4 of the most common entity types for new businesses are sole proprietorships, partnerships, limited liability companies (LLCs), and S-Corporations (S-Corps). While all these entities work well in certain situations, knowing the benefits and drawbacks of each is important when deciding what entity is most beneficial. The main areas to consider are liability protection, ease of set-up and maintenance, tax implications, and future flexibility.
A sole proprietorship is the simplest type of entity available. There are no filing requirements, fees, nor are any documents technically needed. Simply “doing business”, a person forms a sole proprietorship. A sole proprietor can have documents to add structure to the entity, such as an operating agreement, but the level of complexity is still minimal. Partnerships are very similar to sole proprietorships, except with two people involved. Just by running a business together for a profit, two people have formed a partnership. No filings, fees, or documents are technically needed, though in both cases, there may be licensing or registration requirements specific to the kind of business being operated. It is recommended that a partnership draft a partnership agreement, but there are default rules governing profit and loss sharing, decision making, ownership transfers, and other issues if an agreement is never adopted.
Partnerships and sole proprietorships do not limit liability of the owners in any way. This means that if something goes wrong in the course of business, the owner can be held personally liable, putting all their personal assets at risk. This is where an LLC or S-Corp can be beneficial. A person who runs a business through an LLC or S-Corp gets limited liability. This means that if something goes wrong in the course of business, their personal assets are protected and only the assets owned by the entity are at risk. However, owners of new LLCs and S-Corps can undo this limited liability by agreeing to personal guaranty agreements that might be required by lenders or in other large contracts necessary for the company to operate and/or grow. A personal guaranty holds the owner personally liable if the entity cannot fulfill the contractual obligation. A personal guaranty does not completely negate the limited liability to all parties, but only the parties to the contract at issue.
While limiting liability is a significant benefit, there is also more complexity in forming and running an LLC or S-Corp. Both entities need to pay a small fee and file articles of organization with the secretary of state. While not technically needed, it is a practical necessity to have an operating agreement as well. There are default rules under Minnesota Statute 322C that fill in any “gaps” that are not addressed by an entity’s operating agreement. Both LLC and S-Corp entities also need to file an annual renewal with the state to remain in good standing. While it sounds like a completely different entity, an S-Corp is an LLC that has made a federal “S” election. To make an S election, an LLC files a form with the IRS when requesting a federal EIN. Not all LLCs can make an S election. The requirements for an S election are: 1). Less than 100 owners or “shareholders,” 2). All shareholders must be private individuals, 3). Shareholders cannot be nonresident aliens, and 4). The S-Corp can only issue one class of stock. In addition to the annual renewal requirement, an S-Corp also must file quarterly estimated payroll taxes with the Minnesota Department of Revenue.
As far as taxes go, owners of S-Corps are taxed differently than the other 3 entity types. Sole proprietorships, partnerships, and LLCs are known as “pass through” entities, which means the entity itself is not taxed but all the income or loss the entity incurs is passed through to the owner. This avoids the double taxation that corporations have, being taxed on initial earnings and then shareholders being taxed on distributions. However, owners of sole proprietorships, partnerships, and LLCs must pay self-employment tax in addition to income tax on any income earned through their business. While for most new and small businesses, this still results in a lower tax bill, certain business owners can benefit more under an S-Corp. An owner of an S-Corp must pay themselves a “reasonable wage” for the work they do based on similar jobs in a similar area. Federal and state governments treat the reasonable wage the same as for the other entity types, being subject to income and self-employment tax. However, if there is any other income to the entity, it is paid to the owner(s) as a dividend, and is not subject to the self-employment tax, only income tax. So, if an entity is going to make more than what would be a reasonable wage for the owner, it will help the owner if the entity is an S-Corp.
Finally, for all 4 entities, there is a balance of flexibility and structure/stability. The more detailed organization documents are, the more protection and certainty the owners will have. At the same time, the owners can be bound by those documents. As a business grows, stability and consistency will be beneficial, but only if the owners are confident in their direction as they will be giving up flexibility in the process. All 4 entity types can easily change their entity form to a corporation as they grow and desire more stability, but it is more difficult (and expensive) to change from a corporation to any other entity.
Jacob Grow