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 the main entity structures and how they compare from a liability and tax perspective:
Sole Proprietorship
This is the simplest entity structure and one that doesn’t take much setup at all. Essentially, if you start operating a business, and you’re the only owner and operator of that business, it is a sole proprietorship.
- Liability Protection – essentially none. Since there is no separate legal entity, the owner owns all the assets of the business and assumes all of the debts. Personal assets can be at risk as well in the case of a legal issue since there is no entity structure in place to shield and separate the personal assets from the business ones.
- Tax Treatment – sole proprietorships are treated as a “flow through” entity where all profits and losses of the business simply flow, or pass, through to the owner, who picks up these items on their individual tax return and pays tax at the individual level only. Owners get to take advantage of the section 199A Qualified Business Income Deduction to reduce taxable income; however, they get hit with two different IRS-level taxes – income tax and payroll tax. Often, that could result in a federal tax rate of 25-30%+, plus state taxes as well.
- Good for simplicity and easy set up. Bad for liability protection. Neutral for tax planning.
Partnership
The partnership is the equivalent to the sole proprietorship, but would apply if a business has two or more owners. Once again, this doesn’t take much setup and if you start a business with multiple owners, this will be the default treatment.
- Liability Protection – essentially none. Since there is no separate legal entity, the owner owns all the assets of the business and assumes all of the debts. Personal assets can be at risk as well in the case of a legal issue since there is no entity structure in place to shield and separate the personal assets from the business ones. Given there are multiple owners, it is pivotal to construct a partnership operating agreement that outlines the roles/responsibilities, ownership, and legal rights and protections of all partners. Without this agreement, there is no only risk of liability exposure with outside parties, but also with your own partners.
- Tax Treatment – partnerships are treated as a “flow through” entity where all profits and losses of the business simply flow, or pass, through to the owners, who pick up these items on their individual tax returns and pay tax at the individual level only. The profits and losses are generally allocated based on ownership percentage – so if one partner owns 60% of the business, they will be allocated 60% of profits and losses. Partners get to take advantage of the section 199A Qualified Business Income Deduction to reduce taxable income; however, assuming they are active in the business (and not just “limited”, or investment-only partners) they get hit with two different IRS-level taxes – income tax and payroll tax. Often, that could result in a federal tax rate of 25-30%+, plus state taxes as well.
- Good for simplicity and easy set up. Bad for liability protection. Neutral for tax planning.
Limited Liability Company
The limited liability company (LLC) is the most popular choice for small business owners. And for good reason – it includes built-in liability protection (it’s in the name after all) and it’s flexible from a tax perspective. This takes more setup and maintenance than the sole proprietorship and partnership since this involves a separate legal entity formed with a state; however, its benefits typically outweigh the additional costs.
- Liability Protection – “limited liability” is in the name after all, and 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 – the general tax treatment of LLCs is they are considered “flow through” entities where all profits and losses of the business simply flow, or pass, through to the owners, who pick up these items on their individual tax returns and pay tax at the individual level only. This should sound familiar – as the default tax treatment for an LLC with one owner, is the same as the tax treatment for a sole proprietorship, and the default tax treatment for an LLC with two owners, is the same as the tax treatment for a partnership. But, I mentioned flexibility when it comes to the LLC structure – and here is where it gets interesting. As an LLC, the business can make a tax election to be taxed in a different way – with the two most common options being a S Corporation or a C Corporation. We cover the C Corporation structure below, but a quick note on S Corporations is warranted here. An LLC taxed as an S Corporation is often the most beneficial structure, and the best of both worlds, for small businesses. This is because you retain the liability protection offered by the LLC, while opening the door to a nifty tax benefit that allows you to save on payroll tax (more on that another day). What’s more – with an LLC, you can start off with one structure – say a partnership – and then eventually change to another structure, like a S Corporation or Corporation. This flexibility is very appealing and opens up the door to effective tax planning opportunities.
- Neutral for simplicity and easy set up. Good for liability protection. Great for tax planning.
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.
