited to 100 shareholders, limiting its fund-raising potential. Partners and members of limited liability companies can also contribute capital, but they also have some control in the business.

Business Losses in the Early Years

If a business is expected to sustain losses in its 1^st few years, as many do, then it is best to start as a sole proprietorship, partnership or some other pass-through entity because losses can be deducted by the business owners from other income. However, any losses sustained by a C corporation can only be deducted by the corporation — not by its owners. However, once a business becomes profitable, then a C corporation can be a better choice since there are greater tax-free fringe benefits for the employee-owners of the C corporation than for other business entities. Consequently, many businesses start as an S corporation, which allows losses from the start-up phase to pass through to its owners, then the owners can change to a C corporation once the business shows steady profits.

Fringe Benefits

C corporations can offer the most tax-free fringe benefits, including group term life insurance up to $50,000, health insurance coverage, medical reimbursement plans, up to $5250 worth of educational assistance annually, $5000 worth of dependent care assistance, adoption assistance, and more.

Corporations can also set up employee stock ownership plans, allowing employees to receive ownership interest in the company. Some C corporations can also offer stock that qualifies as small business stock where 50%, 75%, or 100% of the gain can be excluded from income if the stock was held for more than 5 years. C corporations can also offer incentive stock options and non-qualified stock options. While S corporations are not prohibited from offering stock option plans, their 100-shareholder limit means that only S corporations with fewer employees could offer this fringe benefit.

However, to maintain preferential tax treatment, the corporation must offer it to employees who are also not owners. Another important consideration is whether the business can actually afford the fringe benefits since the business must pay for them even if they are tax-free.

However, sole proprietors, partners, LLC members, and S corporation shareholders who own more than 2% of the stock in their corporations are not treated as employees, so their fringe benefits are subject to different tax rules less favorable than for employees.

Ownership

If there is only 1 business owner, then a partnership is unavailable. However, a single owner can still choose a sole proprietorship, a limited liability company with a single member, or a C or S corporation.

Shareholders of S corporations must be individuals, not partnerships or corporations, who are not nonresident aliens, though there are certain exceptions, and the number of shareholders cannot exceed 100.

Tax Rates

Individuals are subject to a top tax rate of 37%, while the C corporation top tax rate is 21%. However, dividends paid by a C corporation to its owners are not deductible, so both the corporation and the individual shareholders must pay tax on paid dividends. However, dividends are taxed at a lower rate, or maybe not all, depending on the taxpayer's income, and employment taxes do not apply to dividends, lessening the disadvantage of their double taxation.

A major disadvantage of the C corporation is that it must pay ordinary income taxes on long-term capital gains. On the other hand, the top long-term capital gains tax rate for individuals is, at most, 20%, a rate that only applies to taxpayers in the 37% bracket; for all others, the rate is 15% or 0%.

Employment Taxes

Employment taxes — Social Security and Medicare taxes — must be paid on earned income. Employers pay 1/2 of the tax while the employee pays the other half. An additional 0.9% Medicare tax applies to those individuals earning at least $200,000 annually. However, only the employee pays the tax — there is no employer share, but the employer must collect the tax. Employment taxes apply only to earned income, not to the profits of the S corporation. However, self-employment tax must be paid by sole proprietors and owners of pass-through entities. Because the owners are both employers and employees, they must pay the entire tax, but they are allowed to deduct the employer's portion of the tax, so they pay about 14.13% of their net income for employment taxes.

Business income to a silent partner is considered passive income, so it is not subject to employment taxes but is subject to the 3.8% tax on net investment income if the partner's income is high enough. Corporate profits are not subject to employment taxes.

