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The FAQ on Business Entity Types
Updated: Nov 28, 2022
You have that excellent new service or idea that will change the world! You have the logistics worked out. You know your costs. You even know your perfect business name. Have you thought about the different types of entities your business could be - sole proprietor, partnership, corporation, S-corporation, or LLC?
Knowing which business entity type to register as can save you big when it comes to taxes, benefits, personal liability, and recordkeeping requirements. Each type of business entity formation is unique, with pros and cons. Below, you'll find the four business entities to see which type fits your needs best.
Sole Proprietor, Single-Member LLC, & Spouse-Owned Businesses
These entity types are the same, even though the names are slightly different. Here are the common things about this business entity type.
Common Tax Forms
Schedule C (Form 1040), Profit or Loss From Business
Schedule F (Form 1040), Profit or Loss From Farming
Schedule SE (Form 1040), Self-Employment Tax
Resource: IRS Pub. 334, Tax Guide for Small Business
Accounting & Recordkeeping Requirements
Accounting is less involved than partnerships and corporations. Double-entry bookkeeping is not required as no balance sheet is needed when filing Schedule C or F.
A business owned solely by two spouses may elect not be taxed as a partnership and may file as two sole proprietorships to minimize bookkeeping requirements.
Cannot file as a fiscal year business unless owner files Form 1040 under the fiscal year rules.
Fringe Benefits
Excludable fringe benefits are generally not allowed for the owner.
Exceptions: Health insurance is deductible if the spouse is an employee of the sole proprietorship, and the owner is covered as a family member of the employee-spouse. The spouse is also eligible for dependent care assistance fringe benefits, de minimis fringe benefits, and working condition fringe benefits.
Liability
Owner is personally liable for all debts and lawsuits against the business.
Exception: If organized as an LLC, liability is usually limited to owner’s investment
and his or her own malpractice or debt guarantees.
Organization and Ownership
One individual carrying on an unincorporated trade or business.
A qualified joint venture whose only members are spouses may elect not to be taxed as a partnership and file as two sole proprietorships. An LLC may not make this election.
Easiest business to organize with minimal legal restrictions.
The entity does not exist apart from the owner. Business starts and ends based on engaging in and ending engagement in business.
The owner has complete freedom over business decisions and is entitled to 100% of the profits. The owner is limited by his or her own ability to raise capital and obtain financing. Outside investors cannot be part owners.
Transfer of ownership consists of selling the business assets.
A single-member LLC is taxed as a sole proprietorship unless the election is made to be taxed as a corporation.
Taxation of Profits and Losses
The owner is self-employed and pays self-employment (SE) tax on net profits.
Net profits are subject to income tax in the year earned and cannot be deferred by retaining profits.
Losses offset other income in year incurred, such as W-2 wages, interest, dividends, and capital gains. Exceptions: Losses cannot be used to offset income from activities subject to passive loss, at-risk loss, and hobby loss rules.
Owner may qualify for the 20% qualified business income deduction (QBID).
Pros & Cons
Partnership
Partnerships are the least used business entity for new businesses selling goods. Some new service-based companies will start as a partnership.
Common Tax Forms
Form 1065, U.S. Return of Partnership Income
Resources: IRS Pub. 541, Partnerships (IRC Subchapter K, §701 through §761)
Accounting & Recordkeeping Requirements
Small partnerships are not required to provide a balance sheet and can use the same bookkeeping system as a sole proprietor. Larger partnerships must provide a balance sheet with the return, which requires double-entry bookkeeping.
A partnership must generally use the same tax year as its partners, but can use a fiscal year if there is a business purpose or an IRC section 444 election was made.
Complex books and records are needed when a partner exchanges property, other than cash, for a partnership interest or for special allocations and basis elections.
Fringe Benefits
Partners are eligible for some excludable fringe benefits. Taxable benefits are reported as guaranteed payments or an adjustment to a partner’s distributable share of profits.
