Business Entities: Understanding the Different Types and Their Tax Implications

Even if you’re not aware of it, every business has an “entity type.”

We’re here to walk you through the many types of business entities and help you choose the one that’s right for you.

the five most common entity types

Almost every company falls into one of the following categories:

Business Entity Type	Summary
Sole proprietorship	A single person owns and operates the business. The owner individually pays all taxes and debts. There is no business entity here. Profits and losses are reported on Schedule C of their personal tax return.
Partnership	There are two or more owners who own and run the business. Partners must file taxes on their own profits. Costs, obligations, and losses are all passed down to them equally.
The C corporation	Shareholders, a board of directors, and management oversee the corporation and its owners. The company is a separate legal entity that must pay corporation taxes—usually reserved for larger corporations.
The S corporation	Like a C corporation, the income, losses, deductions, and credits are passed on to the shareholders, who inform them of their personal income taxes.
Limited liability company (LLC)	A hybrid business form in which owners can choose whether to be taxed as corporations or as individuals on their personal taxes.

The company structure you choose will directly impact the following:

• The size and operations of your organization
• How are you taxed?
• Your share of profits
• Your level of ownership and accountability
• Your legal liability
• Your funding possibilities

questions to consider while deciding between different types of business entities

Begin by asking yourself a few questions to understand better your short- and long-term objectives, leadership style, financial responsibilities, etc.

• Will you be an individual solo leader with a small team? Will you be hiring partners and working with investors?
• Do you want to make all of the decisions in your company? Or do you prefer to work with partners, board members, or investors?
• How big do you want your company to get?
• How will you obtain funding for your venture?
• Will you bring in shareholders and issue them stock? If not, are you interested in doing so in the future?
• Do you intend to be in business for the long haul?

helpful resource: cost-effective accounting solutions for startups how to streamline payroll and keep finances in check

• sole proprietorship

This is the place to start if you want to run your own business and don’t have grand plans to become the next Uber or Apple. In fact, the government considers you a sole proprietor the moment you start running a firm on your own.

You can operate as a sole proprietor indefinitely or hire contractors or employees, but if your income exceeds a particular threshold, you should incorporate it.

pros

– Sole proprietorships are easy and cheap to establish.

– Legal documentation is minimal (municipal licenses and permissions may be needed).

– Ideal for various small businesses like grocery stores, art studios, and boutiques.

Sole proprietorships are the simplest and least expensive to establish. There is no legal documentation required except for municipal licenses and permissions so that you may get started right away.

Many small businesses, from mom-and-pop grocery stores to art studios to garment boutiques, begin as sole proprietorships.

cons

– Sole owners are taxed as individuals, facing higher tax rates than corporations.

– Sole responsibility for the company’s finances and debts.

– Personal assets at risk in case of financial difficulties.

– Obtaining financing is challenging as banks and investors view it as a riskier venture.

– Limited expansion potential due to financial constraints.

As a sole owner, you are taxed as an individual, which means you must forego a far more considerable percentage of profits than you would as a corporation. You are also solely responsible for the company’s finances. If your company runs into financial difficulties, you are personally liable for any debts and may lose your personal assets.

Sole proprietorships also find it considerably more challenging to obtain financing or acquire funds as sole proprietors—banks and investors regard it as a riskier venture, so if you want to expand, this may not be the best option.

who should use it?

The sole proprietorship option is generally suitable for you if you wish to manage a small firm with few employees.

Successful people in this role are at ease in making all business decisions while being accountable for all costs, debts, and legal responsibilities.

sole proprietorships – quick understanding

Criteria	Sole Proprietorship
Ownership is limited to one person.	Total ownership by the firm owner, who operates as a sole proprietor
Taxation rules	Business earnings and losses are reported on the owner’s personal income tax return.
Profit share	The owner receives 100% of the profit share.
Accountability and legal responsibility	As a sole proprietor, you are fully responsible for all the business’s debts and any lawsuits against it.
Sources of funding	Owners can utilize their own money and savings or take out loans.

