Starting a new business, whether your first or one of many, is always fraught with challenges. One of those is choosing the correct business entity, which is now more important than ever due to the Tax Cuts & Jobs Act (TCJA).
Each structure has its advantages and disadvantages, and it is important to choose the best one for your particular business. Just because someone in the same line of work as you chooses to be an S-Corp doesn’t mean that will be the right entity for you. Individual circumstances and future plans have to be considered.
Having an experienced CPA’s advice on this is vitally important, but here are some things you should know when considering the different entity options and which will work best for your business.
- Investors, including banks, private equity and venture capitalists prefer to invest in C-Corps.
- This entity is best (typically) for those that plan to eventually do an IPO.
- There is a clear line of demarcation between personal assets and business debts.
- C-Corps have a much lower tax rate under the TCJA, which reduced it from 35% to 21%.
- One disadvantage is C-Corps is the fact that the entity is taxed in addition to capital gains earned by shareholders and investors, in essence meaning they are double-taxed.
- Like C-Corps, there is a hard separation between personal and business assets.
- C-Corps are pass-through entities, so they are not subject to double taxation. Owners pay taxes once on business income, reporting it on their personal taxes returns.
- Under TCJA, owners benefit from Section 199A where they can deduct as much as 20% of qualified business income (QBI) when filling their 1040s.
- S-Corps are limited to 100 shareholders, all of whom must be U.S. citizens. Additionally, they can only have one class of stock, so they are not typically good for fast-growing tech companies or those that want to lot of options for raising capital.
Limited Liability Corporations (LLCs)
- Often used by those who are self-funding their start-up since getting outside investors is harder for LLCs.
- Business owners are protected from personal liability.
- LLC owners only pay taxes on flow-through income on their personal returns. If the business experiences a loss, the flow-through can lower the owner’s tax burden for the year in which the loss occurs.
- Section 199A pass-through deduction of up to 20% of QBI is available to LLC owners, same as S-Corps, though losses must be carried forward.
- If the business expects to need to raise capital, they will likely have to convert to a C-Corp, which will mean incurring additional costs.
Partnerships & Sole Proprietorships
- As pass-through entities, owners pay taxes, and can deduct losses, on their personal returns.
- Both of these entities are easier and cheaper to create.
- Sole proprietorships are often a good fit for people who intend to work alone and not hire staff.
- Partnerships are frequently chosen by professional services firms with multiple owners with different percentages of ownership, such as those in accounting, law, architecture or medicine.
- Partners are personally responsible for business liabilities as well as debts incurred by decisions made by other partners, which can make it difficult to raise outside funding.
There are pros and cons to each entity and many factors that need to be considered before choosing the best one for our business. We have helped scores of businesses make these decisions and would be happy to work with you as well.