Choosing the right business entity structure is one of the first and most consequential decisions an entrepreneur or business owner makes, because business entity options and their tax implications affect everything from how the IRS taxes your income to how they structure shields your assets from creditors. In most cases, a new business will operate as an S-corporation, partnership, sole proprietorship, or C-corporation. While it is sometimes possible to change your entity structure down the road, getting it right from the start can save significant time, money, and complexity.
Business Entity Options: What Every Business Owner Should Understand
Each entity type carries distinct financial advantages and disadvantages. Understanding those differences helps business owners select the structure that best balances legal protection with tax efficiency.
S Corporations: Tax Implications and When They Make Sense
S corporations avoid the double taxation drawback of C corporations by passing profits and losses directly to owners’ personal income without subjecting them to corporate tax rates.
Advantages
- S corporation business income avoids self-employment or payroll tax, saving tax at Medicare (and potentially Social Security) rates.
- Owners pay income tax once, when they earn it – unlike C corporations, who pay tax twice: first when the corporation earns income and again when it distributes earnings.
- An individual or up to 100 shareholders (with restrictions) can own an S corporation.
Disadvantages
- Owners must receive dividend distribiutions proportionately.
- Active owners must join the payroll and be receive a ”reasonable salary.”
- The IRS treats passive investors’ distributions as “passive income,” making those earnings subject to Net Investment Income Tax.
- Foreign owners or groups of entities cannot own S corporations.
- Generally, individuals, not other entities, must own S corporations. In some cases where the owner makes a tax election, certain qualified trusts can own S corporation stock.
- When an S corporation distributes property that has appreciated or depreicated above or below Fair Market Value (FMV), the IRS treats the transaction as an FMV sale to the shareholder, creating taxable gain for S corporation owners.
- The IRS does not treat owner salaries as Qualified Business Income (QBI) for the purpose of the Section 199A QBI deduction.
When S Corporations Make Sense
- When the company can meet all the qualifications of the corporate structure (100% U.S. shareholders, less than 100 total shareholders, all shareholders are eligible to own S corporation stock).
- When the company’s substantial income and self-employed payroll tax savings are enough to cover the costs of losing out on some QBI and can accommodate the administrative costs of filing additional income tax returns and payroll tax returns.
- When the company doesn’t own appreciating real estate and stocks that it plans on holding for the foreseeable future.
Partnerships: A Flexible Business Entity Structure for Multiple Owners
Partnerships represent the simplest structure for two or more investors to own a business together. These structures, like S corporations, avoid double taxation by passing income directly to partners. However, partnerships are subject to self-employment taxes.
Advantages
- Owners can assign partnership income in multiple ways, and distributions do not need to be proportionate.
- Owners pay income tax once, when they earn it, unlike C corporation owners, who pay tax twice.
- Partners receive basis from “recourse” loans, unlike in S corporations, where shareholders only receive basis from money personally loaned to the company.
- Corporations, other partnerships, trusts, and foreign nationals can all own partnerships.
- Partnerships carry less stringent filing requirements and lower overhead costs to establish and maintain. Georgia, for example, does not assess its net worth tax to partnerships.
- Partnership owners do not pay themselves salaries, which eliminates payroll service fees and associated administrative costs.
- Partnerships can distribute appreciated property without generating a gain.
Disadvantages
- Active participants pay all partnership income as self-employed income, and the IRS subjects passive investors to Net Investment Income Tax.
- Guaranteed payments are not eligible for the Qualified Business INcome (QBI) deduction and the IRS subjects them to self-employment taxation.
- Partnerships that have activity during a given tax year must file Form 1065 for that year, which adds administrative costs.
- Distributions don’t have to be proportionate which can cause partners to have disagreements. For example, when the majority partner receives a distribution that covers taxes due and the minority owner does not, the minority owner faces a tax shortage. In cases such as this, the minority owner generally has a fairly strong argument in court for forcing the majority owner to pay distributions that cover taxes.
When Partnerships Makes Sense
- When the company deals in real estate and earnings aren’t subject to self-employment tax.
- When the company has owners that aren’t eligible to own S corporation stock.
- When the company owns appreciating real estate and stocks that it plans on holding for the foreseeable future.
- When the company has multiple owners but does not generate enough profit to justify payroll service fees or the QBI cost of an S corporation structure.
Sole Proprietorships: The Simplest Business Entity Option
In a sole proprietorship, the owner retains complete control over the entity’s operation.
Advantages
- Sole proprietorships do not need to track bsasis or prepare a balance sheet with their tax returns.
- Like other pass-through entities, owners pay income tax once, when they earn it.
- Sole proprietorship income qualifies for retirement plan contribution calculations.
- Because sole proprietorships do not file tax returns, the owner only has to file one return.
- Sole proprietors do not take salaries from their companies, saving administrative costs of payroll service providers and payroll tax return preparation.
- All sole proprietorship income qualifies for QBI calculations.
Disadvantages
- The IRS taxes all sole proprietorship income as self-employed income.
- Sole proprietorships can only have one owner.
When a Sole Proprietorship Makes Sense
- When a single-owner company does not generate enough income to justify electing S corporation taxation.
- When the company’s owner wants to avoid filing payroll or tax forms quarterly, or wants to consolidate tax filing into a single return.
- When the company’s owner generates the vast majority of the income and the owner isn’t comfortable pushing the limits of “reasonable salary,” and when the company generates QBI income.
C Corporations: Tax Implications for Growth-Focused Businesses
A C corporation is a legal entity that’s separate from its owners. It can earn a profit, pay taxes, and carry legal liability independently.
Advantages
- C corporations pay income tax at a flat rate of 215, which means companies that plan to reinvest earnings can do so in the early stages without significant tax bills
- Any number of shareholders can own a C corporation, which cna also issue different classes of stock with different dividend rights.
- Other corporations can own C corporations, and the dividends-received deduction helps avoid double taxation between corporations.
- C corporations can operate on fiscal year-ends, unlike S corporations, which must generally use year-ends.
Disadvantages
- C corporations must pay dividend distributions proportionately to owners of the same stock class.
- Active participants must join the payroll and receive a reasonable salary.
- C corporations cannot deduct losses and are no longer eligible to carry them back to generate refunds in prior, profitable years (as of the TCJA’s enactment in 2018).
- When a C corporation distributes appreciated or depreciated property below FMV, the IRS treats the transaction as an FMV sale. This creates a taxable gain for the company and a dividend to owners at FMV.
- The IRS generally taxes dividends to owners at capital gains rates, and subjects them to Net Investment Income Tax; even when owners actively participate in the business.
When C Corporations Makes Sense
- When the company wants to eventually make a public stock offering and expand past 100 investors
- When the company wants or needs to have a fiscal year-end
- When a self-directed IRA partially owns the company.
- When the company wants to accumulate funds to reinvest and opts to take advantage of the relatively low C corporation tax rate up front
- When other C corporations own enough of the company that the dividends-received deduction eliminates double taxation.
Changing Your Business Entity Structure
- It’s easier to go from a partnership or sole proprietorship to a corporation than vice versa.
- C corporations can elect to be taxed as S corporations, but C corporation-retained earnings are taxed at dividend rates when distributed.
Choosing the Right Business Entity: Talk to RYBD.
Entrepreneurs need to carefully study these business entity options and tax implications to determine which one optimally balances legal protections and risks with benefits. In this blog post, we defined each entity type and offer our opinion about when each should be used. However, the information contained in the blog should be used as a preliminary guideline to narrow the options. Consultation with your RYBD advisor, who can assist with securing a legal opinion, is recommended prior to filing for the chosen entity. Contact us today to get started.
