What Entity to Create When Starting A Business

Choosing the right type of business entity is critical for tax efficiency and liability protection. Here’s a breakdown of the pros and cons for the 6 most common entity types from a tax professional:

Starting a business is a big deal, make sure you weigh the pros/cons and set up your entity to maximize business potential.

1. Sole Proprietorship

Pros:

• Simple to Set Up: Minimal paperwork and low cost.

• Pass-Through Taxation: Business income is reported on your personal tax return (Schedule C).

• No Separate Tax Return: Reduces administrative burden.

• Self-Employment Tax Deduction: Half of self-employment taxes are deductible.

Cons:

• Self-Employment Tax: Subject to 15.3% on net income for Social Security and Medicare.

• No Liability Protection: Personal assets are at risk.

• Limited Deductions: Fewer opportunities to optimize taxes compared to corporations or partnerships.

2. Limited Liability Company (LLC)

Pros:

• Flexibility in Taxation: Can choose to be taxed as a sole proprietor, partnership, or corporation.

• Pass-Through Taxation: By default, profits and losses pass through to the owners’ personal tax returns.

• Liability Protection: Owners' personal assets are shielded from business liabilities.

• More Deductions: May deduct business expenses like health insurance premiums.

Cons:

• Self-Employment Tax: Profits are still subject to self-employment taxes unless taxed as an S corporation.

• Annual Fees: States may charge filing fees and annual report fees.

• Complexity: Slightly more administrative requirements than a sole proprietorship.

3. Partnership

Pros:

• Pass-Through Taxation: Income and losses are passed through to partners’ personal tax returns.

• Shared Responsibility: Multiple partners share financial obligations and management.

• Flexibility: Can structure partnership agreements to allocate income and losses.

Cons:

• Self-Employment Tax: Partners pay self-employment tax on their share of income.

• Joint Liability: Partners may be personally liable for business debts unless structured as an LLP.

• Complex Reporting: Must file Form 1065 and issue K-1s to partners.

4. S Corporation (S-Corp)

Pros:

• Tax Savings on Self-Employment Taxes: Only salaries are subject to Social Security and Medicare taxes, not distributions.

• Pass-Through Taxation: Income passes through to shareholders, avoiding double taxation.

• Reasonable Salary Rule: Owners can pay themselves a reasonable salary and take remaining profits as distributions.

Cons:

• Strict Requirements: Limited to 100 shareholders, all must be U.S. citizens or residents.

• Complex Administration: Requires payroll, corporate formalities, and filing Form 1120-S.

• State Taxes: Some states impose additional taxes or fees on S-Corps.

5. C Corporation (C-Corp)

Pros:

• Separate Tax Entity: Owners’ personal income is not affected by the corporation’s earnings.

• Flat Corporate Tax Rate: Lower corporate tax rates may apply (e.g., 21% federally as of 2024).

• No Self-Employment Tax: Owners are paid as employees and do not pay self-employment taxes.

• Fringe Benefits: Can offer benefits like health insurance and retirement plans without taxing the recipient.

Cons:

• Double Taxation: Corporate profits are taxed, and dividends to shareholders are taxed again.

• Complex Compliance: Requires strict adherence to corporate formalities and filing Form 1120.

• Cost: More expensive to establish and maintain.

6. Nonprofit Corporation (501(c)(3))

Pros:

• Tax-Exempt Status: Income related to the nonprofit's mission is not taxed.

• Donor Tax Deductions: Contributions are tax-deductible for donors.

• Eligibility for Grants: Can access certain funding only available to nonprofits.

Cons:

• Strict Compliance: Must adhere to strict IRS and state regulations.

• Limited Purpose: Activities must align with a charitable, religious, or educational purpose.

• No Profit Distribution: Profits cannot be distributed to owners or shareholders.