Choosing the right business entity in the US

When starting a business in the United States, it is very important to choose a business format. Choosing a business format is an important decision that affects your entire business, including taxes, liability, and organizational structure. Here, we will explain the advantages and disadvantages of the main business forms in the United States: Sole Proprietorship, Partnership, Limited Liability Company (LLC), S-Corporation, and C-Corporation. Consider what kind of people are suitable for each type of business.

Sole Proprietorship

A sole proprietorship is the simplest form of business because it is an extension of the owning individual taxpayer rather than a separate legal entity. A taxpayer is a sole proprietor if he or she is self-employed and the sole owner of an unincorporated business. A business does not exist apart from its owner. That responsibility is the personal responsibility of the owner.

There are no special declarations for sole proprietorships. Owners report all business transactions on their personal income tax returns (Schedule C-Form 1040).

Sole proprietorships are suitable for people who are independent and want to run a small business. It is also suitable for those looking for easy tax handling and full management rights.

Advantage

• Easy establishment: No special procedures are required, and you can automatically start as a sole proprietor.
• Direct tax: Income tax is paid directly, making tax processing easier.
• Lower costs: Doing business costs, legal, accounting, and administrative expenses may be lower.
• Full management rights: You have full control over the business.
• Flexibility: Easy to convert to other business formats.
  

Disadvantage

• Personal liability: personal and business assets are combined and responsibility is vested in the individual.
• Financing limitations: External financing may be difficult to obtain.
• Growth constraints: Not suitable for large-scale business development.
• Limited Benefits: Limited fringe benefits allowed.
• Self-employment tax: Self-employment tax is levied on sole proprietorships.

Establishment of a sole proprietorship

A sole proprietorship is the easiest business to set up and operate. If an individual conducts business under a name other than their legal name, most states require filing a fictitious business name declaration (also known as a “Doing Business As” declaration or simply a DBA declaration). Forms are available at the county recorder’s office and through some newspapers. This statement must be published in a newspaper of general circulation in the county in which the business is located.

Initial cost

Under Section 195, a sole proprietorship’s start-up expenses (after the first $5,000 deduction) may be amortized over a 15-year period at the taxpayer’s option. Such expenses include those paid or incurred in connection with the creation or acquisition of an active trade or business.

Separation of business and personal use

It is necessary to distinguish between business and personal amounts. We recommend setting up a business bank account.

Partnership

A partnership is a relationship between two or more people who engage in a trade or business together, where each contributes money, property, labor, or skills, and each expects to share in the profits and losses of the business.

The partnership files an information return (Form 1065). That income and deductions are reflected on the partner’s tax return (Form 1040).

Co-management is for people who want to work with a reliable partner and grow their business. It’s a good idea to have partners in your business with complementary skills and resources.

Advantage

• Multiple partners: Allows multiple people to pool capital and effort and jointly run a business.
• Income pass-through: Income is taxed to the partners rather than to the partnership.
• Avoid double taxation: Distributed income is not subject to double taxation.
• Limitation of Liability: The liability of limited partners is limited.
• Resource sharing: Partners can share resources and spread risk.

Disadvantage

• Shared responsibility: Partners share the debts and responsibilities of the business. The general partner’s liability is not limited.
• Taxation of profits: Partners are taxed on their profits even if they are not distributed.
• Administrative complexity: Partners may be required to file multiple state personal income returns for multistate partnership operations.
• Limited business year: If there is no business purpose, the partnership must use either the calendar year or the same year as the partner who owns a majority interest in the partnership.
• Decision-making difficulties: Decision-making can be difficult between partners with different opinions and goals.

Partnership Agreement

A Partnership Agreement is a very important document in partnership business. This agreement documents the rights, responsibilities, and rules for business operations between the partners and provides a basic framework to prevent future disputes.

When forming a partnership, it is a good idea to draw up a contract to clarify the details of how the partnership will operate.

Limited Liability Company（LLC）

An LLC is an unincorporated corporation that offers its members a variety of potential tax and legal benefits, including limited liability, pass-through, and the option to actively participate in the management of the entity.

LLC members or designated managers are not personally liable for the LLC’s debts.

An LLC is a business structure allowed by state law. Different regulations may apply from state to state. If you are interested in forming an LLC, you should check with your state.

Federal tax purposes do not specifically recognize LLCs as separate business entities. Depending on the election made by the LLC and the number of members, the IRS will treat the LLC as a corporation, partnership, or part of the LLC owner’s tax return (a “disregarded entity”). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. For income tax purposes, an LLC with only one member is treated as an entity that is separate and disregarded from its owners, unless it elects to be treated as a corporation by filing Form 8832. However, for employment tax and certain excise tax purposes, an LLC with only one member is still considered a separate entity.

LLCs offer flexibility while protecting assets, making them ideal for businesses with multiple partners. It is also suitable if your business is growing and needs financing.

Advantage

• Limitation of personal liability: Protect your personal assets and take limited liability for business debts.
• Taxation options: You can choose the taxation method, allowing for intermediate tax treatment between personal income tax and corporate tax.
• Income pass-through: Income is taxed to the members, not the LLC.
• Unlimited Membership: An LLC can have an unlimited number of members, and you don’t have to be a U.S. resident to become a member.
• Hiring managers: LLC members can hire managers.

