Business Types and Company Structures: What is Right for You?
So you have a great project or a great idea. What is the best choice for your business structure. A lot of though will go into this, and hopefully this discussion will answer some questions as to the route you’ll take in choosing.
There is a lot to consider when evaluating business structures. Questions like: How much will you pay in taxes? How will your day-to-day operations be run? How much risk do you want? Are sure to come to mind. Fear not, we’ve all been there. This topic will cover raising money in certain business structures, complications of changing business structures or operating in different states and counties, who is liable for loss, and how much will be paid in taxes.
Fundamentally, we will cover the different types of business organizations, develop a basic understanding of the variations in legal treatment by different governments and have a basic understanding of the differences in contractual structures of the detailed organization choices. For the most part, it is a balance of taxes, benefits, and legal protections.
To begin, let’s cover the types of business organizations:
Sole Proprietorships
Sole proprietorships are easily the simplest form of an organization. There is only ONE owner, and that owner is responsible for ALL assets and liabilities (and gets to keep all the profits). Sole proprietorships do NOT protect personal assets from being used to pay debts. Sole proprietorships are the most common form of business entity.
Sole proprietorships are a single individual, in business with their cumulative assets. Loans to sole proprietors are essentially personal loans, and collateral can be anything the owner has. This lack of protection from collection / bankruptcy / insolvency is one of the reasons you may consider other business structure options. That said, sole proprietors don’t generally have a need for major sums of capital. A kid mowing lawns for $20 or a freelance photographer are both examples of sole proprietorships. It’s simple, and it’s easy.
From a taxation standpoint, sole proprietorships are considered pass-through entities. A pass-through entity means that any revenue generated by the business will be taxed at the tax rate of the individual who owns and operates the sole proprietorship. Whatever your tax bracket for federal income tax, your revenues from the sole proprietorship will be taxed at that same rate as well. On top of federal income taxes, the owner will also be responsible for “self-employment tax”, generally around 15.3% and consisting of 12.4% Social Security tax and 2.9% medicare. In essence, as a sole proprietor, you are responsible for 100% of Social Security and Medicare taxes.
Nothing says, “I want to see this small business succeed!” like the government tacking on a cumulative tax rate of around 40%, right? Someone has to pay for federal mistakes!
Regular C-Corporations
Regular C-Corporations are the most common form of business entity in the United States (aside from sole proprietorships which are, by definition, any person who does work for themselves). The “C” in C-Corporation stands for Subchapter C of the IRS code, designating a different form of taxation. C-Corps are owned by shareholders (think publicly listed companies), although they can be private as well. The ENTITY is responsible for all debts and liabilities. Known as the “corporate veil”, C-Corp’s themselves are responsible for their business activities, the owners and managers are not. If the company defaults on a loan or goes insolvent, it is the company that is responsible for paying back assets (hence Chapter-11 bankruptcy, where the company goes bankrupt, but owners are not liable for the debts of the company). C-Corps must also have “Articles of Incorporation” and other documents that can be time-consuming (who will be on the board of directors, how will directors be chosen, how will the business be run, etc… a TON to think about).
Clearly, C-Corps offer much more protection for owners and allow for a freedom of conducting business that would not be available under a sole proprietorship, for example, where the owner might not do a project for fear of the financial repercussions even if the reward is significant.
So how are C-Corps taxed? C-Corps must pay federal income tax or corporate income tax. Currently, the corporate tax rate is 21%, prior to the Tax Cuts and Jobs Act of 2017, it was as high as 35%. C-Corp’s pay 1/2of Social Security and Medicare taxes (7.7%), the other half of Social Security and Medicare taxes are taken out when the “after-tax earings” are distributed as salary or dividends. C-Corps also suffer from double taxation of earnings. Revenue is taxed on the corporate tax return, and after-tax earnings distributed as a dividend are taxed again. If there are no dividends (due to re-investment or losses), there is no double taxation. Crucially, profits generated by C-corps can be re-invested without additional tax. Whew! Finally got a break. There are a variety of tax deductions that can be used to reduce the tax liability as well:
Salaries
Start-up costs
Operating expenses
Advertising
Bonuses
Medical and Retirement costs
There are limits to these deductions. Salaries, for example, must be considered “reasonable”, meaning they must be comparable to compensation given by other companies to individuals in similar roles, but salaries can be increased to minimize the tax liability of a C-corp (that liability would then fall on the individual’s personal tax return).
Everyone likes to complain about how we don’t tax corporations enough… Talk of loopholes, tax breaks, etc… This example only covers the high-level taxes these companies pay, not including things like property taxes, local taxes, state taxes, excise taxes (the list goes on). C-Corps need to be able to take advantage of business losses, development costs, etc. in order to stay competitive on a global scale. The more you add to the tax mix, the less competitive your businesses are.
Sub-Chapter S Corporations
How about Subchapter S-Corporations? Again the S stands for Subchapter “S” of the IRS code. All S-Corps must first start life as a C-Corp, after this initial filing, the C-Corp can be converted to an S-Corp by redesignation with the IRS (generally done for smaller businesses with 100 employees or less). S-Corps have the same protections as C-Corps when it comes to debt and liabilities.
So how are S-Corps taxed? Profits from an S-Corp (similar to a proprietorship) flow through directly to the shareholder’s personal tax return. There is no double taxation of earnings that C-Corps have. S-Corps only pay employment-related taxes on wages. Dividends distributed to shareholders are not taxed as well (they would be taxed on the individual’s personal tax return). Pretty spiffy, huh? However, because the profits of an S-Corp are passed directly to shareholders, they are taxed by default. Any input into the company from profits must be taxed relative to the rate of each shareholder’s contribution.
