Choosing a Business Entity Type

Intro

 

A common question for those who are going into business for themselves, or even those who have been self-employed for a while, is what type of business entity should I be?

For those who are unsure as to what this means, it boils down to how the business exists. What type of business is it in the eyes of the IRS? The common choices are sole proprietorship, partnership, or corporation. Within the corporation designation is the choice to be a C Corp or an S Corp. Each of these choices have various tax, legal, and administrative requirements. It’s important to choose correctly to ensure you minimize your taxes and position yourself to reduce legal liability and allow for ease of growth.

Today I’d like to highlight some of the advantages and disadvantages of each, as well as explain some areas of concern to be aware of. There are other considerations when choosing an entity type outside the scope of this article, but they become more complicated. Items like self rental, home office deduction, auto expenses, etc. can be different from one entity type to another, but for the sake of this conversation, we’ll leave those topics to another article or conversation with your CPA when you’re making a final choice on entity type.

You’ll notice I did not mention “LLC” as a type of business for tax purposes. Often times, when I talk to business owners about taxes for the first time and ask how they file, they tell me as an LLC. This is a legal structure, not a tax structure. An LLC stands for Limited Liability Company, and is comprised of members. Depending on how the LLC elects to be taxed and how many members there are, the LLC will be taxed as either a partnership, corporation, or sole proprietorship. This isn’t to say that an LLC does not serve a purpose. What this designation does accomplish is legal protection. However, above and beyond this designation, you still need to elect a tax structure that you are eligible for that best suites you and your company. Let’s start with the easiest one.

 

1. Sole Proprietorship

Pros: Ease of set up and operation, typically lower professional fees (lawyers, CPAs, etc.), payroll not necessarily required

 Cons: Possibility of higher taxes stemming from self employment tax, possible increased legal exposure, limit on number of business partners

Being taxed as a sole proprietor is the easiest way to begin a business. In the eyes of the IRS, you and the business are one in the same. This designation is only available to a single owner (you can’t have any partners unless that partner is your spouse), so there is a possible limitation to growth and ability to raise capital.

There is no formal process to begin a sole proprietorship. If you as an individual hold yourself out for business, have cash receipts or expenses, and have not officially elected a different entity type, you are a sole proprietor. Taxes are easiest under this structure. Because you and the business are essentially the same, you file your business taxes on your personal tax return. There is a specific schedule (Schedule C) where all business activity is reported.

So what exactly gets taxed? As a sole proprietor, you are not allowed to be on W2 wages. Your taxable income from the business is the business’ net profit. It doesn’t matter if you leave the profit in the business to reinvest, or transfer it to a personal bank account. The IRS will tax your bottom line for that year. Period.

It’s important to understand the consequences of this. Many people have heard of the self employment tax. This is going to come up later under other forms of business structure, so it’s important to get this down. As an employee, you pay social security and medicare tax. This shows up as FICA on your pay stub. Social Security is 6.20% and medicare is 1.45%. Social Security is taxed on all wages up to $137,700 (2020 limit) and medicare is taxed on wages in perpetuity.  Not only are you as an individual required to pay this on your wages, but your employer is required to match.

As a sole proprietor, you are both the employee and the employer. This means you will be taxed an additional 6.20% in Social Security up to $137,000 and 1.45% for medicare compared to if you were on a W2. The total tax of 15.3% is referred to as the self employment tax.

Because there are fewer ways to reduce social security earnings as a sole proprietorship (remember, as a sole proprietor, all net income is taxed to you as earnings whether you leave it in the company or not), it is very difficult to limit the self employment tax under this business structure. This can be a major draw back to sole proprietors.

Also, because both the owner of the business as an individual and the business itself are more or less the same, there can be legal liability as a sole proprietor. It is often advisable to become an LLC or DBA (Doing Business As) to reduce personal legal liability as a sole proprietor.

 

2. Partnership

Pros: Ease of set up and operation, payroll not necessarily required, flexibility in compensation for partners

 Cons: Possibility of higher taxes stemming from self employment tax, possible increased legal exposure

 You’ll note that the pros and cons of a partnership are very similar to those of a sole proprietorship. This is because a partnership is essentially two sole proprietors doing business together. This makes them very easy to form. There is no formation paperwork necessary.

