Starting a business is exciting, requires hard work, and making tough decisions. One of the most important decisions to make when starting out is deciding how to organize your business structure. There are many different business structures to consider, but before just choosing the one recommended by a friend, it’s important to understand the different types of entity structures and decide which one is the best choice for you.
Choosing the right entity is crucial because while it’s possible to change your entity type later, it can become very complicated, especially if you have partners. This article will describe the most common types of entity structures to help you choose the one that meets your objectives and provides you with the maximum tax benefit.
Types of Entity Structure
1. Sole Proprietorship
Sole proprietorships are the easiest businesses to form because there is very little that needs to be done to get started. If someone pays you for providing a service or selling a product, then you’ve just become a sole proprietor.
Sole proprietorships are unincorporated. There is no formal entity structure like an LLC or corporation. The owner and the business are one and the same, with no legal distinction. Since there’s no legal distinction between the business and the owner, the owner is responsible for all business liabilities and risks.
Sole proprietors file their tax returns on Schedule C of their personal tax returns. For more information on Sole Proprietorships.
2. C-Corporation
C-Corporations (C-Corp) are the preferred entity type for large companies because of their flexibility and few restrictions. For example, a C-Corp can have unlimited shareholders and complex debt and equity structures. C-Corps are legally separate from their shareholders thus providing limited liability to their investors. The biggest drawback to C-Corps is that they are double-taxed. The corporation pays tax on its net profit and the shareholder pays tax on any dividends it receives from the corporation.
A C-Corp is ideal if you’re looking to bring in outside investors, private equity, or foreign investors because you can set up the C-Corp in any way you want. This flexibility is why large multinational corporations such as Nike, Amazon, and Google are all C-Corps despite the double taxation.
C-Corporations file their taxes on IRS Form 1120. For more information on C-Corporations.
3. S-Corporation
An S-Corporation is the most common type of entity structure for small businesses, but don’t assume that S-Corporations are limited to small businesses. An S-Corporation can have unlimited revenues which makes it ideal for anyone who seeks a corporate structure and wishes to avoid double taxation. S-Corporations are Pass-Through Entities (PTE) which means they do not pay federal corporate tax. Instead, the net income of an S-Corporation is passed-through to each shareholder in a K-1 and the shareholder reports their portion of the S-Corp’s income or loss on their personal tax return.
S-Corporations file their taxes on IRS Form 1120S. For more information on S-Corporations.
4. Partnership
According to the IRS, a partnership is an unincorporated organization with two or more members who carry on a trade, business, financial operation, or venture and divide its profits. A single person cannot form a partnership.
There are different types of partnerships, such as a Limited Partnership (LP), Limited Liability Partnership (LLP), or General Partnership (GP).
Partnerships are excellent structures for entrepreneurs who bring different skill sets to the business. For example, you could form a partnership with a friend to build an apartment building where you contribute the raw land to the partnership and your friend contributes the money for the construction cost, but you decide to split the profits 50/50. This unequal ownership structure is not possible in a corporation, only a partnership could accommodate such a disproportionate ownership interest. A partnership should have a partnership agreement that outlines the key provisions of the partnership.
Partnerships file their taxes on IRS Form 1065.
For more information on Partnerships.
An LLC is an unincorporated hybrid and flexible entity because, in addition to offering liability protection, an LLC has the option to be taxed as either a C-Corporation, S-Corporation, Partnership, or Single Member LLC (SMLLC). Note that a single person cannot elect to have their LLC taxed as a partnership because it takes at least 2 people to form a partnership.
5. Limited Liability Company (LLC)
LLCs are a type of entity structure formed and governed under state laws and require less formality than corporations, which makes them an ideal choice for small businesses just starting out.
LLCs are commonly used by real estate investors, consultants, and those just starting out wanting liability protection, but without all the annual reporting requirements of a corporation. An LLC is required to obtain an EIN.
An LLC has members whereas a partnership has partners and a corporation has shareholders.
An LLC’s required tax return depends on how it chooses to be taxed. An LLC taxed as a C-Corporation files Form 1120; an LLC taxed as an S-Corporation files Form 1120S; an LLC taxed as a partnership files Form 1065; and a Single Member LLC is reported on Schedule C, Schedule E, or Schedule F of a taxpayer’s personal return.
