Choosing a Business Entity – 101
When you’re setting up a new business, you’ll need to choose a type of entity. It’s a big decision, there are several options, and it’s no easy task. That’s why many business owners seek the help of a tax advisor to help make the best decision for their situation.
We’ll focus on four common business entity choices, their main features, and some of their fundamental tax implications. First though, we’ll cover two items that are important to understand when choosing a business entity: LLCs and a new federal deduction available for some types of businesses:
Limited Liability Company, or LLC
An LLC is an entity set up under state law and, as its name indicates, provides liability protection for its owners, who are referred to as “members.” An LLC is not a recognized business structure for federal tax purposes.
For federal tax and generally for state tax purposes, a single-owner LLC is treated as a sole proprietorship. An LLC with two or more members is treated as a partnership. An LLC with any number of owners can elect to be treated as a corporation for tax purposes, by filing Form 8832, Entity Classification Election.
New Federal Deduction
The Tax Cuts and Jobs Act created a new business deduction that will be available starting in tax year 2018. The deduction is equal to 20% of qualified business income, which is generally the company’s net income. The deduction is claimed at the individual tax level and is limited for taxpayers with taxable income over $157,500 ($315,000 for married taxpayers filing jointly). Other limitations apply based on the type of business, wages paid, business assets, the taxpayer’s taxable income, and more.
Now, here are the basics for four types of business entities. While we present some fundamentals below, it’s a good idea to consult with experts to choose the one that’s best for your situation:
1 – Sole Proprietorship
A sole proprietorship is the default entity for an unincorporated business that has only one owner.
A sole proprietorship is also called a “disregarded entity,” because the owner reports business activity on his or her individual tax return. The owner reports income and expenses on Schedule C (Schedule F for farms) of Form 1040, and directly pays tax on the net profits, along with income from other sources, such as interest and capital gains. Owners don’t receive wages from the company and are responsible for paying their own self-employment (Social Security and Medicare) taxes on the business’s net income.
It’s inexpensive to set up a sole proprietorship, and legal costs are usually limited to getting the necessary license or permits, plus insurance. And because there’s only one owner, that person has control over all the business decisions. Sole proprietors may be able to take advantage of the new deduction of 20% of qualified business income, which they can claim directly on Form 1040. Sole proprietors can also deduct 100% of their health insurance costs for themselves and their families as an “above-the-line” deduction on Form 1040.
Sole proprietors can be held personally liable for the business’s debts and other legal obligations, unless the business is a single-member LLC, as explained earlier.
Also, while it can be nice to have full control over business decisions, sole proprietors also bear all the responsibility for the success of the business.
2 – Partnerships
A partnership is the default business entity when two or more people agree to share ownership of an unincorporated business. Two common types of partnerships are general partnerships and limited partnerships (LPs). An LP has at least one limited partner (which is a partner who isn’t actively involved in the day-to-day operations of the business). An LLC with two or more members is treated as a partnership and usually follows the general partnership rules. Some professional partnerships are also set up as limited liability partnerships, or LLCs.
The partnership’s income, deductions, credits, etc., are reported on Form 1065, U.S. Return of Partnership Income. These items are then passed through to each partner, based on the terms of the partnership agreement, via Schedule K-1 (Form 1065). For instance, if the partners have agreed to split all items 50-50, each partner will receive exactly one-half of net income, etc. In turn, the partners report the K-1 items on their individual tax returns. Like sole proprietors, general partners are usually subject to self-employment tax on their respective shares of net earnings.
Partnerships are generally inexpensive and simple to set up, although more may be involved in setting up an LP and other types of partnerships. Usually, developing and negotiating the partnership agreement is the most time-consuming part. Each partner is invested in the business, so the business can take advantage of the combined resources and complementary strengths of each partner. Partners are also potentially eligible for the new 20% deduction, which they claim on their individual tax returns. And partners may also claim the self-employed health insurance deduction.
Also, similar to sole proprietors, general partners have full, shared liability for their own actions and for the business’s actions. General partners’ personal assets are not shielded from the business’s liabilities (a limited partner’s risk and liability is limited to his or her investment in the business). LLC and LLP owners are also shielded from the partnership’s liabilities.
