The Basics of Small Business Entity Selection


When beginning a small business, it is very important to think about the different options you have when it comes to choosing the structure of your business. Each of the business entities will provide different legal and tax implications, and it is up to you to choose the structure that will best suit your business. Out of all the different entities, some of the most common structures that we see throughout the business world are partnerships, corporations, S corporations, and limited liability companies (LLCs).


A partnership is a single business in which ownership is shared between two or more people. This means that each partner will share amongst the overall profits and losses of the business, while participating in all aspects of the business itself. Partnerships are generally very easy and inexpensive to form, and is a good entity choice for small businesses dealing with limited employees and customers.

Once you decide to structure your business as a partnership, you must choose what type of partnership arrangement you and you partners will run under. Each type has its own advantages and disadvantages, but they are overall very similar. A general partnership equally divides the profits and business duties between all partners, unless specific percentages are assigned to the partners. There are no additional fees for creating a general partnership, and each partner may reduce their personal income taxes by reporting any losses from the partnership. However, all partners are personally liable for any debts or liabilities of the business.

A limited partnership, or partnership with limited liability, allows the partners to limit their portion of business decisions, in turn limiting their overall liability. Each partner usually designates a percentage of their investment in the overall business duties, which is why short-term investors tend to be attracted towards limited partnerships. This allows the general partners to focus their attention on the business, and raise cash, all without giving up any control of the business itself. However, the general partners are still liable for any debts or liabilities of the business, and a limited partnership can be more expensive to create than a general one.

Corporations (C Corps)

A corporation, otherwise known as a C corp, is its own independent legal entity, meaning that the corporation is legally liable for any actions incurred, and not its shareholders. Corporations are one of the most complex business structures due to the lengthy tax and legal requirements of formation. Corporations tend to be very costly when it comes to start-up and operating expenses, and are generally selected by larger, more established companies.

One of the biggest advantages of corporations is that they offer the company the ability to raise capital by selling ownership shares of the business through stock offerings. The ability to raise large amounts of capital also attracts high-quality employees to the company because corporations are able to provide benefits and partial ownership potential through stock options, which is something a general partnership cannot provide. Corporations also have limited liability when it comes to business debts and actions because shareholders can only be held accountable for their investment in the ownership of the company.

One of the biggest disadvantages of C corps is that any reported income may be taxed twice. Meaning when the company makes a profit, they are required to pay income taxes on the profits being made. Then, when the corporation makes dividend payments to its shareholders, the shareholders have to pay income taxes on the dividends they earned. Other disadvantages include the increased money and time that is spent incorporating and operating the company. Corporations tend to be highly regulated by federal and state agencies, which bring the burden of increased recordkeeping, paperwork, and tax filing costs.

S Corporations (S Corps)

An S Corporation, otherwise known as an S Corp, is a special type of corporation. An S corp is just a corporation that achieved a Subchapter S designation from the IRS. To file as an S corporation, the company must incorporate first. To achieve S Corp status, all shareholders must sign and file Form 2553, which elects the corporation into becoming an S Corporation.

The one thing that makes S corporations different from C corporations is the avoidance of double taxation. Any business income or loss is “passed through” to the shareholders, who then report it on their personal income tax returns. This passing through allows the corporation to avoid paying federal taxes at the corporate level. Another advantage of S corporations is the additional tax savings for employees. Only the wages of employees who are shareholders are subject to employment tax; all other income is paid to the employee as a “distribution”, and these are taxed at a lower rate. Other advantages of S corporations include limited liability protection from business debts and actions, and benefits from raised capital through the selling of ownership shares.

One of the biggest disadvantages of S corporations is that all shareholders are required to receive compensation that is reasonable. What this means is that any shareholder that works for the corporation must receive wages that are “reasonable”; shareholders with low salaries and high levels of distributions may be red flagged by the IRS, resulting in more employment taxes being paid. Another disadvantage of an S corp is that the operational process of the company as a whole requires stricter recordkeeping and higher costs of paperwork.

Limited Liability Companies (LLCs)

A limited liability company (LLC) is a hybrid entity that combines the advantages of limited liability from a corporation with the operational efficiencies of a partnership. LLC’s are owned by “members”, and the members can be a single person, two or more people, other LLC’s, or corporations.

An LLC operates much like a partnership because the members often create rules that govern the company itself. This leads to less recordkeeping and paperwork overall, and the start-up costs of an LLC are very similar to that of a partnership. An LLC also acts like a partnership because the members distribute profits as determined in the LLC operating agreement.

An LLC operates much like a corporation because the members are not personally liable for any debts or actions incurred by the LLC itself. They also operate like an S corporation, due to the fact that they avoid double taxation by passing through business income or losses to the members of the LLC.

An LLC can operate much like a sole proprietorship, meaning there is only one member that owns and runs the business. This can give the sole member complete control of the business, while limiting their overall liability. The biggest advantage of choosing to be the sole member of an LLC is that any business income is passed through to the individual, and the member reports this income on schedule C of their individual 1040.

One of the most unique things about an LLC is that they can elect to be taxed as an S corporation. This allows for business income to be “passed through” to members of the LLC, while at the same time, the company is viewed as a separate, independent entity from its members. What this means is that the members of the LLC can receive distributions, along with wages, from the LLC itself, and can avoid paying high employment taxes on any distributions to themselves. Electing to treat an LLC as an S corporation for tax purposes combines the ease of operation of a partnership with the tax planning advantages of an S corporation.


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