Most individuals elect to conduct business using a separate business entity to provide a separation between personal assets and business liability. Individuals conducting a business without using a business entity (i.e., those conducting business as a sole proprietor), risk having their personal assets and the assets of their family (e.g., jointly held assets) made available to satisfy lawsuits arising from business liability. Without using a business entity, there is no difference between assets of the business and assets of you personally. Therefore, your personal assets would be used to satisfy liability arising through the conduct of your business.
Secondary reasons that weigh against operating a business in the sole proprietorship form are the following:
Therefore, in all but the smallest number of cases, operating a business as a sole proprietor is not the best structure.
General partnerships (GPs) alone are rarely a good selection for an operating business and almost never the correct choice for a small business. In a GP, each partner (who is referred to as a general partner) is fully personally liable for all of the debts of the partnership. This is exactly what you do not want.
While it is true that a limited partnership (LP) provides the pass through taxation of an LLC or S corporation and also provides a segregation of liability between the assets of its owners and the liabilities of the company, there is one strong reason not to use an LP in many instances. LPs are structured to have one or more limited partners, but must also have one general partner. The general partner remains personally liable for all debt and liability of the partnership. To shelter an individual who would otherwise be a general partner, it is typical to set up a corporation or LLC with that individual as the owner to act as the general partner. Therefore, an LP is not a great choice because you wind up having to set up a corporation or LLC also.
Limited Liability Partnerships (LLPs) provide the benefits of a limited partnership without the requirement of having at least one general partner. However, LLCs function in exactly this way as well. Because the LLC is much better known as a business entity (and much more accepted by the consuming public), I hardly ever have a reason to set up an LLP.
An LLC is a great choice for a business entity. The set up and continued maintenance is very easy, relatively inexpensive, and the LLC provides great operating flexibility. The segregation between business liability and personal assets is complete. In my opinion, the only reason to use an S corporation instead of an LLC is that there are several potential tax benefits, primarily the use of dividends as a surrogate for compensation (discussed in II, below). The others potential benefits are addressed more specifically below.
All corporations begin life as C corporations. Corporations were the original business entity and provide complete liability protection (via the segregation of business liability from personal assets). Corporations in general require more formalities than LLCs but only due to the fact that they have been around for hundreds of years (in the U.S. and England) and there has come to be a set way of doing things within the corporate form.
However, the IRS allows you to make an S election that will provide the ability for you as the business owner to take into your personal income what would otherwise be income of the corporation (this is known as pass through taxation). A primary benefit of pass through taxation is that if your business generates losses in its first year or two of operation, you are allowed to use these losses to offset personal income on your individual 1040. Otherwise, the losses would be effectively trapped in your corporation until you had profits you could offset. For this reason, many business owners incorporate their business and elect to be treated as an S corporation until the company shows a profit. At that time, they revoke their S election so that the corporation is taxed as a separate taxable entity (a C corporation).
Operating as a C corporation for a profitable business allows you to split the profits between yourself (and your tax rates) and the corporation (and its tax rates). As an example, if your business (operating as a C corporation) generated a net profit of $35,000 after paying all expenses of doing business (including your salary), this $35,000 would be retained in the corporation (as “retained earnings”) and the corporation would pay a tax of approximately $5,250 (at 15%). If this amount were generated by an S corporation, the additional $35,000 would be taxed on your personal return at your tax rate (which would be significantly higher than 15%).
A significant benefit of using the corporate form and electing S corporation status with the IRS is that you are able to receive dividends from the corporation. This is potentially important because the tax code requires all small business owners (no matter what business entity form they choose) to pay the same amount of Social Security and Medicare taxes. For the owner-employees of S and C corporations, these payroll taxes are paid directly by the corporation to the IRS and reported on Form 941 on a quarterly basis (along with the income tax withheld by the corporation).
[Just to complete the thought, these taxes are paid by non-corporate business owners (partners in a limited partnership, members of a limited liability company, etc.) as “self-employment” taxes, and are paid as part of quarterly estimated tax deposits. This tax is reported not by the entity, but by the individual on Schedule SE filed with the business owner’s individual Form 1040 income tax return.]
While salaries and bonuses paid by an S corporation (or C corporation, for that matter) are subject to employment taxes, corporate dividends are characterized as “investment” income and are not subject to employment tax.
While working for your S corporation, you must take a salary if the business is profitable. However, taking a combination of salary and dividends will usually reduce your overall employment taxes. For example, if you manage and work for your S corporation and pay yourself $60,000 and take $20,000 from the corporation as a dividend on your stock, you will pay a self employment tax on the $60,000 of approximately $9,180. However, if you were to take the entire $80,000 as salary, you would pay approximately $12,240 in employment taxes. This tax arbitrage is the single biggest advantage of using an S corporation.
However, please note that the IRS is well aware that S corporation owners use this scheme to reduce their tax burden. If you were to be audited by the IRS, you would have to prove that the salary portion above is reasonable when compared to other manager/employees in the same or similar industry. The dividend portion must reasonably be return of your investment in the company, and not compensation for your services. If the IRS were to determine that you actually were “paying yourself with dividends,” they would recharacterize such dividends as salary and require you to pay employment taxes on that amount.
In general, C corporations (not S corporations) receive the most favorable treatment under the tax code. Medical costs, including insurance premiums paid for owners AND employees, are completely tax-deductible to the corporation (and tax-free to the recipient). The C corporation does not have to form a group plan to receive the benefit. An owner/employee of a C corporation can pay for an individual health policy and be reimbursed tax-free by the corporation. If you want to learn more about this, check out IRS Publication 15B, Employer's Tax Guide to Fringe Benefits, at http://www.irs.gov/pub/irs-pdf/p15b.pdf.
Alternately, C corporations can establish a medical reimbursement plan which pays for (and deducts) medical costs not covered by insurance for employees, their spouses, and dependents.
Owners of an S corporation and Member/Managers of an LLC can deduct 100% of the health insurance premiums paid by them (not by the business). This deduction is taken directly on the 1040. However, from a tax perspective, the deduction within the C corporation is almost always more beneficial.
Additionally, just for completeness, S corporations and LLCs are able to deduct health benefits provided to non-owner employees. Such benefits are received by the non-owner employees tax free. This, however, will not apply to business owners.
There you have it. For medical benefits, S corporations and LLCs are treated very similarly—a C corporation, however, is typically the way to go to maximize the benefits of medical deductions. Starting out life as an S corporation and then changing to a C corporation when you become profitable may be a good choice. Since there is no advantage in the health benefit context to an S corporation when compared to an LLC (and vice versa), health coverage should not come into play for your initial analysis of which type of entity to use for your business. However, if you ultimately plan to operate as a C corporation, the above health benefit deductions will be available to you.
An LLC or S Corporation is almost always a good choice for beginning a business. As mentioned above, the LLC is the more flexible and easier to maintain of the two. However, the corporate form is not far behind the LLC when determining an appropriate vehicle for conducting a business. If there are tax advantages of the corporate form of which you will be able to take advantage, the corporate form may be the better choice.