Liability
A general partner is personally liable for all debts and lawsuits brought against the
partnership.
Exception: If the partner is a limited partner, or the business is organized as an LLC, liability is generally limited to the partner’s investment, plus his or her own malpractice or debt guarantees.
Organization and Ownership
Two or more owners conducting an unincorporated trade or business.
Easy to organize with minimal legal restrictions.
Multi-member LLCs are taxed as partnerships, unless the election to be taxed as a corporation is made.
No limitations on the number of partners or partner entities.
More flexibility than a corporation in dividing up profits, losses, ownership of capital, and making special allocations to partners.
Contributing property in exchange for a partnership interest is a tax-free event (except for the receipt of cash).
Liquidating a partnership interest in exchange for property is generally tax-free, unless the liquidation is in cash only.
Getting out of a partnership may be more complicated than starting one. A partnership agreement can restrict selling or transferring of a partnership interest.
State law may limit an LLC’s life.
Taxation of Profits and Losses
The partnership pays no income tax. Profits pass through to partners for individual payment of tax.
Tax to partners cannot be deferred by retaining business earnings.
Pass-through items retain the same character to the partner as they had to the partnership.
A general partner’s distributive share of profits is subject to self-employment (SE) tax. Limited partners’ share of profits not subject to SE tax unless in the form of guaranteed payments.
Payment for partner services to the partnership is not W-2 income, but may be guaranteed payments, profits, or special allocations.
Losses flow through to partners and can be used to offset other income such as W-2 wages, interest, dividends, and capital gains. Exceptions: Losses cannot be used to offset income from activities subject to passive loss, at-risk loss, and hobby loss rules.
Partner may qualify for the 20% qualified business income deduction (QBID).
Pros & Cons
C Corporation
When you think of prominent businesses, this is the business entity type for the name we all recognize and many of the other brands owned by the parent company. Think of The Walt Disney Company - a C corporation that owns many other corporations and partnerships like Disney Parks, The Disney Store, ABC, and more.
Common Tax Forms
Form 1120, U.S. Corporation Income Tax Return
Resources: IRS Pub. 542, Corporations (IRC Subchapter C, §301 through §385)
Accounting & Recordkeeping Requirements
Double-entry bookkeeping may be required if the tax return requires a balance sheet.
No restriction on use of a fiscal year. Exception: A personal service corporation (PSC) must use a calendar year unless it establishes a business purpose for using a fiscal year or makes an IRC section 444 election.
Required to use accrual method of accounting if average annual gross receipts exceed $26 million.
Fringe Benefits
Shareholder/employees eligible for excludable fringe benefits, generally to the same extent as any other employee, with exceptions under the nondiscrimination rules. Benefits can include health insurance and reimbursement, education, life
insurance, etc.
Liability
A shareholder’s liability is limited to the amount invested, plus his or her own malpractice or debt guarantees.
Organization and Ownership
A legal association carrying on a trade or business organized under state law.
Ownership is through owning shares of stock, and there is no limit on number of shareholders, or type of taxpayer or entity.
Forming a corporation may require complex and expensive legal procedures. Corporations must hold board meetings, shareholder meetings, and keep corporate minutes. Corporations are subject to federal and state regulations.
The life of a corporation is perpetual. Transfers of ownership can be as easy as selling or inheriting stock.
Liquidating a corporation is usually a taxable event, and contributions in exchange for stock may be taxable.
Raising additional capital can be as easy as issuing new shares of stock.
Taxation of Profits and Losses
Shareholders who perform services are paid as W-2 employees subject to payroll taxes and reporting rules.
Reasonable wages must be paid and not inflated to reduce corporate tax liability.
Net profits are subject to tax at the corporate rates. Profits distributed as dividends are taxed again on the shareholder’s tax return. Tax to the shareholders can be deferred by retaining earnings for business purposes.
