Business entity selection is a crucial first step in establishing your new business. The structure you choose influences many aspects of your business including operations, taxes, and how much your personal assets are at risk. In the following guide, we’ll discuss the pros and cons of each type of business entity to give you a better idea of which structure may work best for you.
What Are Some Key Factors to Consider in Entity Selection?
There are several different key factors to consider in business entity selection. The most important are liability, taxation, control, and scalability. Let’s look at how each of these factors matter:
- Liability: How much personal risk are you willing to take on? Some structures protect your personal assets, while others do not.
- Taxation: Different entities are taxed in different ways. Some offer pass-through taxation, while others face double taxation.
- Control: Do you want full control, or are you comfortable sharing decision-making with partners or a board?
- Scalability: Consider how easily your business can expand, raise capital, or bring on new owners under each structure.
What Are the Most Common Business Structures?
Sole Proprietorship
A sole proprietorship has one member/owner and is the simplest form of business structure. A sole proprietorship does not register as a separate business entity; your business assets and liabilities are not separate from your personal assets and liabilities. Therefore, you will be held personally responsible for the debts and obligations of the business.
Sole proprietorships can also lead to difficulties in raising capital for business growth. Banks can also be hesitant to loan funds to sole proprietors vs other business structures.
The owner of a sole proprietorship reports profits and losses on their own personal income tax return. Profits are also subject to self-employment taxes. However, there is no separate tax return filing requirement for sole proprietorships.
Sole proprietorships can take advantage of the Qualified Business Income Deduction (QBI) (Section 199a Deduction). They can deduct up to 20% of their net taxable profits on their individual tax return.
A sole proprietorship can be a good choice for a low-risk entity testing the waters to see if their business is a viable venture. 37.4% of small business output classified as “other services” is attributed to sole proprietorships, which is the highest share of any business sector. Other business sectors, such as manufacturing and mining, see a higher proportion of their small business output attributed to other types of business entities like partnerships and corporations.
| Pros | Cons |
| Easy to form | Unlimited personal liability |
| Full control over business decisions | Hard to raise capital for growth |
| No separate tax filing requirement Qualified Business Income Deduction | Profits subject to self-employment taxes |
Partnership
Partnerships are the simplest entities to select for businesses formed by two or more people. There are two kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).
Limited partnerships have one general member with unlimited liability, while all other partners have limited liability. The partners with limited liability usually have limited control over the entity. A partnership agreement should be agreed upon by all members when forming a partnership. This document outlines the structure, responsibilities and expectations of each partner. It is also a safeguard against confusion, disputes and legal complications.
A partnership is a pass-through entity for taxation, which means the profits of the partnership are passed through to the personal tax return of each member. The income passed through to the general partner is also subject to self-employment taxes. Although profits are typically allocated to each partner based on their ownership percentage there is some flexibility with partnership distribution allocations.
Limited liability partnerships give limited liability protection to every member. Therefore, an LLP protects each member from debts against the partnership. Partners are not responsible for the actions of the other members.
General partners can take advantage of the Qualified Business Income Deduction (QBI) (Section 199a Deduction). They can deduct up to 20% of their net taxable profits from the partnership on their individual tax return (subject to tax adjustments).
Selecting a partnership as your business entity can be an appropriate choice for businesses with multiple owners.
| Pros | Cons |
| Multiple owners share responsibility | Joint liability for business debts |
| Pass-through taxation | Potential for disputes with multiple members |
| Flexibility in management structure Flexibility with partnership distributions Qualified Business Income Deduction | Requires a partnership agreement Tax return filing requirement – Form 1065 annually |
Limited Liability Company
Another type of entity business owners can select is the limited liability company. A limited liability company (LLC) can have one or multiple owners and can be flexible in many ways. For example, LLCs can be sole proprietors, partnerships, or corporations for tax purposes. LLCs also protect you from personal liability in most cases. Therefore, your personal assets won’t be at risk if your LLC declares bankruptcy or is a party in a lawsuit.
Partnerships pass through profits and losses to the members of the business. Depending on the type of business entity you select for your LLC, the profits may be subject to self-employment taxes for each member.
LLC members can take advantage of the Qualified Business Income Deduction (QBI) (Section 199a Deduction) if the entity is taxed as a sole proprietorship, partnership, or S Corporation. The members can deduct up to 20% of their net taxable profits on their individual tax return (subject to tax adjustments).
States have various filing requirements for LLCs. Make sure you check with your state’s secretary of state office when forming your LLC.
LLCs can be a good choice for medium to high-risk companies due to the liability protections offered. An LLC would also be a good option for members with significant personal assets.
| Pros | Cons |
| Limited personal liability | Must register a separate business entity |
| Flexible tax treatment (sole proprietor, partnership, or corporation) | Varying rules by State |
| Pass-through taxation for sole proprietors, partnerships and S Corporations members/shareholders Qualified Business Income Deduction | Most members/shareholders are subject to self-employment taxes. |
C Corporation
A C Corporation (C Corp) is a legal entity that is separate from its owners/shareholders. The profits of a C Corp are taxed at the entity level at a flat rate of 21% (as of 2017 TCJA).
One major disadvantage of C Corporations is that they can be subject to double taxation. How this happens:
- Corporate Taxation: When a C corporation earns profits, it pays corporate income tax on those earnings. This is the first layer of taxation.