While partnerships have the benefit of shared resources and responsibility, there will be conflicts. A detailed partnership agreement can help avoid or more easily resolve conflicts.
3 – C Corporation
Corporations are tax and legal entities separate from the individual owners. There are many types of corporate entities, the most common being a domestic corporation. Each corporate entity has its own protections and default rules of operation. A C Corporation is set up under the laws of the state where the business is incorporated. Alternatively, an LLC may choose to be taxed as a C Corporation for tax purposes.
A “regular” or C corporation files Form 1120, U.S. Corporation Income Tax Return. All business activity is reported on this return and, unlike sole proprietorships and partnerships, the corporation directly pays tax on its net profits. Owners pay tax on the salaries and dividends they receive from the corporation on their individual returns at the appropriate tax rates.
Under the Tax Cuts and Jobs Act, starting in tax year 2018, a C Corporation’s business profits are taxed at the new flat rate of 21%. Shareholders’ personal assets, other than their investment in the company’s stock, are protected from business debts and other legal obligations.
C Corporations are complicated and expensive to start and operate. And they’re highly regulated by agencies at all levels of government, so C Corporations have additional recordkeeping obligations. Because C Corporations are a separate legal entity, shareholders must follow certain administrative procedures, such as scheduling specific meetings, keeping records, and maintaining bylaws.
In addition to taxes the C Corporation pays directly, the profits distributed to shareholders in the form of dividends are taxed again at the individual shareholder level. This is what’s often referred to as the “double taxation” of C Corporations. On the other hand, dividends are often subject to favorable capital gain rates for individuals.
4 – S Corporation
A domestic C Corporation (including an LLC that has elected corporate status) with no more than 100 shareholders and that meets certain other requirements can choose to be taxed as an S Corporation by filing Form 2553, Election Statement by a Small Business. An S Corporation has some of the properties of both C Corporations and partnerships.
S Corporations file Form 1120-S, U.S. Income Tax Return of an S Corporation. Similar to a partnership, the corporation reports all income, deductions, etc., on the entity return, but passes them through to the shareholders via Schedule K-1 (Form 1120-S). Each shareholder’s share of these items is strictly based on the shareholder’s percentage ownership of the company. For instance, a shareholder who owns 75% of the company would receive 75% of net income, credits, etc. Owners pay taxes on their distributive shares of corporate profits and on their salaries at their appropriate individual rates. Shareholders are required to pay themselves a “reasonable wage” and pay the employee’s share of Social Security taxes on their wages.
Many small business owners favor the S Corporation structure because of its tax benefits. They enjoy the same types of legal protections that a C Corporation offers. Unlike a C Corporation, after-tax profits distributed to shareholders are generally not taxed again as dividends at the individual level, so S Corporation owners avoid the double taxation problem. Like sole proprietors and partners, S Corporation shareholders are potentially eligible for the new deduction of 20% of qualified business income. Shareholders are also eligible to claim the self-employed health insurance deduction.
Like a C Corporation, an S Corporation must be set up at the state level, which can also be difficult and expensive. The entity must still elect S Corporation status at the federal level at the beginning of its first year. Also, like C Corporations, S Corporations must follow certain administrative procedures, such as scheduling specific meetings, keeping records, and maintaining bylaws.
Because shareholders pay FICA and Medicare taxes on their salaries (rather than self-employment tax), they are subject to IRS scrutiny regarding “reasonable compensation.” The IRS can reclassify after-tax distributions as W-2 wages in an audit.
Most Will Benefit From Professional Help
In the end, your business entity choice has several significant legal implications, including corporate governance responsibilities, capital requirements, shareholder rights, and tax obligations. The new 20% deduction for sole proprietors, partners, and S Corporation shareholders, as well as the new C Corporation rate structure, can make the decision even more complicated.
Before making a final decision, you may benefit from getting professional advice from an attorney who specializes in business formation, as well as a tax professional. From a tax and accounting perspective, Block Advisors has you covered. We’ll help you navigate the tax implications so you can focus on growing your new business. Find a tax advisor nearest you now.