Deciding on which type of entity to form for your business can be confusing. Trying to understand the tax implications of that decision can be even more difficult. How do you know which choice is right for your business? Let’s take a look at the options.
Sole Proprietor
This is the most manageable entity to set up. And just like the name implies, it is just you, the sole owner of the business. With this type of entity, you will report income and expenses on form Schedule C of your personal tax return. The Net Income from Schedule C will be subject to both Self-Employment Tax and regular Income Tax.
Single Member LLC or SMLLC
A Single Member LLC is taxed similarly to the Sole Proprietor. However, the LLC status provides the owner with some protection against personal liability. Net Income from the Schedule C will be subject to both Self-Employment Tax and regular Income Tax.
Partnership
A partnership happens when two or more individuals form a company. They may elect to form an LLC for liability protection or may function without. This type of entity will require a separate tax return called a Partnership Return unless the individuals are married, live in a community property state, and meet specific criteria they may elect to file as a Schedule C on their personal tax return.
Partnerships will report all income and expenses on IRS Form 1065. The operating agreement for the partnership determines the allocation of gains and losses. Partners do not take payroll and are generally paid via Guaranteed Payments and/or Distributions.
Net income/loss for a partner is reported to the partner on Schedule K-1. The partner then uses the K-1 to report the information on their personal tax return. Partnership income is subject to both Self-Employment tax and regular Income tax.
S-Corporation
S-Corp election is made by filing Form 2553 with the IRS. An LLC, Partnership, or Corporation may choose to elect S-Corp status. S-Corp status is a type of tax treatment that can allow the business to have the liability protection of an LLC or corporation with the tax benefits of pass-through entities such as the partnership or SMLLC.
S-Corporations will report income and expenses via IRS Form 1120-S. Allocation of gains and losses is determined by each shareholder’s ownership percentage in the business.
Shareholders active in the business are required to be on payroll and receive “reasonable compensation.” Any profit above the reasonable compensation can be paid to the shareholders via Distributions.
Net Income/Losses will be reported to the Shareholder on Form K-1. The shareholder then uses the K-1 to report the information on their personal tax return. With an S-Corp, the shareholder pays ½ of the Self-Employment tax on the payroll wages. The other ½ of the Self-Employment tax is paid by the company and can be taken as a deduction against income. Distributions are not subject to Self-Employment tax. Excess Distributions, however, may be subject to Capital Gains.
C-Corporation
By default, Corporations are considered a C-Corporation unless they choose to elect S-Status via Form 2553. Additionally, an LLC can elect to be taxed as a Corporation by filing Form 8832 with the IRS.
With a C-Corp, income and losses are not passed along to the individual owners to be reported on their personal tax returns. The net income in a C-Corp is subject to tax at the current corporate tax rates.
Shareholders in a C-Corp are generally paid via dividends. Dividends paid to shareholders are taxed at both the corporate level and again on the individual’s tax return. This is where the term double-taxation originated.
To avoid double taxation, a corporation may elect to put shareholders on payroll and pay them a salary. This is generally used in smaller corporations where the shareholder is also an employee. The salary paid to the shareholder for work performed may be taken as a deduction against income. However, there is a limitation on the amount that can be paid as salary.
Which entity type is right for your business will depend on various factors and should be discussed with your CPA, tax advisor, and attorney.
If you are unsure what is best for your business, reach out to us for a consultation. We offer tax planning and consulting services to assist you in those decisions.