For more information on Limited Liability Companies (LLC)
6. Single Member LLC (SMLLC)
A Single Member LLC (SMLLC) is an LLC that is owned by one person. Even if you are married and you own the LLC together, it can be treated as a SMLLC. A SMLLC has the same functions as a regular LLC except that SMLLC cannot be a partnership because it takes at least 2 people to form a partnership. A SMLLC can elect to be taxed as either a disregarded entity, C-Corporation, or S-Corporation.
A disregarded entity is an individually owned non-corporate entity that is not treated as a separate entity by the IRS. A SMLLC that is a disregarded entity would not file a federal tax return, but would instead report the income, expenses, and net profits of the SMLLC on the individual’s personal return on either Schedule C (as a sole proprietor), Schedule E (for rental activities), or Schedule F (for farming activities).
Some states require SMLLC, even if they are a disregarded entity, to file state income tax returns. Click here to find out if your state requires an income tax return.
While a SMLLC that is a disregarded entity with no employees or excise tax liabilities does not need an EIN, there may be instances when it must obtain an EIN. An EIN may also be required by the home state to open a bank account.
Other Types of Entities
1. A Professional Corporation (PC)
A professional corporation (PC) is commonly used by doctors, CPAs, engineers, attorneys, and other professionals. Some states require professionals to operate their business as a PC versus a general corporation. In addition, such states may also restrict ownership of PCs to only professionals. For example, a CPA firm that is a PC cannot have non-CPAs as shareholders.
The key difference between a PC and a general corporation is that shareholders of a PC do not have unlimited liability protection. For example, a doctor who owns a PC may have liability protection for business debts but can be held personally liable for malpractice.
2. Benefit Corporation (B-Corporations)
A B-Corporation is a hybrid entity that combines the features of a non-profit and a for-profit corporation. While the purpose of a traditional corporation is to maximize shareholder profits, the purpose of a B-Corp is to benefit society as a whole and make a profit. B-Corps are focused on promoting social responsibility, fair trade practices, and environmental awareness.
Like all entities, B-Corps are formed at the state level, and not all states allow for their formation. Maryland was the first state to allow the creation of Benefit Corporations in 2010. Today, there are many states that allow for the formation of B-Corps, click here to find out if your state allows B-Corps.
3. Series LLC
Series LLCs are a group of LLCs that are owned by a parent LLC. They are ideal for business owners who want to consolidate control of several entities into one parent company but also enjoy the limited liability of each subsidiary entity. An example would be a restaurant owner who has multiple locations. The owner would create a parent LLC and several child LLCs to each own and operate the individual restaurants. Another example would be a real estate investor who wants to own each property under a separate LLC to protect against liability from one property spilling over to another.
The concept of series LLCs is relatively new and was first introduced in Delaware in 1996. However, not all states allow for the creation of series LLCs. Click here for a comprehensive list of which states allow the formation of series LLCs.
4. Qualified Subchapter S Subsidiary (Q-Subs or QSSS)
A qualified subchapter S Subsidiary (Q-Sub) is when an S-Corporation wholly (100%) owns one or more S-Corporations. A Q-Sub is similar in concept to a series LLC, except that with a Q-Sub, an S-Corporation owns another S-Corporation.
Entrepreneurs routinely start and run different businesses. Q-Subs are great for entrepreneurs to separate assets and business activities into separate entities for liability protection and planning purposes.
To qualify as an S-Sub, the parent S-Corp must make an election by filing IRS form 8869 (Qualified Subchapter S Subsidiary Election) which is different from Form 2553. The subsidiary does not file form 2553 because the subsidiary S-Corp is not treated as a separate entity per the IRS.
One of the benefits of a Q-Sub is that only one tax return is filed by the parent, and the subsidiary S-Corps is consolidated into the parent company. However, states may require each individual Q-Sub to file a separate tax return and pay.
5. Nonprofit
Nonprofit organizations are formed at the state level and are usually organized to help people. The name itself means that the organization is not in business to earn a profit for its owners. Any income earned from a nonprofit is used to further the organization’s mission. There are five types of nonprofits recognized by the IRS:
- Charitable
- Churches and Religious organizations
- Private foundations
- Political organizations
- Other non-profits
Nonprofits must obtain an EIN and apply with the IRS for tax-exempt status. Nonprofits must file federal income tax returns on IRS form 990.