Solomon & Hoover CPAs, PLLC Blog

Choosing a business structure, or entity, is an important decision that requires owners to consider several factors. The right structure depends on your circumstances, which may change over time.

3 Entities

One-person businesses often start out as sole proprietorships because they’re easy to set up and operate. But such structures offer no protection against personal liability. Partnerships don’t provide liability protection either — at least to their general partners. That’s why most established businesses operate as one of three entities: C corporation, S corporation or limited liability company (LLC).

All three structures limit their owners’ exposure to personal liability for their company’s debts and obligations. But they can differ greatly when it comes to flexibility, taxes and access to financing.

Flexibility and formalities

LLCs generally offer more flexibility than C and S corporations. They’re relatively easy to set up and have few restrictions and corporate formalities. Members have flexibility in the allocation of profits and losses.

By contrast, S corporations can’t have more than 100 shareholders (though most members of the same family are treated as a single shareholder) or more than one class of stock. Also, eligible S corporation shareholders are limited to individuals, certain trusts and tax-exempt organizations, and employee stock ownership plans (ESOPs).

Tax considerations

S corporations and LLCs are “pass-through” entities. This means that all of their profits and losses are passed through to the owners, who report their shares on their personal income tax returns.

But when it comes to self-employment taxes, S corporations may have an advantage: LLC members, unlike S corporation shareholders, may be subject to self-employment taxes on their entire profits, even if the profits aren’t distributed to them. However, S corporations must pay “reasonable” salaries to owner-employees, which are subject to self-employment tax.

C corporations have one distinct tax disadvantage: Their profits are subject to corporate income tax at the entity level and then to personal income tax when they’re distributed as dividends to shareholders. However, to the extent the C corporation is able to distribute profits in the form of salaries and bonuses (keeping in mind “reasonable compensation” restrictions), the deduction for wages paid eliminates double taxation.

C corporations also have some tax advantages. They may be able to deduct employee benefits — such as health reimbursement plans — for owners. Additionally, due to the graduated tax rates of a C corporation, a business may be able to build up and retain capital at a lower current tax rate than it would as an LLC or S corporation.

Attracting financing

S corporations can have trouble attracting equity investors because of limits on the number of shareholders and their inability to issue preferred stock. LLCs, on the other hand, are allowed an unlimited number of investors and enjoy the flexibility to create different types of interests to meet investors’ needs.

All types of business entities have access to bank loans. But banks may be more likely to ask for personal guarantees from S corporation shareholders and LLC members.

Planning and professional advice

Choosing a structure for your business is a complex process. But with planning and professional advice you can find the right entity for your needs.

© 2012 Michele M. Hoover, CPA. Alexander & Hoover, P.A., Certified Public Accountants, specializes in providing a wide range of diversified accounting, tax, finance, and consulting services to individuals and businesses.