- Shareholder Taxation: If the corporation distributes any of those after-tax profits to shareholders in the form of dividends, the shareholders must then pay personal income tax on those dividends. This is the second layer of taxation.
For example, if a C corporation earns $100,000 in profit, it would pay $21,000 in corporate tax (based on the current federal corporate tax rate). If it then distributes the remaining $79,000 to shareholders, those individuals will pay personal income tax on their portion of the dividends, resulting in the same profits being taxed twice.
C Corporations offer the strongest protection for their owners from personal liability. But the cost to form a C Corporation can be much higher than other business entities. Corporations require extensive record keeping and formalities such as board and shareholder meetings.
Corporations are also completely independent from their shareholders. C Corps can issue multiple classes of stock with different rights for different classes of shareholders. They also have an advantage when raising capital; they can raise funds through stock sales, which can also attract employes with employee stock incentive plans.
A C Corp is a good choice for a medium to high-risk business, companies wanting to raise capital and businesses that may want to issue an initial public offering (IPO) of their stock in the future.
| Pros | Cons | |
| Flat rate taxation at 21% | Double taxation on dividends | |
| Limited liability protection | Complex setup | |
| Unlimited growth potential | More administrative overhead |
S Corporation
Another type of corporate entity you can select is an S Corporation. An S Corporation (S Corp) is a special type of corporation that you can create by having your tax advisor make an election with the IRS on Form 2553.
S Corporations are pass-through entities, meaning income, losses, deductions, and credits flow directly to shareholders’ personal tax returns. This structure avoids the double taxation faced by traditional C Corporations, where income is taxed at both corporate and individual levels.
Shareholders who actively work in the business can be treated as employees, receiving a reasonable salary subject to employment taxes. Additional profits can be distributed as dividends, which are not subject to self-employment tax, potentially reducing overall tax liability.
Shareholders can take advantage of the Qualified Business Income Deduction (QBI) (Section 199a Deduction). They can deduct up to 20% of their net taxable profits on their individual tax return (subject to tax adjustments).
As a separate legal entity, an S Corp provides personal asset protection for its shareholders. This means personal assets are generally shielded from business debts and liabilities.
S Corps have strict eligibility requirements. To qualify as an S Corp a business must:
- Have no more than 100 shareholders
- Have only one class of stock
- Be owned by U.S. citizens or residents
Since S Corps can only issue one class of stock, they lack flexibility in allocating profits and losses among shareholders. An S corporation is required to allocate profits and losses among the owners based strictly on the percentage of ownership or number of shares held.
S Corps also have increased administrative responsibilities. They are required to adhere to corporate formalities including holding regular board and shareholder meetings and maintaining meeting minutes.
Not all states treat S Corporations the same way the federal government does. It is important to check out the rules for S Corporations in your state before deciding on this entity structure.
| Pros | Cons |
| Pass-through taxation (avoids double taxation) | Strict eligibility requirements and formalities required by Corporations |
| Limited liability protection | Tax return filing requirement – Form 1120S annually |
| Potential savings on self-employment taxes Qualified Business Income Deduction | Varying rules by State |
What Are Some Common Mistakes When Selecting a Business Entity?
- Not Selecting a Legal Entity
When you do not explicitly select a business entity, you are operating as a sole proprietor and leaving your personal assets exposed to business liabilities.
- Choosing a Structure Based Solely on Tax Benefits
While tax advantages are important, selecting an entity purely for tax reasons can backfire. For example, an S corporation may offer savings on self-employment taxes, but it also comes with strict eligibility rules and formalities.
- Ignoring Long-Term Business Goals
Many entrepreneurs focus only on their immediate needs. If you plan to raise capital or bring in investors later, forming an LLC might not be ideal. C Corporations, for instance, are better suited for equity financing and issuing shares.
- Overlooking State Specific Rules
Not all states treat different business entities the same way. For example, S Corporations may be taxed differently at the state level than they are federally. Failing to research local regulations can lead to compliance issues and unexpected costs.
- Keeping It Too Casual with Multiple Owners
When multiple people are involved, informal arrangements can lead to disputes. Partnerships and LLCs require clear operating agreements that define roles, responsibilities, and profit-sharing. Skipping this step can result in legal and financial complications.
- Failing to Seek Professional Advice
Choosing an entity is a legal and financial decision. Relying solely on online articles or templates without consulting a CPA or attorney can lead to misclassification, missed tax opportunities, or exposure to liability.
Which Business Entity Should You Select?
Business entity selection is one of the most important decisions you’ll make as a new entrepreneur. Each entity structure, whether it’s a sole proprietorship, partnership, LLC, S Corporation, or C Corporation, comes with its own set of advantages and challenges.
Your choice will impact how you’re taxed, your personal liability, the business’s ability to raise capital, and the growth potential of the business. Take time to assess your goals, risk tolerance, and long-term vision. And remember, you don’t have to make this decision alone.
At OnPoint Tax & Consulting, we specialize in helping small business owners make these crucial decisions. Working with a trusted tax advisor ensures you are starting your new business venture on the right path.
Not yet a client of OnPoint? We’d love to meet you! Schedule a consultation today.