What is the best type of entity to establish my business as?
If you’re reading this, you might be considering starting a business. I’m sure you already know what your business will be named, who you will employ, and where your office will be set up. Just as important is choosing how to organize/incorporate it.
You can make your entity an S-corp, C-corp, LLC, Single Member LLC, FLP, sole proprietorship, etc. Each has its own advantages and disadvantages, and it’s important to choose the most appropriate based on your situation.
The type of entity you choose affects how you pay taxes, shapes your retirement planning, investment strategies, succession planning, and more.
What Entity Type Should I Choose?
Sole Proprietorship
A sole proprietorship is the default structure for single-owner businesses. It’s the simplest from an administrative standpoint as it requires no formal filing or setup. You as the owner and your business are legally indistinguishable, and all income/expenses will flow directly through to your personal tax return on Schedule C.
Sole proprietors are subject to self-employment taxes on all business income, currently 15.3% on earnings up to the Social Security wage base.
Retirement plan options under a sole proprietorship are limited to SEP-IRAs and individual 401(k)s, which can limit your ability to maximize tax-deferred savings. Also, the lack of entity-level distinction makes succession planning more complex as there's no separate business interest to transfer.
While simple, they provide no liability protection and limited tax planning opportunities.
Single-Member LLCs
Single-member LLCs have the tax simplicity of sole proprietorships. They're "disregarded entities" meaning income flows through to your personal return as the owner, as it would in a sole proprietorship.
With a single-member LLC you can choose S-corp tax treatment, potentially reducing self-employment tax exposure. This requires you to pay reasonable compensation to yourself as the owner-employee, with the remaining profits distributed as non-employment income.
Business transfers are easier thanks to membership interest sales. Also, they provide a clearer separation between business and personal assets for estate planning purposes. Lastly, they also add liability protection.
Multi-Member LLCs
Multi-member LLCs are taxed as partnerships, with profits and losses flowing through to members based on their ownership percentages (or as specified in an operating agreement). They offer flexibility in profit and loss allocations, making them more attractive to businesses with diverse ownership structures or varying capital contributions.
Being taxed as a partnership allows for custom allocations of income, deductions, and credits among members, which opens the door to sophisticated tax planning opportunities. All members are usually subject to self-employment taxes on their share of business income, unless they're passive investors.
Multi-member LLCs are advantageous for estate planning. As a parent, you can gift LLC interests to your children while keeping management control. Then, you could qualify for valuation discounts that reduce gift and estate tax exposure. The operating agreement can also include buy-sell provisions that help streamline ownership transitions.
S-Corporations
S-corps offer liability protection and tax efficiency for small to mid-sized businesses. As an owner who works for the S-corp, you must receive reasonable compensation as a W-2 employee. Then, additional profits can be distributed without self-employment taxes.
As business income grows, S-corps become more attractive. If your business generates $200k in profit, you could take an $80k in salary (subject to payroll taxes) and $120k in distributions (avoiding self-employment taxes), resulting in significant tax savings compared to sole proprietorships.
S-corps also open you to more retirement planning opportunities because you can establish a 401(k) plan and maximize contributions (as both an employee and employer).
However, S-corps face restrictions on ownership. They can have only one class of stock and a maximum of 100 shareholders, all who must be U.S. citizens.
S-corp stock can be transferred to family members as long as they meet the requirements, which is helpful for estate planning and wealth transfer.
C-Corporations
Unlike the previously discussed entities, C-corps are separate tax entities that pay corporate income tax on their profits. While this creates double taxation (corporate tax + individual income tax on dividends), C-corps have unique advantages for high-growth businesses.
Retained earnings are taxed at corporate rates, which are lower than individual rates for high-income business owners. This allows for tax-efficient wealth accumulation within the business. C-corps can also deduct 100% of employee benefit costs, including health insurance for shareholder-employees.
If your business is planning for significant growth or an eventual sale, C-corps provide the most flexibility. They can have multiple classes of stock, unlimited shareholders, and ownership to non-U.S. citizens.
C-corps also allow for more sophisticated financial planning. They can facilitate complex equity compensation arrangements, support charitable giving strategies through corporate-level deductions, and provide platforms for multi-generational wealth transfer through varied stock classes.
Family Limited Partnerships (FLPs)
FLPs are mainly used for estate and gift tax planning. Parents usually serve as general partners with management control and gift limited partnership interests to their kids at discounted valuations.
FLPs are taxed as partnerships, with income flowing through to partners based on their ownership percentages. Their key advantage is valuation discounts. Limited partnership interests can be valued 20-40% below their proportionate share of underlying assets due to lack of control and marketability restrictions.
How Does the Entity I Choose Affect My Overall Financial Plan?
Retirement Planning
Sole proprietorships and single-member LLCs limit you to SEP-IRAs and individual 401(k)s.
S-corps and C-corps allow you to maximize 401(k) contributions through employee deferrals and employer contributions.
C-corps have additional benefits, like deferred compensation plans and executive life insurance arrangements.
Investment Management
C-corps can accumulate earnings for investment purposes.
Pass-through entities usually distribute earnings to owners, who then make personal investment decisions.
S-corp owners must plan for tax liability on their pass-through income, potentially using less aggressive investment strategies to maintain liquidity.
Estate Planning
C-corps can support multi-generational planning through varied stock classes.
LLCs and FLPs allow for custom distribution provisions and management succession. The ability to transfer interests at discounted values while retaining management control makes them attractive to wealthy families.
Choosing the best entity type for your business is a balancing act that requires you to have a clear picture of your current financial situation and your long-term goals. Your income, need for liability protection, number and type of owners, growth and exit strategies, estate planning goals, and retirement planning will all come into play.
The best choice might change as your business grows. Depending on circumstances, your business could transition from a sole proprietorship to an LLC to a C-corp as it develops.
As always, we recommend working with a tax professional who understands both tax strategies and wealth management.
Author: Rob Cucchiaro, CFP, CRPC, AAMS
Questions answered in this blog:
What type of entity should I choose?
What is an S-corp?
What is a C-corp?
What is an LLC?
What is a Single Member LLC?
What is an FLP?
What is a sole proprietorship?
What is the tax treatment of an S-corp?
What is the tax treatment of a C-corp?
What is the tax treatment of an LLC?
What is the tax treatment of a Single Member LLC?
What is the tax treatment of an FLP?
What is the tax treatment of a sole proprietorship?
How does the entity I choose affect my overall financial plan?
How does the entity I choose affect my retirement planning?
How does the entity I choose affect my investment management?
How does the entity I choose affect my estate planning?