Probably the most common question I get from people is “What kind of business entity should I set up?” The answer is that business entities are not one-size-fits-all and the best entity for you depends on your unique situation. The major business entities choices are:
- Sole proprietorship
- Limited Liability Company or LLC
- Partnership
- Corporation
Sole Proprietorship: If tomorrow you decided that you were going to start mowing lawns for income, you would be considered a sole proprietor. There is nothing legally that you need to do aside from obtaining appropriate business licenses and filing and paying taxes. The corresponding tax form is Schedule C of your Form 1040, your individual tax return – there is no separate tax return for the business. Along with their being no additional paperwork, there is also no additional legal protection or tax advantage to being a sole proprietor as compared to the other entity choices. Your personal assets are fair game to business related creditors, and you are subject to self-employment taxes (15.3%) on every dollar of net income (income after business expenses) you earn.
LLC: The LLC is probably the most common business entity used these days, with its biggest benefit being that it limits your legal liability, meaning that your personal assets can in many circumstances be protected from claims against your business. If you are the only member of your LLC, then for tax purposes your business is referred to as a “disregarded entity.” This means that just as a sole-proprietor, your business income is reported on Schedule C of your Form 1040 and you are subject to self-employment taxes on every dollar of net income. When there is more than one member in your LLC, even if that person is your spouse (unless you are in a community property state), then you are generally considered a partnership for tax purposes and must file Form 1065, which is a separate tax form for partnerships. However, both single-member and multiple-member LLCs do have the option to elect to be taxed as an S-corporation (I will explain more about those in a minute!).
Partnership: The classic partnership, either a limited partnership or a general partnership (differences in legal liability), has fallen a bit to the wayside with the rising popularity of the LLC. However, whether you are a conventional partnership or a multi-member LLC that has not made an S-corporation election, your taxes are reported on Form 1065. The partnership is what is referred to as a “pass-through entity,” which means that no taxes are paid on the company level. When forming the partnership, the company files Articles of Organization which sets out specifically what will be contributed to start the business, what ownership percentages each partner will have, and what percentages of income will be allocated to each partner. The income allocation percentages are up to the discretion of the organizers and are not based on ownership percentages. At tax time, income is allocated to the partners based on these predetermined percentages on their Partnership Form K-1 and reported on Schedule E of their Form 1040. Just like with sole proprietors and single-member LLCs, generally any income allocated to the partner is subject to self-employment taxes. However, if the partner is a limited partner, then only the amount of their guaranteed payment, their “salary” for services rendered, is subject to the self-employment taxes. The rules are a bit more “gray” for LLCs taxed as partnerships, but generally any actively involved members are subject to self-employment tax on their net income allocation.
Corporations: Under the corporations’ umbrella, there is the traditional corporation and then there is the S-corporation – the small business corporation for organizations with less than 100 owners, among some other rules, and is what you want if you are a small business. Like the partnership, the S-corporation is a pass-through entity; however, the income is strictly allocated based on percentage of ownership only. The major benefit with the S-corporation is that owners are not subject to self-employment taxes on income. If owners render services to the company and are actively involved in the day to day operations, they are actually employees of the company and as such are paid a reasonable salary based on their duties. Employment taxes are paid with regular payroll activities along with other employees, and the shareholder-employee will receive a Form W-2 from the company at year end. Aside from the shareholder-employee’s salary, the owners of the corporation are not subject to further self-employment related taxes, which can result in substantial tax savings in the long-run.
As you can see, each kind of business entity is unique, and as each small business has its own uniqueness, business entity choice is not one-size-fits-all. If you are in the process of starting a new business and want to know which type of entity is best for you, get in touch and we can talk!