One of the fundamental decisions facing small business owners is choosing the right business structure. Some of the most common options include the following: Sole Proprietorship, Partnership, Limited Liability Company (LLC), S Corporation (S Corp), and C Corporation (C Corp). Differentiating between these options is necessary to establish the foundation of a successful business. Whether starting a business or modifying an existing business, the way the company is structured has a large impact on these three considerations: personal liability, taxation, and operational flexibility. Before looking into the considerations for each of the mentioned business entities, it is important to understand some often-overlooked differences between employees and self-employed individuals.
Key Differences Between Employees and Self-Employed Individuals
Most individuals in the workforce are employees. From a liability standpoint, an employee is not held personally liable for the debts of the business. This may seem obvious, but it is a key consideration. In other words, if the company faces liability in the form of a debt or a lawsuit, an employee’s personal assets are protected. To look at employees from a taxation perspective, there are advantages and disadvantages. One of those advantages is less FICA tax than self-employed individuals. If you are relatively new to the workforce, you may notice that the amount you receive in a bimonthly paycheck is not simply your salary divided by 24. There are deductions taken from your paycheck such as FICA, federal income tax withholding, and any retirement contributions. FICA tax is comprised of 2 parts: a 12.4% tax for social security and a 2.9% tax for Medicare (15.3% total FICA tax)[1]. Employees are only responsible for half of this amount (7.65%) and their employers pay the other 7.65% FICA tax. Contrast this to a self-employed individual who pays the full 15.3% FICA tax, and it is evident that there are tax breaks offered to employees. However, it is not all bad for self-employed individuals as they are able to deduct business-related expenses from their taxable income.
Sole Proprietorships and Partnerships
Now, if you are self-employed or looking to start a business, sole proprietorships and partnerships may seem appealing for simplicity. Sole proprietorships and partnerships are often chosen by small business owners for their ease of formation. In terms of liability protection, both structures offer minimal protection compared to entities like LLCs or corporations. In a sole proprietorship, the business and the owner are considered one and the same, leaving the owner personally liable for business debts and legal obligations. Similarly, partnerships expose partners to personal liability for partnership debts and actions. On the taxation front, both structures benefit from pass-through taxation, meaning that business income and losses pass through to the individual owners' tax returns[2]. This can result in tax simplicity, as there is no double taxation as seen in C Corps. Operationally, sole proprietorships provide the utmost autonomy to the owner, who makes all business decisions. Partnerships, on the other hand, allow for shared decision-making and workload but require clear partnership agreements to define roles, responsibilities, and profit-sharing among partners.
Limited Liability Companies (LLCs)
Perhaps the most familiar business entity is an LLC. LLCs have become a popular choice for small business owners seeking a middle ground between the simplicity of sole proprietorships/partnerships and the complexity of corporations. One of the standout features of an LLC is its robust liability protection. Much like corporations and unlike sole proprietorships/partnerships, LLCs offer a "limited liability" shield, separating the personal assets of the owners (referred to as members) from the business's debts and legal liabilities. This means that, in most cases, members' personal assets are safeguarded, and their liability is typically limited to their investment in the company. From a taxation perspective, LLCs offer flexibility. By default, they are treated as pass-through entities, with income and losses flowing through to members' individual tax returns. Operationally, LLCs provide a great deal of flexibility in management and decision-making. They can choose to be managed by members or appoint a manager, allowing for versatile approaches to leadership and organizational structure. This adaptability, combined with the liability protection and tax options, makes LLCs an attractive choice for many small business owners.
S Corporations (S Corps)
While S Corps share certain advantages with LLCs, they also exhibit distinct differences. In terms of liability protection, both structures provide a safeguard for the personal assets of owners, separating them from the business's liabilities. However, S Corps and LLCs differ significantly when it comes to taxation. In fact, many people have probably heard of LLCs that elect to be taxed as S Corps. In contrast to the default tax status of an LLC, in which all income is typically subject to self-employment taxes, an S Corp provides the flexibility for owners to pay themselves a “reasonable salary”, subject to self-employment taxes, while distributing the remaining profits as dividends, which are generally exempt from self-employment taxes. This allows an S Corp owner to have a portion of their income not subject to self-employment taxes, which can result in large tax savings. It is imperative to mention that what constitutes “reasonable salary” is a bit of a gray area and pushing the limits can lead to IRS audit and potential penalties and interest[3]. Though this is an enormous perk of an S Corp, it comes with the drawback of inflexible profit splitting. While owners of LLCs can allocate profits and losses disproportionately among owners, an S Corp’s profits and losses must be allocated strictly based upon ownership percentage[4]. For example, if you have 50/50 ownership in an S Corp with another individual, even if you contribute more to the business and have a much more involved role, profits and losses are split evenly. This is a major consideration for small business owners that may have multiple owners who provide disproportionately to the business.
C Corporations (C Corps)
C Corps are distinct from the other options in several key ways. In terms of personal liability, C Corps provide a significant level of protection for their shareholders. The corporation itself is considered a separate legal entity, shielding the personal assets of shareholders from business debts and legal liabilities. However, C Corps do come with a unique taxation system known as "double taxation." Unlike sole proprietorships, partnerships, LLCs, and S Corps, where business income is typically taxed only at the individual level, C Corps are subject to taxation at both the corporate level and the individual level. This means that C Corps pay corporate income tax on their profits, and then shareholders pay personal income tax on any dividends they receive which results in less potential income for shareholders. While this may seem like a tax disadvantage, C Corps offer certain benefits, such as the ability to reinvest profits in the business and access to a wide range of deductions and tax credits.
Moving Forward
Selecting the right business structure is a pivotal decision for small business owners, as it impacts personal liability, taxation, and operational flexibility. Those venturing into small business ownership may consider sole proprietorships and partnerships, which offer simplicity but lack liability protection. LLCs strike a balance by providing robust liability protection, pass-through taxation, and operational flexibility, making them a popular choice. On the other hand, S Corps offer a unique tax advantage, allowing owners to minimize self-employment taxes by designating a reasonable salary and distributing the remaining profits as dividends. This tax benefit comes with the trade-off of inflexible profit splitting. Finally, C Corps offer strong personal liability protection to shareholders but are subject to double taxation. Understanding these distinctions is essential for small business owners as they navigate the complexities of business structure and careful analysis is important in the early stages of setting up the business as it can be challenging to change the structure after the fact. It is also a good idea to seek professional assistance when making these important decisions. Ullmann Wealth Partners is here to offer expert assistance and guidance on issues such as this that could impact your overall wealth management plan.
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[1]https://www.irs.gov/taxtopics/tc751
[2]https://www.irs.gov/businesses/partnerships
[3]https://turbotax.intuit.com/tax-tips/small-business-taxes/how-an-s-corp-can-reduce-your-self-employment-taxes/L4abUcaRn
[4]https://www.wolterskluwer.com/en/expert-insights/llc-vs-s-corporation-advantages-and-disadvantages#:~:text=Owners%20of%20LLCs%20can%20allocate,this%20could%20be%20especially%20beneficial.