Accounting Periods and Methods

Business entities may be restricted in their choice of tax year or accounting method, depending on the type of business and on the type of entity. Partnerships, LLCs, and S corporations must use the calendar year unless there is a business purpose for using a fiscal year. Large corporations must use the accrual method of accounting, which most do since it more accurately represents the financial status of the business. More information: Tax Year and Accounting Periods

Deductibility of Owner's Payment of Expenses

The deductibility of business expenses paid by the owner depends on the type of business entity. A sole proprietor can just deduct the expenses from income or revenue, even from another business or from employment in another business. A partner can deduct paid expenses as an above-the-line deduction but only if the partnership agreement requires those expenses to be paid without reimbursement.

However, shareholders of a corporation are treated as employees, so the deduction of expenses is limited. But the corporation can avoid this by setting up an accountable plan, which is deductible by the corporation and tax-free to the employee.

Multistate Operation

The choice of business entity may also be important if the business operates in more than 1 state. Some states treat entities differently than federal law. For instance, some states do not recognize S corporations, so they are treated as C corporations.

A multistate tax headache occurs for pass-through entities, because each partner or LLC member must file a tax return for each state in which the entity does business. A C corporation, on the other hand, must file only 1 state tax return for each state in which it does business. Generally, the state can tax a business if it has a nexus in the state, meaning that the business has a physical presence within the state, although this definition has been broadened recently to include salespeople working within the state and may even include remote workers of the company.

Consequences of Terminating a Business

When a C corporation terminates, both the corporation and its owners may incur a tax liability because of the termination. An S corporation, however, may have to pay a capital gains tax on appreciated property it held as a C corporation.

The sale of a sole proprietorship is treated as a sale of the underlying property, with the result that some gains are taxed as ordinary income while others may be subject to the more favorable long-term capital gains tax. The sale of stock in a C corporation may be taxed more favorably if it qualifies as a small business stock.

How business losses affect the owners also differs according to entity type. Losses suffered from a sole proprietorship must be borne by the owner but can be deducted against other income; creditors can go after the owner's personal assets to satisfy their claims. Losses from a partnership or LLC are treated as capital losses. Shareholders of corporations could treat their losses as §1244 losses, if the stock qualified as §1244 stock, where at least some of the losses can be treated as ordinary.

Because a sole proprietorship is not a separate legal entity, only the owner can declare bankruptcy, which will also affect his credit report and credit score. Sole proprietors and general partners cannot escape personal liability for the liabilities of the business. However, owners of limited liability companies and corporations are generally beyond the reach of the creditors of the business.

Beneficial Ownership Information Reporting

Any small business required to file documents with a secretary of state to start its business or a foreign company registered to do business in the U.S. must report its beneficial owners to the federal government. There are many exempt categories, including publicly traded companies and nonprofits, but the primary exemption is for large operating companies employing more than 20 employees working at least 30 hours per week, with more than $5 million in gross receipts in the previous year, and has a physical presence in the U.S. Most of the other exempt categories are regulated by other laws, such as banks and insurance companies.

Beneficial owners own or control at least 25% of the company or are company officers who exert substantial control. 

For each beneficial owner, report:

• full legal name
• birth date
• address
• identification number uniquely identifying the owner and the issuing jurisdiction
  • e.g., Social Security number, individual taxpayer identification number (ITIN), state driver's license or other state identification, foreign passport

When to report: 

• Companies existing as of January 1, 2024: by January 1, 2025
• Newly formed businesses: within 90 days of when creation or registration becomes effective
• beneficial ownership changes

Penalties for noncompliance:

• civil penalties: $500 per day, $10,000 maximum
• criminal penalties: up to 2 years imprisonment

However, as of January 2025, the requirement to report beneficial ownership is suspended because of court cases. However, taxpayers may voluntarily provide this information to the U.S. Department of the Treasury's Financial Crimes Enforcement Network (FinCEN) at BOI E-FILING.  More information: https://www.fincen.gov/boi

Notes

• IRS audit rates are much higher for sole proprietorships with incomes exceeding $50,000 than for other business entities, because sole proprietors are more likely to hide income or to overstate deductions.