Partnerships
Partnerships are similar to sole proprietorships, except of course, a partnership must have more than one member. Through partnerships, money, skills and property are given to the partnership for ownership in the partnership. A skill-based example of a partnership would be a pair of legal professionals starting a practice. Ownership in a partnership doesn’t need to be equal, and ownership percentages are recorded in a Partnership Agreement.
Similar to a sole-proprietorship, a partnership is treated as a “flow-through entity”, where all profits and deductions are distributed based on the partner’s ownership percentage. If an owner controls 80% of the company, they will be responsible for taxes on 80% of the profits and will get to take 80% of the business deductions (mileage, expenses, etc…). Partners also carry FULL LIABILITY, much like a sole proprietorship. Liability will also be distributed by ownership percentage in the partnership.
Limited Liability Companies
If a corporation was too complex and a sole proprietorship or partnership too risky, then an LLC is Goldilocks. This is choice for you. LLC’s are hugely popular in the United States due to a couple reasons: LLC’s are organized like a partnership. There are owners and ownership percentages, the setup is simple and ownership is simple. LLC’s deal with liability in the same fashion as a corporation. Debts and liabilities are the responsibility of the LLC, not the owners, so you get plenty of protection from bankruptcy or insolvency. LLC’s must also file “Articles of Organization” like a corporation detailing what business ownership will look like and how the business will be run, so this will take a little effort, but there are plenty of free and paid resources that offer templates for Articles of Organization.
LLC’s are taxed as a flow through entity, and like a partnership. Taxes the owners are responsible for will depend on their share of ownership in the LLC. All profits are passed directly to the owners, who are responsible for the taxes. Same with deductions, where each owner will get to claim deductions on their taxes relative to their ownership (if a shared expense). Expenses that are incurred
Form 5 & 5A LLC’s
Form 5 LLC’s are unique to the natural resources sector (oil, gas, & mining). This type of agreement was pioneered by the Rocky Mountain Mineral Law Foundation as a template for Joint-Venture, Earn-In, and Dilution provisions. With the concept of dilution: If a participating party fails to add to the budget, non-contributors will be diluted (reduced proportionally). Form 5 LLC’s also favor “Distribution in Kind” over “sell off and distribute profits” where distributions are in a form of property other than cash (such as securities, physical assets, etc.). Legally, Form-5 LLC’s are governed as a “common law” arrangement, and where liability is shared amongst the owners (Joint liability).
Quite literally, these From 5 LLC’s are businesses formed out of Join-Ventures or Earn-In agreements. If two companies wanted to partner on a project, a form 5 LLC could be set up to cover that project along, leaving the businesses who own their agreed portions of the Form 5 partnership to do as they please outside of the Form 5. These arrangements are most common in:
Exploration projects
Development projects
Mine Operating Agreements (Form 5A), Mining Limited Liability Company (Form 5)
Taxation on Form-5 LLC’s are complex and significant. At a high level, there are allocations for tax deductions, percentage depletion risks, and “In-Kind distributions. In-Kind is any form of distribution other than cash (such as property or stock). It’s hard to dig into this too far without background on the ownership terms of the agreement and structures of the parent companies.
Master Limited Partnerships
Master limited partnerships (MLP’s) are a bit of a unique beast. MLP’s are partnerships that act like a corporation, and are publicly traded. MLP’s have no employees, but have two different types of owners, general partners and limited partners. General partners run the business and are responsible for any services. Limited partners are “silent partners” who provide capital to the MLP in return for units or shares in the MLP. Silent partners are partners with no involvement in the business operations and services. MLP’s are generally energy based business, but can extend into commodities. As opposed to publically listing a C-corp for example, MLP general owners ensure ownership in their operations without the potential of dilution.
As far as taxes are concerned, MLP’s provide large dividends to share/unitholders that are tax-deferred. Dividends are reported as profits and a depreciation on assets, driving the taxable income to $0. Taxes are paid when an investment in an MLP is sold.
Publicly Traded Companies
I’ll spare you the gory details of the IPO profess, but publicly traded companies are typically C-Corps. Shares of ownership in the company are sold in return for investment capital (i.e. when you buy a share of stock, the company receives that as capital). Public listing provides the greatest power for raising capital than all other business structures we have previously discussed. If you need to go big in a hurry, listing publicly is the way to go. Publicly listed companies also have several venues by which they can raise capital. First and foremost, they can sell stock (equity) in exchange for your cash. When you buy one share of stock, you own a certain percentage of that company (equity). Publicly traded companies may also issue bonds (debt). If a public company needs to raise capital but is avoiding dilution of shareholders equity, they can issue bonds to raise capital. If you buy a bond, you are giving money to the company in return for a future re-payment of the sum you paid for the bond, plus interest. This is the same concept the United States uses with Treasury bonds.
This brings us to our next topic. How are publically traded companies taxed? These companies need to pay corporate income taxes, just like their non-public C-corp cousins, and can use the same deductions to limit tax liability. Shareholders pay taxes as an individual, and dividends are taxed as personal income (the company does not pay taxes on the income of shareholders).
Conclusion…
We have briefly covered the business and tax structure of the most common forms of businesses in the United States. Hopefully this has given some insight into what business structure will benefit you the most, and what you can expect when it comes to taxes (yuck). There is plenty to consider, but first and foremost, understanding what the goals are of the business will drive the decision on what business structure to pick (if you are a freelance photographer, you probably don’t need the protections of a C-Corp and will end up paying ridiculous sums in taxes).
Unfortunately, from the perspective of someone starting a business, there is a significant hurdle to jump when it comes to taxes. Although this is a huge topic on its own, I’ll discuss it a little. When you leave your job, you are leaving a significantly lower tax rate than you will see as a small business owner or startup. This is stifling for many, and proves too much of a hurdle. Lower taxes on business helps drive success in new ventures and something I wish to see more of.
