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:
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.