If you’re a young professional starting a business or even a seasoned entrepreneur, you know how the excitement of diving into something new can sometimes cloud practical decisions, such as choosing a tax-efficient entity structure. Often, new entrepreneurs seek quick, low-cost ways to start their businesses, overlooking long-term tax and growth implications. Tax planning is a critical component of entrepreneurship, and we often guide business owners in determining the proper entity structure, focusing on future goals to avoid costly mistakes later. Working with a professional team of financial, tax, and business experts is essential. Let’s review some key questions you should ask as you begin planning and the advantages and disadvantages of each entity type.
Questions to Ask When Choosing a Business Entity
Each business entity type has different considerations that could affect a business owner’s exit strategy, retirement, or long-term tax liability. While you can change entity types later, it could be complex and costly and limit various benefits. It’s important to answer various questions about your business to gauge which entity type will suit both your current and long-term goals and needs. Here are a few questions to discuss with your professional team:
- Will you have partners in the business? Certain entity types may offer more flexibility for multiple partners. When choosing an entity, you should consider factors like ownership distribution, decision-making, and how efficiently a partner can enter or exit the business. Additionally, considering future hypothetical scenarios, such as how you’ll protect your personal interests and assets if a partner leaves unexpectedly, is also critical.
- Will you seek outside investors for the business? Could you potentially have more than 100 outside investors? If investors are part of your plan, choosing an entity structure that facilitates shareholders or issuing stock is critical. Some entity types restrict how many shareholders you can have, limiting your options. Potential investors also evaluate factors like risk, flexibility, and tax treatments when deciding where to invest. The wrong entity structure could restrict benefits or make your venture less appealing.
- What level of liability protection do you need? Without the appropriate liability protection, you could expose your personal assets to undue risk due to debt or lawsuits. The right entity type will offer safeguards, separating your personal and business finances. While entity types with liability protection often involve higher initial setup costs and more complexity than most new entrepreneurs want to manage, it could provide peace of mind later.
- Will you conduct business only in the U.S. or globally? If you plan to operate internationally, you’ll require an entity type that complies with international tax and business laws. Factors like employee practices, managing different currencies, and your personal liability risk can change overseas and are important to consider. Further, if you aren’t currently operating globally, specific entity types may limit your ability to scale later.
- How do you plan to exit your business in the future? Considering exit strategies, such as if you’ll eventually sell or keep the business in your family, is essential. Entity types vary in tax treatments when selling or transferring ownership, which could affect your future proceeds and shareholder payouts.
What Is the Best Business Entity for Tax Purposes?
The best entity type for tax purposes depends highly on your business and situation, which we addressed in the above questions. Let’s explore the pros and cons of each type:
Sole Proprietorship
Sole proprietorships are the easiest and least expensive to set up. They have fewer reporting and regulatory requirements than other businesses and give entrepreneurs full control over decision-making. This entity type also allows for pass-through taxation, so business owners can report their business taxes on their personal returns, avoiding double taxation.
However, sole proprietorships also put all personal liability on the business owner, which could affect their property, savings, and other assets if faced with a lawsuit or debt. Sole proprietors must also pay self-employment taxes, which could be significant. It’s also important to note your business will typically end in your absence unless you otherwise specify.
Partnership
Similar to a sole proprietorship, partnerships are relatively simple and affordable to begin and also benefit from pass-through taxes to avoid double taxation. Additionally, partnership agreements provide more flexible terms for owners. Partners share the business’s responsibilities and decision-making, which could help alleviate workloads and offer diverse perspectives.
Disadvantages include unlimited personal liability, self-employment taxes, and instability if one or more partners leave the business. Partnerships may also involve disputes over profit-sharing or the business’s direction, adding to the entity type’s complexity.
Limited Liability Company (LLC)
Limited liability companies provide personal liability protection, which is the driving advantage to help business owners protect their personal assets. Like sole proprietorships and partnerships, LLCs also avoid double taxation with the added flexibility to be taxed as a corporation if the owner chooses. This could help reduce taxes and offer additional opportunities but may come with more complex tax treatments.
Disadvantages of an LLC include higher initial setup costs and more complex filings and requirements. LLCs are also not universally recognized, so business owners should consider varying state and international laws.
Is an LLC always the best way to “save on taxes?”
Not necessarily. An LLC is beneficial in sheltering liability and providing tax flexibility but it can preclude the ability to use some charitable exit strategies and have higher maintenance costs than other similar tax-saving structures. Depending on your revenue, a different entity type, like a S corporation, might be better than an LLC with similar benefits.
C Corporation (C Corp)
C Corporations offer personal liability protection to owners, protecting personal assets and enabling the issuance of stock, which could be more attractive to investors. They are also internationally recognized and allow reinvesting earnings rather than distributing them to shareholders, which is beneficial when growing the company. C Corps are taxed at the corporate tax rate, which could be lower than an individual owner’s tax rate, potentially resulting in lower taxes.
The drawbacks of C Corps are they are expensive and complicated to initiate and manage, with several formalities and administrative requirements that can be burdensome, particularly for new or small businesses. The biggest disadvantage is that C Corps are subject to double taxation, first on their profits at the corporate level and then again when dividends are distributed to shareholders.
S Corporation (S Corp)
S Corporations also offer personal liability protection to owners, and unlike C Corps, they avoid double taxation by allowing the company to pass profits directly to shareholders. They can also help reduce taxes overall, as employees, who are shareholders, only pay self-employment taxes on their salary and not their profit distributions.
However, S Corps are the most complex and costly of the options we’ve discussed. They also restrict shareholders to no more than 100 U.S.-based individuals. There are several regulatory and administrative requirements, including board oversight, recording meeting minutes, and issuing shares. Employee-shareholders must also pay themselves a “reasonable” salary, which the IRS watches closely to avoid abuse.
Is an “S Corp” always the best way to go?
Not always. There are several complexities and requirements when operating as a S Corp. While multiple owners seeking board oversight may find one beneficial, it may not always be ideal.
How Do I Choose the Right Entity Type for My Business?
As we’ve shared, determining a suitable business entity type can be complex, requiring thoughtful, strategic planning that considers various factors, such as personal risk, scalability, international laws, and more. The goal is to find the best match for your current business structure and growth plans. It’s crucial to consult with legal, tax, and financial advisors to understand the pros and cons of each based on your business and needs.
As business owners and advisors, we regularly work with entrepreneurs when choosing a business entity that helps mitigate high taxes and supports their personal and professional goals. Contact us to learn how we work alongside your extended team of professionals to design tax-efficient plans to meet your goals today and in the future.
CCMI provides personalized fee-only financial planning and investment management services to business owners, professionals, individuals and families in San Diego and throughout the country. CCMI has a team of CERTIFIED FINANCIAL PLANNERTM professionals who act as fiduciaries, which means our clients’ interests always come first. How can we help you?
CCMI provides personalized fee-only financial planning and investment management services to business owners, professionals, individuals and families in San Diego and throughout the country. CCMI has a team of CERTIFIED FINANCIAL PLANNERTM professionals who act as fiduciaries, which means our clients’ interests always come first.
How can we help you?