One major difference, though, is that the business does have a separate tax filing. The partnership will file a tax return, and profits of the business “flow through” to the business owner’s personal tax return on a form K-1. The partnership does not pay taxes. The owners pay them on their personal tax return. Profits can be split between owners however the partners see fit. While ownership percentage does dictate who receives what portion of profits (losses), ho much each partner receives can be changed through the use of guaranteed payments.

As with a sole proprietorship, partners are not allowed to be on W2 wages. Because of this, partnership owners can be subject to high self employment taxes just like sole proprietors. Any profits from the partnership are taxed to the owner in the year they are earned, whether the partner actually receives the cash, or leaves it in the business.

 

3. Corporation

There are two main types of corporations, and they are treated very differently for tax purposes. We will look at each type separately.

A. S Coporation

Pros: Possibility to reduce self employment tax, added legal protection

 Cons: Higher professional fees, increased administrative work, payroll is required

 S Corporations are more difficult to form than sole proprietorships or partnerships. They require official filing with the IRS. Like partnerships, they must file their own tax return, but taxes are passed through to the owners of the S Corp on a K-1 which is included on their personal tax return. Therefore, the Corporation does not pay taxes; the owners do.

Unlike partnerships and sole proprietorships where owners are not allowed to be on payroll, owners are required to be on payroll in an S Corp. They must also be paid a reasonable salary. There is no definitive answer as to what a reasonable salary is, but a general rule of thumb is for owners to pay themselves the going rate in their industry for the work they do. This could be calculated based on an industry hourly rate, or an annual salary if they are working full time. This is where some tax savings can come into play. (note that this is only true if the company is profitable. It’s not necessary to pay yourself a reasonable salary that exceeds your earnings).

What’s nice about an S Corp, is that whatever is left as company profit after owners have paid themselves on a W2 along with all other expenses is not subject to self employment tax. So, for example, if you had a profit of $100,000 as an S Corp owner, and then paid yourself on a W2 $60,000, the remaining $40,000 would only be subject to federal and state income tax. Had you been a partnership or sole proprietorship, that $40,000 would also be subject to self employment tax. This can be a huge savings.

Just like sole proprietorships and partnerships, owners are taxed on earnings in the year they are earned whether or not they distribute the earnings to themselves. Owners must also allocate earnings to themselves based on ownership percentage, meaning there is less flexibility in dividing earnings in an S Corp than there are is in a partnership.

S Corps can be established with one owner. There is no need for partners.

B. C Corporation

Pros: Possibility to reduce self employment tax, added legal protection, easier to acquire capital through investors

 Cons: Higher professional fees, increased administrative work, “double taxation”

 

Like an S Corporation, C Corporations must have payroll. However, there are circumstances where the owners need not be on payroll. For small companies, this is not usually possible. However, owners who are not involved in the day to day operations of the company (think silent investor) are not required to take a paycheck.

The earnings of a C Corporation are also only taxed to owners when they are distributed. This is unique to C Corps. What this means, is that the net earnings of the company can stay in the company bank account, and owners will not pay tax on them until they are distributed. When they are distributed, owners will pay tax at the preferential dividend rates of either 15% or 20%. This can be considerably lower than what the federal tax rates might be.

The catch to all of this is that the Corporation itself will also pay taxes on earnings. This effectively double taxes net income to C Corp owners. Earnings are taxed once at the Corporate rate, and again at the individual level.

The overall structure of a C Corp lends itself well to acquiring capita from investors. This is one of the major benefits of a C Corp. They can issue multiple share classes (types of stock) and have no limit on the number of shareholders (Unlike S Corps that can only issue one shareclass and are limited to 100 investors). Typically, larger companies are C Corps

 

Wrapping it all up

 As mentioned earlier, there are other considerations when choosing an entity type, but this is a high level view at how these entities function regarding taxes. This can help steer you in the right direction, but this is not enough information to make a final decision. If you’d like to discuss what might be best for you as a business owner, we will gladly review your needs and help you decide.