Starting a business is an exciting venture, and it is crucial to select the right business structure that aligns with your business goals and desired level of protection. In North Carolina, the most common business entities are the Sole Proprietorship, Limited Liability Company (LLC), S Corporation, and C Corporation. This article will provide a brief overview of each entity and highlight their key differences in structure and tax treatment.
If you are considering starting a business, the professionals at Wilson Ratledge are here to help. We have decades of experience helping the Triangle’s entrepreneurs and welcome the opportunity to talk to you about your new business entity.
1. Sole Proprietorship/Partnership
A sole proprietorship or general partnership is the simplest form of business structures to create. A sole proprietorship is an unincorporated business owned by a single individual, while a partnership is an unincorporated business owned by more than one individual. With both, there is no separation of liabilities (no “corporate veil”) insulating the owner(s) from liabilities arising from the operation of the business.
Key Features:
- Liability: The owner(s) has(have) unlimited personal liability for business debts and obligations.
- Formation: No formal registration is required with the state.
- Management: The owner(s) has(have) full control over business operations.
- Taxation: “Pass-through” (also commonly referred to as “flow-through”)-no “double-tax” (see discussion of C corporations, below). For sole proprietorships, the business tax return is part of the owner’s personal return. A general partnership files an information return, however, tax items “pass through” or “flow through” to the partners and are reported on personal income tax returns as well.
- Termination: The life of the sole proprietorship ends with the death of its owner, and, generally, the life of a partnership ends when there is only one partner.
There are other forms of partnerships with varying degrees of liability protection; however, the scope of this article is limited to the more common business entities. Because partnerships do not offer the liability protection that limited liability companies and corporations do, they are less and less common. You can find helpful general information on the various partnership structures available in North Carolina here.
2. Limited Liability Company (LLC)/Limited Liability Partnerships
The appeal of an LLC often comes from both (i) the protection it offers (“corporate veil”) against personal liability for the company’s liabilities (except to the extent an owner has to personally guaranty, such as for a bank loan or lease) and (ii) taxation. There is no separate chapter of the Internal Revenue Code that applies to LLCs, which are essentially a hybrid of corporations and sole proprietorships (for LLC’s with one owner, known as single-member LLCs) or general partnerships (for multi-member LLCs). A single-member LLC can remain a sole proprietorship for tax purposes (by default), or elect to be taxed as a corporation (typically an S corporation). A multi-member LLC can remain a general partnership for tax purposes (by default), or elect to be taxed as a corporation (again, typically an S corporation).
Another benefit of the multi-member LLC that is taxed as a partnership, is flexibility in allocations of taxable items (profits, losses, capital gains, etc.), resulting in the ability to structure “waterfall” provisions for founders and investors. This flexibility is not available to S corporations, and similar benefits for shareholders in a C corporation require various classes of stock (preferred or common, which can be further designated as different series-Series A, Series B, etc.).
Key Features:
- Liability: Members’ personal assets are generally protected from business debts and liabilities.
- Formation: Requires filing Articles of Organization with the North Carolina Secretary of State.
- Management: Members can manage the LLC or delegate management to designated managers. An operating agreement is highly recommended to govern the entity, especially in a multi-member LLC, similar to bylaws for a corporation.
- Taxation: Typically taxed as a “pass-through” (“flow-through”) S corporation or partnership, no “double-tax” (see discussion of C corporations, below). Profits and losses flow through to members’ personal tax returns (and can be allocated other than pro-rata if the LLC is taxed as a partnership). An LLC can also choose to be taxed as a C corporation.
- Continuity of Life: Except in the case of a disregarded entity, the life of the entity continues regardless of the death or exit of its owners, until a separate dissolution event occurs.
3. S Corporation
Historically, businesses were either sole proprietor/partnerships, or corporations. Corporations offered continuity of life and liability protection and the others did not. While partnerships and LLCs evolved and retained many partnership characteristics, the world of corporations also evolved with the introduction of S corporations. S corporations are essentially traditional corporations but with pass-through tax treatment similar to partnerships, discussed below; however, this structure is available only to “small businesses” which are limited in the number and type of shareholders they can have, along with other rules.
Unlike traditional C Corporations that produce double taxation for their shareholders—first, business profits are taxed at the corporate level, and dividends are further taxed at the shareholders’ personal level—an S corporation allows for pass-through taxation, similar to a partnership. This means the corporation itself does not pay income tax. Instead, business income, losses, deductions, and credits flow through to shareholders, who report these on their individual tax returns, avoiding the “double tax”.
Another benefit of the S Corporation is the potential for reduced self-employment taxes. Here’s how it works: owners who also provide services to the business must be paid a “reasonable” salary for those services, which is subject to employment taxes (payable by the corporation and the employee). However, profits are taxed only as pass-through income, which is not subject to employment tax. Note: these profits are taxable whether the owner takes a draw on them or not. This is true for any tax pass-through or flow-through entity.
However, while there are benefits to the S corporation structure as discussed above, it also comes with its own shareholder eligibility and other administrative requirements. Any entrepreneur considering this path should seek legal and tax advice to navigate the complexities.
Key Features:
- Liability: Shareholders have liability protection.
- Formation: Initially formed as a C Corporation and then elects S Corporation status through the IRS.
- Management: Shareholders elect a board of directors for high level oversight of officers, who manage day-to-day business operations. In a small business, one person may fill more than one of these roles.
- Taxation: “Pass-though, no “double-tax” (see discussion of C corporations, below)
- Continuity of Life: The life of the entity continues regardless of the death or exit of its owners, until a separate dissolution event occurs.
4. C Corporation
One reason founding entrepreneurs might opt for a C Corporation over other entities is that the business plan contemplates rapid and significant growth, and raising additional capital from investors such as venture capital and private equity groups who have a marked preference for the structure and familiarity of a C Corporation.
Being free of the restrictions placed on S corporations, C Corporations also have wider latitude in employee benefits like stock options, health benefits, and retirement plans. In today’s labor market, these benefits can also make the C corporation an appealing choice for recruiting and retaining the best talent.
Lastly, on the flip side of the double taxation coin discussed above, if rapid growth and expansion are a part of your business plan, C Corporations are uniquely able to retain and reinvest earnings from one year to the next offering a distinct advantage for businesses that prefer to channel their profits back into the company rather than distribute them immediately.
Key Features:
- Liability: Shareholders have limited liability protection.
- Formation: Requires filing Articles of Incorporation with the North Carolina Secretary of State.
- Management: Shareholders elect a board of directors for high level oversight of officers, who manage day-to-day business operations.
- Taxation: Subject to double taxation. The corporation pays taxes on its earnings, and shareholders pay taxes on dividends.
- Continuity of Life: The life of the entity continues regardless of the death or exit of its owners, until a separate dissolution event occurs.
Contact Our North Carolina Business Formation Attorneys
Choosing the right business entity depends on various factors such as your business goals, desired level of control, tax implications, and potential risks and liabilities. Remember that the decision isn’t set in stone—you can change your business structure as your company grows and needs change. It is critical that you consult with a business attorney to understand which entity is best suited for your startup. Whether you are just starting out or looking to restructure an existing enterprise, the North Carolina business attorneys at Wilson Ratledge are here to guide you every step of the way. Reach out to us today to schedule a consultation.