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 is a major consideration, since, for a sole proprietorship or a general partnership, the business owner is personally liable for the liabilities of the business, 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, for many small businesses, lenders will require a personal guarantee for any loans extended to the business.
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.
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 a lot of 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 1st 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 owner can change to a C corporation once the business shows steady profits.
C corporations can offer the most fringe benefits that are tax-free, 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. 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 does have to 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 that are not as favorable as they are for employees.
If there is only 1 business owner, then a partnership is not available. However, a single owner can still choose a sole proprietorship, limited liability company that has a single member, or a C or S corporation. However, an S corporation cannot have more than 100 shareholders who must be individuals who are not nonresident aliens. (In certain cases, estates, trusts, and nonprofit organizations can also be shareholders.)
Individuals are subject to a top tax rate of 39.6%, while the C corporation top tax rate is 35%. 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 the money. 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 applies to taxpayers in the 39.6% bracket; for all others, the rate is 15% or 0%.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, corporations have received the best benefits, which includes the following changes:
- The top corporate tax rate is reduced from 35% to 21%.
- Business interest is no longer fully deductible. Instead, excluding depreciation, the deduction cannot exceed 30% of income.
- Eliminates the corporate alternative minimum tax.
- New investment purchases can be fully expensed in the 1st 5 years, but then it is phased out over 5 more years.
- The §179 deduction is increased to $1 million.
- The deduction of net operating losses is limited to 80% of taxable income.
- Previously, research and development expenses could be immediately deducted, but now they would need to be written off gradually.
Unlike the changes for regular taxpayers, most of which expire in 2025, most of the tax changes for businesses have been made permanent.
Also, pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorship's and independent contractors will be able to deduct 20% of their revenue. However, this deduction starts to phase out for couples earning at least $315,000 or $157,500 for singles.
Employment taxes — Social Security and Medicare taxes — must be paid on earned income. Employers pay ½ of the tax while the employee pays the other half. An additional 0.9% Medicare tax applies to those individuals who earn at least $200,000 annually. However, only the employee pays the tax — there is no employer share. 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 any 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 are required to use the calendar year, unless there is a business purpose for using a fiscal year. Large corporations are required to use the accrual method of accounting, which most do, since it more accurately represents the financial status of the business.
Deductibility of Owner's Payment of Expenses
If the owner pays the expenses of the business, then the deductibility of those expenses will be determined by the type of business entity. A sole proprietor can just deduct the expense 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 expenses are treated as miscellaneous itemized deductions in which only the portion of expenses that exceeds 2% of the shareholder's adjusted gross income is deductible. However, the corporation can avoid this result by setting up an accountable plan, which is deductible by the corporation and tax-free to the employee.
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, only has to file 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.
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, since 50% of the stock can be sold tax-free while the other 50% will be subject to a 28% capital gains rate, thus yielding a 14% tax rate on the overall sale.
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 may be able to 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.
- IRS audit rates are generally much higher for sole proprietorships with incomes in excess of $50,000 than for other business entities, because sole proprietors are more likely to hide income or to overstate deductions.