Tax Advantages & Disadvantages of Business Entity Selection

There is a significant importance for tax professionals to be capable of assisting clients and entrepreneurs with the process of choosing the correct business entity structure. There is a greater importance for entrepreneurs to seek assistance or to also understand the advantages and disadvantages of the available business entity structures available as well. Choosing the appropriate business entity structure will not only assist a business in accomplishing their business objectives, but also will determine aspects regarding taxation of income and how their assets will be protected. The most common business entity structures include: Sole Proprietorships, Limited Liability Companies, Partnerships, and Corporations. Understanding the tax advantages and tax disadvantages of the previously mentioned business entity structures may become the difference of operating a successful business and operating an unsuccessful business.

Sole Proprietorship
A sole proprietorship is a business owned by one individual whom typically operates the business on a day-to-day basis; there is also no formal legal structure involved with a sole proprietorship. Generally sole proprietorships are an ideal business entity structure for small businesses such as those involving crafts. A couple advantages outlined by include:

• No filing requirements and no requirements in order to start.
• Incomes and losses are reported on Schedule C along with personal income taxes.

A couple disadvantages of the sole proprietorship business entity structure includes:

• Sole proprietors are legally responsible for all liabilities and debts associated with the business.
• If the sole proprietor is sued, taxed, or defaulted both the business and personal assets from a tax standpoint are considered the same and are at risk.

The sole proprietorship business entity structure consists of more than 70 percent of all businesses within the United States; however sole proprietors only make a fraction of the income of the remaining 30 percent of available business entity structures. Therefore, while the sole proprietorship is a popular structure it is not necessarily the correct structure for all businesses.

Partnerships
An additional business entity structure consists of partnerships; a business with more than one owner who all are actively engaged in the operations while equally sharing, unless specified in a written agreement, in the profits and losses. There are two forms of partnerships that exist consisting of a General Partnership and a Limited Partnership. A general partnership is commonly formed through a verbal agreement and is not required to file a partnership agreement with the state; however, it is highly recommended that partnerships implement a written agreement as quickly as possible. Advantages of a general partnership include:

• Easy to establish with no filing requirements.
• A flow-through entity structure with profits and losses flowing directly to the partners’ personal income tax return.
• Offer different classes of shares.
• Tax-deferred property distribution amongst partners.

Disadvantages of general partnerships include:

• Partners are dually and separately responsible for the actions of their partners regardless of whether the actions knowingly obligated the business.
• Certain employee benefits are not deductible from business income.
• The opportunity for flexible partnership structures may complicate accounting and tax preparation.

A limited partnership consists of two types of partners including general partners and limited partners; limited partners are those partners that have limited liability in addition to limited input regarding management decisions. A limited partnership is not a common business entity structure for retail or service related businesses and typically caters to companies invested in real-estate. Advantages of a limited partnership include:

• Limited liability with associated business debts.
• General partners possess an avenue for acquiring investment without needing to involve investors with management.

Additional types of partnership structures that exist include husband and wife partnerships referred to as Qualified Joint Venture and family partnerships.

Limited Liability Company
A limited liability company (LLC) is a hybrid business entity structure that includes the limited liability features similar to what corporations possess while also possessing the tax and operational efficiency and flexibility that partnerships benefit from. The tax flexibility includes the ability to elect a classification, not legal classification, regarding federal income tax purposes as treatment as a partnership, a corporation, as well as a disregarded entity. Additional advantages also include:

• Limited liability provided to owners regarding business debts.
• Flexibility in tax classification, profit distribution, and tax planning.

Disadvantages of limited liability companies include:

• Laws vary by state regarding the formation and treatment of LLCs.
• Depending on the state some restriction may apply to the number of owners or location of owners.

Corporations
Corporations are a unique business entity structure that can consist of one person or a group of individuals incorporated as a separate entity within the state the business is headquartered. The owners of a corporation include the corporations’ shareholders and corporations possess the ability to enter into contracts, get sued, as well as get taxed on their own. Different types of corporations include C – Corporations such as General Motors and Starbucks as well as S – Corporations which is commonly used as a pass-through entity for taxation. Advantages of C – Corporations include:

• Unlimited shareholders my own stock.
• Multiple classes of stock are allowed.
• Shareholders may easily and publicly trade stock.

Disadvantages of C – Corporations include:

• Double taxation.
• Complicated structure.
• Losses do not pass through to shareholders.

Advantages of S – Corporations include:

• Avoids double taxation.
• Provides ability to limit employment taxes to owners whom receive reasonable compensation.

Disadvantages of S – Corporations include:

• Unable to distribute profits flexibly such as you are able to with LLCs.
• Shareholders are limited to 100 as well as limited to one share of stock.

Conclusion
With the proper planning and research business owners have the flexibility and freedom to elect a business entity structure providing their business with numerous advantages coupled with possible disadvantages. Therefore it is important for tax practitioners to dedicate time and energy with their clients to ensure the proper business entity structure has been implemented.