Choosing what type of entity to become can be one of the most important decisions an owner faces when starting a new business. This decision will have an impact on a number of factors, including liability, ability to raise capital, ease of ownership transfer, reporting, and how much you pay in taxes. There are several different options, with each option having its own unique tax and legal consequences. When evaluating these different options, keep in mind two key factors: liability and flexibility.

Sole Proprietorship
Sole proprietorships are easy and inexpensive to form.  Owners report the income on their personal tax returns, and no legal formalities are needed. However, sole proprietorships are also one of the riskiest options since all of the owner’s personal assets are at risk.

Partnerships arise when there are two or more owners. There is a tax filing requirement at the entity level, but all of the income flows to the partners. Partnership taxation makes the contribution and distribution of property relatively simple and unlikely to have unintended tax consequences. Contributions to partnerships in exchange for ownership interest are generally tax-free.

A general partnership, like a sole proprietorship, offers no liability protection for the owners. A limited partnership is a type of partnership set up with one general partner, who is personally liable for the partnership’s debts, and limited partners, who fund the partnership. Limited partners cannot be held personally liable for the partnership’s debts. Limited liability partnerships are another type of partnership that offer partners liability protection from the malpractice of other partners. This type of partnership is common for law, medicine, and accounting professions.

“C” Corporation
C corporations are separate legal entities subject to “double taxation,” meaning the company pays tax on the net income at the entity level, and then, owners are also taxed on the earnings when they are distributed as dividends. C corporations require more initial work to set up, such as drafting the articles of incorporation, bylaws, and electing the board of directors. Raising capital can be easier since corporations can offer bonds and issue different types of stock. Owners of a C corporation are not personally liable for the debts of the corporation.

“S” Corporation
S corporations share many of the same legal qualities as C corporations, but the tax implications are similar to partnerships. However, S corporations only need one owner, unlike partnerships. All income and deductions flow through to the owners of the S corporation in proportion to their ownership interests. S corporation owners can also deduct losses up to the amount of basis in their ownership interest, but debt basis for S Corporation owners only includes debt the owner loaned to the company.

Limited Liability Company (LLC)
LLCs offer the limited liability protection of a corporation and the tax implications of a partnership. When two or more owners form an LLC, the default federal tax status is that of a partnership – all income, deductions, and credits flow through to the owners of the LLC and are taxed only once. That being said, members of an LLC also have the option to be taxed as a corporation. Over the last couple of decades, LLCs have continued to grow in popularity. The benefits of limited liability for owners and the flexibility of tax reporting make it an attractive option.

Partnerships, or LLCs that choose to be taxed as a partnership, allow for the special allocation of income and losses (in contrast to an S corporation, which requires income and losses to be reported in proportion to ownership percentages).

In years of losses, owners of partnerships and S corporations can deduct losses up to the amount of basis they have in their ownership interest. This means that owners of partnerships and S corporations can potentially use these losses to offset income of similar character on their personal income tax returns and lower their tax liability. This is an advantage compared to C corporations that retain losses within the corporation.

Self-Employment Tax
Self-employment tax can also be a factor influencing what entity to choose. Sole-proprietors and single member LLCs report income on their personal tax returns. The entire amount of this income is subject to self-employment tax. Partnerships, including LLCs taxed as partnerships, pay self-employment tax on guaranteed payments they receive from the partnership; they also might pay self-employment tax on the net income if they materially participate in running the company. S corporation owners receive wages from the S corporation which must be “reasonable.” The net income of the S corporation is then not subject to self-employment tax. The ability to limit self-employment tax has been one of the reasons many small business owners have chosen to become an S corporation.

Take the time to consider your options. Choosing the right business structure will largely depend on your business and situation, and there are many factors that go into choosing an entity. Be sure to consult with your legal and tax advisors before doing so.