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• partnerships

Having someone to share the workload is wonderful; a partnership allows two or more people to do just that. This sort of organization depends on each partner’s collective resources, talents, and efforts.

Partnerships are formed in legal offices, bars and restaurants, creative agencies, and family businesses. General partnerships and limited liability partnerships are two types of partnerships.

who should use it?

Being a strong collaborator and having complete faith in your partners is critical to success in this line of work. There are three kinds of partnerships to consider:

1. A general partnership is appropriate if you and your collaborators intend to distribute all contributions, earnings, and losses equally.
2. A limited partnership might be a good idea if one or two partners do most of the hard work, but one or more partners will have limited managerial say and liability.
3. Finally, if you want to try out a new company idea with some friends or family for a limited time, consider forming a joint venture. If you intend to continue operating the train after its expiration date, you must enter into a general partnership.

partnerships – quick understanding

Criteria	Partnership
Structure of Partnership Ownership	Two or more people co-own a business.
Taxation regulations	Each owner reports their portion of the profits on their own tax returns. In addition, the partnership must file an annual information return (Form-1065).
Your profit margin	In a general partnership, all partners share equally; otherwise, the operating agreement or the partners’ investment ratio governs.
Accountability and legal responsibility	All expenses, debts, and losses are equally divided among the partners, except in limited partnerships.
Sources of funding	Partners’ combined resources, plus loans.

 

• the C Corporation

C-corporations are the most popular type of corporation in the United States. It relieves individuals of liability since the C corporation is its own legal organization, which is different from a partnership or a sole proprietorship. As a result, the business can make and lose money and is taxed separately from its owners.

pros
– C corporations offer liability protection for owners’ personal assets.

– Debts, losses, and litigation don’t affect personal assets.

– Ability to sell stock or bring in investors for expansion.

– Trump Tax Reform introduced a 21% flat tax rate, making C corporations more attractive.

The most significant advantage for owners is liability protection—you don’t have to worry about debts, losses, or litigation against the firm affecting your personal assets. You can also sell stock or bring in investors to help drive expansion. The Trump Tax Reform also made C corporations more appealing by instituting a 21% flat tax rate.

cons

– Setting up a corporation is complex and costly, involving legal expenses.

– Communication required with the Secretary of State and the IRS.

– C corporations entail higher ongoing maintenance payments.

– Double taxation: taxed as a legal entity and again on shareholders’ gains.

– Suitable for businesses anticipating rapid growth and expansion.

– Shareholders, board of directors, and management roles involved, often with owners holding one or more positions.

Setting up a corporation is complicated and costly—state legislation, federal rules, and local bylaws can all result in extensive legal expenses; be ready to communicate with both your Secretary of State and the IRS.

C corporations also have substantially higher ongoing maintenance payments. Finally, the corporation is taxed twice as an independent legal body and again when stockholders file their gains on their personal tax returns. This is commonly known as “double taxation.”

Shareholders run C corporations, a board of directors, and management—typically, the business’s owners hold one or more of these positions. It’s an excellent choice for businesses that anticipate rapid growth and expansion.

C Corps – quick understanding

Criteria	C Corporation
Ownership Structure	Shareholders, a board of directors, and management oversee the corporation and its owners. Even if a shareholder or owner leaves, the corporation continues to exist.
Taxation regulations	The business pays tax at a lower corporate rate as a separate entity. In their individual returns, shareholders declare their share of profits (paid in salaries, bonuses, and dividends).
Your profit margin	Profits can come to you in three ways: 1. Shareholders’ salaries or bonuses 2. Dividends distributed to shareholders 3. Shares for sale
Accountability and legal responsibility	The corporation is recognized as a separate legal entity.
Sources of funding	Increase your capital by selling equity to investors.