Disadvantage

• New Business Entities: Because LLCs are new business entities, liability protection can be lost if the LLC is formed in one state and does business in another state that does not have an LLC law.
• Business Restrictions: States such as California have severe restrictions on the type of business you can do.
• Self-employment tax: Business owners who are actively involved in the management of an LLC are subject to self-employment tax.
• Limited fiscal year: LLCs are typically required to have the same tax year as the members of the LLC, and as a result, most LLCs are limited to a calendar year.
• Risk of Termination: LLCs are at increased risk of inadvertent termination because certain procedural requirements must be met for the LLC to continue in the event of bankruptcy, death, resignation, or withdrawal of a member.
• California LLCs must pay a minimum franchise tax of $800 and a fee based on gross receipts.

Operating Agreement

Creating an Operating Agreement: An Operating Agreement is a document that outlines the rules of operation for an LLC and agreements between its members. While not required to be filed in California, it is recommended to maintain it as an internal document.

Advantages of hiring managers

If the LLC does not appoint a manager, its income is subject to self-employment tax and the members must pay self-employment tax. On the other hand, by naming a manager, the LLC’s income may not be taxed as self-employment income for its members. Instead, managers are responsible for running the LLC and making decisions, and their compensation is treated as employee salary. This may result in tax benefits for the member by allowing them to avoid being subject to self-employment tax.

S-Corporation

S-Corporations are suitable for business owners who want a smaller corporate form and those who want to minimize profits with tax options. Due to restrictions on the number of shareholders, it may not be suitable for large-scale business development.

Advantage

• Limitation of personal liability: Protect your personal assets and take limited liability for business debts.
• Avoiding double taxation: An S-Corporation can distribute profits to its shareholders with only one tax payment on her. (C-Corporation dividends cannot be deducted, resulting in double taxation.)
• Self-employment tax savings: Distributions of profits to shareholders are not subject to self-employment tax, regardless of whether the shareholder is active in the business.
• Loss Deduction by Shareholders: Shareholders can deduct losses in an S-Corporation.
• Choice of accounting method: S-Corporations are specifically exempted from the accrual basis rules and may continue to use a cash basis of accounting if the nature of their business makes it available.

Disadvantage

• Domestic corporation: Must be a U.S. corporation.
• Nondeductible benefits: Benefits paid on behalf of employees who are 2% (or more) shareholders are not deductible.
• Stock restrictions: Cannot hold more than one type of stock.
• Shareholder Restrictions: Only individuals and certain trusts can be shareholders. The number of shareholders is limited to 100, and non-US residents cannot become shareholders.
• No accumulation of corporate profits: A company cannot accumulate corporate profits because the profits are taxed to the shareholders.

Election Requirement

A corporation may elect to become an S-Corporation at any time during the previous tax year or before the 15th day of the third month of the tax year. Most S corporations are required to use a calendar year, so the election due is March 15th. If made after March 15th, the election will be treated as having been made in the following year.

All shareholders of a corporation must consent to the election to become an S-Corporation. You consent by completing Form 2553 and signing in the appropriate fields. You must list each shareholder’s name, social security number, stock ownership, and tax year.

C-Corporation

For federal income tax purposes, C-Corporations are recognized as separate tax entities. This results in double taxation for most companies. Income is taxed first to the company that earns it and then to shareholders when the earnings and profits are distributed as dividends.

C-Corporations are suitable for companies that plan to raise large amounts of capital and grow over the long term. It also requires management with expertise in regulatory and tax treatment.

Advantage

• Split income: As an independent taxpayer, it can be used to split income between a corporation and its owners, potentially resulting in a lower overall tax rate.
• Deductible Benefits: You can deduct amounts paid for employee/owner fringe benefits, such as medical insurance or medical reimbursement plans, disability insurance, or group term life insurance.
• Limitation of personal liability: Protect your personal assets and take limited liability for business debts.
• Funding: Large-scale financing is possible and you can issue shares to raise capital.
• Long-term growth: Suitable for businesses planning long-term growth and going public.

Disadvantage

• High level of management and regulation: Establishment and operation requires a high level of management and many regulations must be followed.
• Double taxation: Profits are taxed both as a corporate tax and as a shareholder’s personal income tax.
• Obligation to go public: If a company reaches a certain level of sales or number of shareholders, it may be obligated to go public.

Summary

When starting a business in the United States, the type of business you choose is the key to success. Each type of business has its own characteristics, and each has its own advantages and disadvantages.

1. Sole Proprietorship: The simplest and lowest cost form. All responsibilities and profits belong to the owner, but personal responsibility is large and financing is difficult.
2. Partnership: The combination of capital and effort by multiple partners. Responsibility and benefits are shared, but the disadvantages are that decision-making becomes more complex and responsibility is shared.
3. Limited Liability Company (LLC): Provides greater flexibility and limited personal liability. Tax treatment options are diverse, but there is uncertainty as a new entity.
4. S-Corporation: A small corporation form that allows you to avoid double taxation and save on self-employment taxes. However, there are severe restrictions on shareholders.
5. C-Corporation: Suitable for companies looking to raise large amounts of capital and grow, but requires double taxation and advanced management.

It is important to consider the size of the business, growth plans, financing needs, and the owner’s liability tolerance to choose the best business structure. Strategic choices based on your individual business goals and resources will pave the way for business success.