Losses do not pass through to shareholders. Business losses must be carried over to a year with profits. Capital losses must be carried over to a year with capital gains. At-risk limitations, hobby loss, and passive loss rules do not apply.
Pros & Cons
S Corporation
As a cousin of the C Corporation, the S Corporation business entity is a good hybrid fit for many small businesses because you get corporation liability protection but a more favorable tax rate for many shareholders. We always talk about the S Corporation last since it is a particular part of the Internal Revenue Code (IRC) for corporations - commonly called subchapter s.
Common Tax Forms
Form 1120-S, U.S. Income Tax Return for an S Corporation
Resource: IRC Subchapter S, §1361 through §1379
Accounting & Recordkeeping Requirements
Double-entry bookkeeping may be required depending on income and other factors affecting the need for a balance sheet on the return.
Must use a calendar year unless it establishes a business purpose for using a fiscal year, or it makes an IRC section 444 election.
Fringe Benefits
Shareholder/employees are eligible for some excludable fringe benefits. Benefits added to taxable wages on W-2 of more than 2% shareholders include accident and health plans, up to $50,000 of group health insurance, and meals and lodging furnished for the employer’s convenience.
Liability
A shareholder’s liability is limited to the amount invested, plus his or her own malpractice or debt guarantees.
Organization and Ownership
A corporation that has elected to be taxed as an S corporation by filing Form 2553, Election by a Small Business Corporation. (There is a timing requirement for completing this form, so do read those instructions!)
Ownership is through owning shares of stock. Limited to 100 shareholders. (Spouses and their estates and all members of a family, as defined in IRC section 1361(c)(1)(B), and their estates can be treated as one shareholder for this test.)
Stock is limited to one class of stock with equal rights to distributions and liquidation proceeds.
Shareholders are limited to individuals, estates, certain trusts, and certain charities. Corporations and certain partnerships are ineligible to own stock.
Other ownership and organization issues are the same as a C corporation.
Taxation of Profits and Losses
An S corporation generally pays no tax. Profits flow through to the shareholders.
Pass-through items retain the same character to the shareholder as they had to the corporation.
Distributions are not subject to self-employment tax.
Shareholders who perform services are paid as employees and income is reported on a W-2.
Losses flow through to shareholders and may be used to offset other income, subject to passive, at-risk, and hobby loss exception rules.
Shareholder may qualify for the 20% qualified business income deduction (QBID).
Pros & Cons
Wait! What About LLCs?
A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state may use different regulations, you should check with your state if you are interested in starting a Limited Liability Company. Owners of an LLC are called members. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner (see above) . A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.
Classifications
Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”).
Effective Date of Election An LLC that does not want to accept its default federal tax classification, or that wishes to change its classification, uses Form 8832, Entity Classification Election, to elect how it will be classified for federal tax purposes. There are some special timing deadline to watch when electing a new classification as an LLC. An LLC may be eligible for late election relief in certain circumstances.
Business Formalities
A common problem with a closely-held business is failure to adhere to business formalities. Trouble can occur when business and personal funds are intermingled, the business is not adequately capitalized, or reasonable compensation for services is not paid.
For example, separation of funds can be a key in preserving the liability protection of the “corporate veil.” Courts can pierce the corporate veil if they find the corporation is
an “alter ego” of the shareholder, which is likely to occur if shareholders pay personal expenses from the corporation checkbook or vice versa.
Transactions such as capital contributions or loans between the business and the owners can also be recharacterized by the IRS, creating unexpected negative tax consequences.
If you still have questions, we're always here to help you work through the options so you can start your new business on the best tax foot. Seeking the advice of legal counsel can also be wise, depending on the type of business you will operate.*
*Legal Disclaimer: This post contains general information for taxpayers and should not be relied upon as the only source of authority. Taxpayers should seek professional tax advice for more information. This information was current at time of posting; we are not responsible for updating this or any blog post/article for subsequent changes in the law or its interpretation.
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