• The S Corporation

An S corporation must always begin as a C corporation. When a business applies to become an S corporation, it keeps its status as an independent legal entity, offers its owners limited liability protection, and is under the control of a board of directors, shareholders, and management.

So, why should you bother forming an S corporation?

Significant tax savings.

Unlike C corporations, S corporations elect to pass on the business’s income, losses, and deductions, and their owners get tax credits, which they report on their own tax returns. Because it makes no profit, the company is not subject to federal income tax.

Because of this significant tax benefit, S companies are subject to various restrictions. For example, they can only have one class of stock and a limit of 100 shareholders, all of whom must be US residents or citizens—these are quite restrictive criteria, especially when you’re at a stage in your firm where you really want to propel your growth.

Also, the IRS will be watching you—or, at the very least, your payroll. Because of the tax advantages of an S corporation, the IRS continuously examines the wages of shareholders who are employees to ensure they are being treated relatively and paying the correct amount of taxes.

helpful resource: how does the irs get people to pay the taxes they owe

who should use it?

US citizens can only form an S corporation. And if you’re looking for tremendous growth, this isn’t the place to be—remember the 100-shareholder limit. However, forming an S corporation is a good way to save taxes if you want a business that will last beyond your tenure and is willing to be meticulous about meeting strict filing requirements.

S Corps – quick understanding

Criteria	S Corporation
Structure of ownership	Shareholders, a board of directors, and management oversee the corporation and its owners. Even if a shareholder or owner leaves, the corporation continues to exist.
Taxation regulations	Shareholders record the company’s revenue, losses, deductions, and credits on their personal tax returns because the S corporation does not pay federal taxes.
Your cut of the profit	Your profit margin distributions are made to owners and shareholders based on the percentage of their investment.
Accountability and legal responsibility	The corporation is regarded as a distinct legal entity. If shareholders fail to correctly record their salary on their annual tax returns, they may face financial penalties.
Sources of funding	Gain capital by selling shares to investors (limited to up to 100 shareholders who are citizens or residents of the United States).

 

• LLC (Limited Liability Company)

An  LLC (limited liability company) is a hybrid business entity. Owners can choose how they are taxed—if they wish to be treated as a corporation, that is an option. On the other hand, owners and shareholders can choose to have the business’s profits, losses, credits, or deductions processed in their individual tax returns, much like in sole proprietorships, partnerships, and S corporations.

who should use it?

If you want to give your venture some flexibility and want a legal structure that is relatively easy to set up, an LLC is a clear choice. Like a C or S corporation, an LLC provides owners and stockholders limited liability protection, so their personal assets are never at risk if the firm suffers losses, debts, or lawsuits.

If you don’t have a clear exit strategy in mind, make sure you choose long-term partners or shareholders when forming an LLC. If one of the partners leaves, you must dissolve the LLC.

LLC – quick understanding

 

Criteria	Limited Liability Company
Ownership structure	It can be a sole proprietorship or a partnership with partners, investors, and shareholders.
Taxation regulations	Taxation can be done as a corporation or on the owner’s tax returns.
Your profit margin	Profit margin is directly proportional to each owner’s investment percentage, or through an agreement
Accountability and legal responsibility	An LLC is considered a separate legal entity.
Sources of capital	Gain capital through investments and loans made by owners and shareholders.

 

changing the legal structure of your company

Businesses change in the same way that humans do. C corporations can transform into S corporations; sole proprietorships can transform into LLCs, and so on.

You can modify your business structure as needed. Fulfill all federal, state, and local requirements, and seek legal advice during establishment or changes. An accountant can help maintain compliance with entity regulations.

It’s crucial to understand that even though you initially choose a legal structure to suit your business at the moment, you can modify your entity type in the future. Check federal, state, and local requirements to ensure you have completed all necessary documentation.

When establishing or changing your entity, you should consult with a lawyer. However, once your company is established, a good accountant can help you ensure that all of your accounts are in accordance with the entity’s regulations.