The Business Entity Myth: Why You’re Choosing the Wrong Structure

Welcome back to another episode of We Are Talking Money. I'm Dustin Hocken. Many of you are business owners, and maybe you're wondering, is my current business structure right for me? Today I'm going to walk through your options and the pros and cons of each. Stay tuned, we'll be right back.

There are many types of businesses that we're going to walk through, but let's start with the sole proprietorship, commonly known as a sole prop. This is the business that's owned by one person. The advantage to this business is it's very easy to set up. There's no legal declaration or filing.

Another advantage is that it's very easy to make decisions, because there's no partner or board of directors. Making a decision in a sole prop is simply just as easy as deciding what you want to do and then implementing. However, as you can imagine, this also can be a disadvantage. With partners, with a board of directors, they can vet ideas, and usually the best ideas rise to the top.

Another disadvantage is the liability of a sole prop. With a sole proprietorship you have unlimited liability, meaning if your business falls into financial trouble, all your personal assets could also be on the line. Another disadvantage of a sole prop is raising capital. Other types of businesses, such as a corporation, can simply sell shares to raise capital for their business. While a sole prop is the easiest and simplest setup, it might not be the right business for you.

Next business entity is a partnership. A partnership is just an agreement between two parties to go into business together for a profit. This business is also very easily formed, like the sole prop. Decision-making in this business is also very simple, because you're just dealing with the partners. It does give you a little more protection compared to the sole prop, where you're just making all the decisions on your own, but still fairly straightforward if you want to make a decision.

The taxation of a partnership is it's a flow-through entity, meaning all the profits flow through the business to the owner's tax return. It's not subject to double taxation.

One of the biggest disadvantages of a partnership is each partner is liable for the business debts, a condition known as jointly and severally liable. That means that liability extends to the total net worth of each partner. This means that a poor decision by one partner could create negative consequences for another partner. Another disadvantage of a partnership is if there's a disagreement between both parties, or what if one partner doesn't even want to be in business anymore? This could ultimately become the downfall of the business.

Next up, limited partnerships. Limited partnerships can be categorized in two categories: general partnership or limited partnership. The general partner has unlimited liability and is in control of the day-to-day operations. The limited partner plays a passive role in the business. This could be an angel investor, and their liability is limited to the amount that they invest in the business.

We talked about it earlier, but one of the disadvantages of a limited partnership is the general partner has unlimited liability for the business. Another disadvantage is the limited partner won't really have much to say when it comes to the business and how it's running. Because there's much less liability for the limited partner, their say in the business is, well, limited.

Next up, the corporation, the C Corp. A corporation is a business owned by one or more parties. Ownership is characterized by stock, which represents fractional interest in the business. A corporation can be taxed either as an S Corp or a C Corp. For now, let's start with the C Corp.

An advantage of the C Corp is there's limited liability to whatever shares you own in the business. A corporation usually finds it easier to raise capital, because they can simply sell more shares in the marketplace. Now, if it's a smaller corporation, the owner may have to personally guarantee a loan from the bank. This means the liability will bleed over through the business into more of the personal side.

Another advantage is a corporation has infinite life. So unlike a sole proprietorship, where the owner dies, the business stops, a corporation theoretically has infinite life. If the owner of a corporation passes away, those shares are easily transferred to the next generation.

The largest disadvantage of a C corporation is how it's taxed. A C Corp is first taxed on its corporate income before it makes any dividends to shareholders. When the distributions in the form of dividends are made to the shareholders or owners of the company, that's also taxed, hence double taxation.

Next up, the S corporation. For all tax purposes, the S corporation has all earnings flow through the business to the shareholders of the company. Therefore, there's no double taxation like we saw with the C Corp.

Another advantage of the S Corp is an owner can pay themselves what the IRS deems as a reasonable salary. Now, this income is subject to all employee and employer taxes. The powerful part of an S Corp is not the salary, but it's when the owner takes a distribution. These distributions are not considered employee wages or self-employment income, therefore we don't have to pay the FICA tax, saving 7.65%.

Remember, without paying these taxes, we're not paying into Social Security, so you will have a reduced Social Security benefit. This makes it all the more important to be saving enough for retirement. Now, speaking of Social Security, depending on your age, we might not want to plan for this at all. We'll do more shows on this in the future, so stay tuned.

The main downfall with the S corporation is you're limited to 100 the appropriate fees. You also have to file an additional tax form, Form 1120s. This is the form used to track all income, gains, losses, credits and deductions, and other information from corporations. Your CPA will likely charge you additional annually for this form.

Lastly, let's talk about an LLC, or limited liability company. Big advantage of this is that there's limited liability for the owner. This protects your personal assets. However, it should be known that there's a process called piercing the corporate veil, where personal assets will be liable for fraudulent or illegal activities.

Another advantage of the LLC is it's a flow-through entity, like a sole proprietorship or partnership, so there's no double taxation like we saw with the C corporation. The LLC is also very useful in practice, because you can choose to structure your business as an S corporation. This allows you to take full advantage of the reasonable salary and distribution rules that are afforded to S corporations. The disadvantage of the LLC is it's going to be more expensive than a partnership or sole proprietorship, and many states may impose ongoing fees.

Well, there you have it, the most common business structures that we see day-to-day, and the advantages and disadvantages of each. I hope this is helpful. If you have any questions regarding your business structure, please don't hesitate to reach out.

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