One of the first decisions you have to make as a new small business owner is choosing the type of legal entity to operate under. While seemingly minor, this decision will have a significant, long-standing impact on both the liability protection and tax implications for both the business, and yourself as the owner. It is pivotal to closely consider both the legal and the tax piece in this process – many businesses don’t consider either, some only consider one, but the best businesses have a keen eye on both.
With that, let’s take a look at one of the main entity structures available to business owners and how it measures up from a liability and tax perspective:
Corporation
If you are planning on raising venture capital, you likely will want to use this corporate structure since it is the preferred vehicle for institutional investors to invest in, but outside of that, for the average small business owner typically an LLC will do just fine. While from a liability standpoint, the corporation gets the job done, it leaves something to be desired on the tax side of the table.
- Liability Protection – Similar to the LLC, this structure creates a liability shield separating the business from the owners’ personal assets. In the event of a legal issue, personal assets should generally not be at risk when utilizing this structure. However, an important asterisk to the above though, is without proper bookkeeping and separation of business and personal assets (via separate business bank accounts and separate business credit cards), that concept of limiting your personal liability becomes much murkier. If it is unclear where a business assets and liabilities stand versus your personal assets and liabilities, due to a lack of separate accounts or proper bookkeeping, in the event of a legal issue, you may find that your personal assets are at risk.
- Tax Treatment – Corporations are taxed at their own separate entity level. So unlike the “flow-through” entities discussed above, the profits and losses generated in a corporation are taxed at that corporate level – with the business responsible for filing a tax return and paying tax. And if everything stopped there, this structure wouldn’t be too bad from a tax perspective – but unfortunately it does not, since of course the individual owners of the corporation must pay their share of tax as well. In this case, the owners do not pay tax on their share of allocated income like in a partnership, or pay tax on 100% of income as in a sole proprietorship, but instead they pay tax when distributions are sent from the business to the owners in the form of dividends. In other words, in a corporate structure there are two levels of tax: one at the entity level and one at the owner level on distributions. This “double taxation”, where the same dollar of income could be taxed twice, typically makes this structure disadvantageous and inefficient from a tax perspective.
- Bad for simplicity and easy set up. Good for liability protection. Bad for tax planning.
