Choice of Entity for Your Small Business – Tax & Legal Considerations
Most business owners are driven by their burning passions and abounding hard work. While this is great, it can be difficult navigating the complex yet necessary nuances of starting a business. One of the first major decisions that have to be made is the choice of entity for your business.
Choosing the right business structure is not exactly the most exciting part of being an entrepreneur. There are probably dozens of other things you would much rather be doing, like improving your product or service, building a website, or marketing. However, your choice of entity is pivotal for determining how the IRS will tax your earnings and how personally liable you are in court litigations.
These factors may not sound important to you now. Maybe because you are just starting out and don’t have any earnings or maybe you have already chosen a business structure for your company. Either way, learning the tax and legal implications of each structure will empower you to make the right choice of entity for you and your business.
Types of Entities That Exist
Most companies will fall into one of five business entities:
- Sole Proprietorship
- Limited Liability Company
- S Corporation
- C Corporation
Each of these 5 entity types is distinct from one another and have advantages and disadvantages associated. Consider what each one has to offer when deciding on your choice of entity.
Sole proprietorships are the simplest form of business structures. Operating as a sole proprietorship does not require any additional filings or paperwork. No employer identification number (EIN) is required or any additional filing of a tax return. As the business owner, you are the sole proprietor.
How Are Sole Proprietorships Formed?
There is no requirement to register a sole proprietorship with the state, unlike the other business types. Something to keep in mind is the regulatory licensing requirements that may be required, depending on your industry (i.e operating a hair salon or restaurant).
As a sole proprietor, your legal name is the name of your business by default. However, if you want your sole proprietorship to operate under a different name, you would have to file a DBA form (Doing Business As…) in your state.
Tax Implications of Sole Proprietorships
Because sole proprietorships operate under the social security number of its owner, the business’ income and expenses would be reported on the Schedule C (Profit and Loss From Business), Schedule SE (Self-Employment Tax) and Form 1040 (U.S. Individual Income Tax Return).
Sole proprietorships are indistinguishable from its owner. The income and expenses incurred by the sole proprietorship are treated as being incurred by the owner on Schedule C of the owner’s individual tax return. Losses reported on the Schedule C can be used to offset income earned from other sources on the owner’s tax return.
Sole proprietorships are required to file Schedule SE to calculate the amount of self-employment tax that it is owed. This amount flows through on Form 1040 and added to the tax owed. You would only owe taxes on income earned.
Legal Implications of Sole Proprietorships
As an owner of a sole proprietorship, you are personally for all actions of the business. If a disgruntled client or employee decides to sue your business, your personal assets (ie your house and personal money) can be seized for payment. Another example is if the sole proprietorship takes out a business loan and for whatever reason is not able to pay it back. The owner is personally liable to repay the loan.
Capital funding for a sole proprietorship is harder than for other business types. Selling stock is not allowed and banks are hesitant to lend because of the increased risk of default associated.
Another choice of entity you have is partnerships. Partnerships involve a business arrangement between 2 or more entities that agree to own and operate a business. Partnerships are similar to sole proprietorships except it involves more than one entity.
How Are Partnerships Formed?
All that is needed to form a partnership are 2 consenting parties agreeing to go into a business together in efforts of earning a profit. No additional forms need to be filed to start a partnership, though a formal partnership agreement should be considered to avoid conflicts down the road. Ideally, this agreement would be written or reviewed by a lawyer which costs anywhere between $1,000 and $2,000.
Tax Implications of Partnerships
Partnerships are considered “pass-through” entities, meaning its profits are taxed on the individual level. The income and expenses of the partnership are passed through to the partners and reported on Form 1040.
Though the partnership itself does not pay taxes, it is required to file Form 1065 (U.S. Return of Partnership Income) to the IRS every year. This is used for informational purposes only.
Legal Implications of Partnerships
Partnerships have unlimited liability. Meaning, if sued, partners are legally responsible for damages caused by the business. Additionally, each partner is responsible for the actions of all other partners. Making trust and a partnership agreement even more important.
Types of Partnerships
Until now, general partnerships have been described. But there are 2 other common types of partnerships: limited partnerships (LP) and limited liability partnerships (LLP). All partnerships are taxed the same i.e. earnings and losses pass through to its owners. However, both LPs and LLPs offer greater legal protection for its partners.
