The legal structure of your business is important to its growth and value. Whether your business operates as a sole proprietorship, partnership, limited liability company (LLC) or corporation should depend largely on factors such as operating formalities required, legal liability, taxation, and how easy it is to transfer the business ownership. It can be a significant decision that often receives too little attention from business owners.
Instead of making an informed choice, owners tend to “wander into doing business as one entity or another,” said Jacqueline Wiggins, JD, LLM, CLU, ChFC, director, advanced sales at MassMutual.* She recommends researching the different options with a team of professionals to include your attorney, tax advisor, and financial professional.
You’ll want to start by understanding the basic features of five common business entities.
This is the simplest of all structures under which an owner can conduct business. There is no separate legal or tax entity. The owner has full control of the company and is personally liable for business losses, lawsuits, or judgments. In terms of taxation, the owner reports business profits and losses on Schedule C of their personal tax return.
A sole proprietorship lacks a formalized legal structure and is subject to fewer regulations and rules than other entities.
A partnership structure involves two or more owners who operate a business for profit. Like the sole proprietorship, the business and its owners are not separate entities. The major disadvantage of this structure is a legal one: Although partnership debts are generally satisfied first with partnership assets, ultimately each partner is personally liable for the business debts. From a tax perspective, it’s a pass-through entity with one level of taxation. The partnership files an annual informational return with the IRS but doesn’t pay taxes. Instead, each partner reports their share of the profits and losses on their personal income tax return.
Unlike other options, a C corporation is a separate legal and tax entity, which puts a clear dividing line between the owners and the business. The business issues stock and an owner’s liability is limited to the amount they paid for their stock. As a result, the owner’s personal assets are separate and aren’t exposed. Additionally, stock is relatively easy to transfer for purposes of business and estate planning. A major disadvantage of a C corporation is double taxation. The company pays taxes on its earnings and then the owner pays tax when they receive compensation or dividends.
An S Corporation, like the C Corporation, is a separate legal entity. Because it is a corporation, it offers limited liability that helps protect the personal assets of the owners. The S Corporation also issues shares of stock which allows the owners to transfer the business interest. From a tax perspective, unlike the C Corporation, the S corporation is a pass-through entity. Similar to a partnership, the entity files an annual informational return with the IRS, and the owners pay their share of the taxes due on their personal returns. As a result, the S corporation avoids double taxation.
Limited liability company (LLC)
An LLC combines the best traits of corporations and partnerships. It’s a fairly new entity and became available in most states only in the 1990s. The legal advantages are the same as those of a corporation, in that the owners are shielded from personal liability, but unlike a corporation, an LLC chooses its tax status. It can be taxed as a separate entity, like a C corporation, or a pass-through entity like a partnership or S corporation. It’s the owners’ decision which taxation model they elect.
The choice of business entity isn’t set in stone and can be changed at any time. In fact, owners should revisit their decision as the business grows and includes new owners or family members. Succession and estate planning strategies, deferred compensation benefits for owners, and tax rates will all have an impact on which entity is appropriate. Wiggins is familiar with the ways in which certain planning strategies may lead to changes in business structure. “A sole proprietorship may be the appropriate entity until the owner’s priority shifts to transferring the business,” she said. “At that point, incorporating or forming an LLC and having stock or units to sell or gift may make the process of transfer much more efficient.”
Wiggins also described an instance when an owner’s concern about incorporating the business faded and his priorities shifted to retirement planning. “In this instance, a C corporation gave the owner access to the widest range of executive benefits, including deferred compensation and executive bonus plans. It also gave them the opportunity to deduct 100 percent of his long-term care insurance premiums,” she explained. “The C corporation is the only structure that supports these benefits for the owner.”
As the business grows in scope and adds employees, protection from personal liability often becomes a top priority. A business partnership, for example, may convert to an LLC as the business evolves and becomes more successful. Limiting personal exposure can also become a primary objective for owners who’ve grown their personal wealth. Wiggins stated, “If an owner invested $100,000 in her partnership, and now has personal assets totaling $1 million dollars, her $1 million will be on the line if an employee has an accident with a company car.” Converting to an LLC or corporation would eliminate this personal exposure.
Choosing a structure for your business isn’t a “set it and forget it” decision. You have flexibility to make changes as corporate and individual tax rates, as well as estate tax thresholds, change. That’s a decision you’ll want to discuss with your tax and legal professional as your business becomes more successful, your personal assets grow, and you set new goals for the future.
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Your MassMutual financial professional can help you explore which entity is right for you and your business’s needs. Contact us today to learn more.
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*Licensed, not practicing on behalf of Massachusetts Mutual Life Insurance Company, or its affiliated companies.