Limited Partnerships (LP)
There is a “general partner” in limited partnerships that take on a managerial role within the company. They are responsible for the day to day operations of the company. As such, they have unlimited liability or no personal protection of their assets. Limited partnerships also have limited partner(s). Limited partners are not involved in the daily operations and are simply investors. Their liability is limited to the amount of their financial investment.
Limited partnerships are formed by filing formation documents and paying applicable filing fees with the appropriate state agency.
Limited Liability Partnerships (LLP)
Limited liability partnerships provide limited liability to all of its owners. Personal assets cannot be used to satisfy the obligations of the company. Each partner is liable for their own personal acts within the business and is not shielded from liability in that regard.
It is important to note that LLPs are only available to certain types of professional businesses like accountants, lawyers, dentists, engineers, etc. What constitutes a “professional” business is decided by each state.
Limited liability partnerships are formed by filing formation documents and paying applicable filing fees with the appropriate state agency.
Limited Liability Company (LLC)
Limited liability companies is a business structure formed by one or more parties where members are not personally liable for the obligations of the company. LLCs are considered a blend between partnerships and C corporations (discussed later).
How Are LLCs Formed?
Each state has their own statute for registering LLCs. Typically, filing Articles of Incorporation and paying the applicable fees are required. Some states may require the filing of an operating agreement that outlines the rules for the operations and ownership of the business.
Tax Implications of LLCs
LLCs are taxed similarly to partnerships. The earnings and losses are passed through to owners on the individual tax return and therefore avoids the double taxation associated with C corporations. For single-member LLCs, income and expenses are reported on the Schedule C of Form 1040. For multi-member LLCs, income and expenses are reported on the Schedule E of Form 1040. Only multi-member LLCs are required to file Form 1065 for informational purposes.
Legal Implications of LLCs
Limited liability companies are similar to C corporations because of their limited liability feature. All members are not personally liable for the debts of the company. There are some cases where a member could be held personally liable but those are in circumstances where the member was negligent or careless.
S Corporations (S Corp)
An S corporation is a type of business corporation that is taxed only once. S corporations are more appealing to small businesses because of its lack of double taxation. An election on Form 2553 must be filed to be treated as an S corp for tax purposes.
How Are S Corps Formed?
You must file Articles of Incorporation and applicable formation documents with your respective state. Filing fees will apply. When forming an S corp, you must first register the organization as a corporation or LLC first. Once the business is formed under one of these structures, an IRS Form 2553 must be completed to elect subchapter S treatment. The form asks for basic information such as business name, EIN, date of incorporation, shareholder or member information, address and fiscal year. Once an approval letter is received from the IRS, the business is operating an S corporation.
Tax Implications of S Corporations
S corporations file Form 1120S even though the corporation itself does not pay taxes. Earnings and losses from the corporation are reported on Schedule K-1 of the owner’s individual return. One tax benefit S corporations have over LLCs and partnerships is that S corps do not pay self-employment tax. However, shareholders who work in the business are required to pay themselves a reasonable salary and of course, Medicare and social security taxes apply. But what is considered reasonable? This is largely subjective but comes down to the job responsibilities, dividends paid in relation to the salary received, and salaries of individuals in similar roles.
Legal Implications of S Corporations
S corporations have limited liability just like C corporations. Shareholders are not held personally liable for debts and obligations of the corporation.
C Corporations (C Corps)
A C corporation is a business structure where profits are taxed separately from the shareholders at the corporate level. Many large companies are C corps because of the unlimited life, limited liability, flexible funding options, and more features.
How Are C Corps Formed?
C corporations are formed by filing Articles of Incorporation to the Secretary of State and pay the filing fees. C corporation formation requires the filing of corporate bylaws and a board of directors meeting.
Tax Implications of C Corporations
C corps are different from the other business structures because it requires earnings on the corporate level to be taxed, in addition to distributions to shareholders. Hence the term, ‘double taxation’. C corps have to carry losses forward or backward, reducing income on other years. Distributions to shareholders are only taxed once they are considered dividend income. Otherwise, earnings retained in the business are taxed are only once.
Legal Implications of C Corporations
C corporations are completely separate from its owners. They have limited liability. Shareholders are not held personally liable for debts and obligations of the corporation.
There are a number of ways you can structure your current or future business. Whether you put more emphasis on tax impacts or legal impacts, it is important to know and understand all of the elements surrounding the structure you choose. Also, keep in mind that Federal and State legislation changes over time and it is good practice to evaluate your current structure and update if needed.
Contact us today if you need help choosing your choice of entity!