When starting a business, entity selection is one of the first decisions you make as a business owner and a very important decision from a tax perspective. It tremendously impacts how much you pay in taxes and how much money you get to keep.
A business owner can select four main entity types: Sole Proprietorship, Partnership, Corporation, and Limited Liability Company. Here is a brief overview of each.
Sole Proprietorship is the default and most common entity type. You are a sole proprietor if you are an unincorporated individual engaged in a trade or business activity for profit. Sole proprietors have pass-through taxation. Pass-through taxation is when a business does not pay taxes on income at the entity level. Instead, the income flows to the owner, who then pays personal income taxes on their share of the business. Sole proprietors do not file separate business income tax returns. Instead, they report the business income and expenses on Schedule C of their tax return. The net business income is then subject to the marginal ordinary income tax rate and the 15.3% self-employment tax.
Similar to sole proprietorships, partnerships are the default business entity for two or more parties engaged in a trade or business activity for profit. And similar to sole proprietorships, partnerships also have pass-through entity taxation. A separate partnership income tax return must be filed, and each partner must report their share of business income on their income tax return. However, they have great flexibility in how income, deductions, and credits are allocated to each partner. In addition, the partners are subject to ordinary income tax and self-employment tax on their share of net business income. There are a few different types of partnerships, including general partnerships (GP), joint ventures, limited partnerships (LP), limited liability partnerships (LLP), and limited liability limited partnerships (LLLP). The "limited" entities require special state filings and partnership agreements. But for tax purposes, they are all treated in the same fashion.
Corporations are created through articles of incorporation filed with the state. They are entities separate from their owners. They file their tax returns and pay their taxes. As of this writing, the corporate tax rate sits at 21%. That rate is lower than individuals' 37% top marginal tax bracket. However, due to Double Taxation, that difference may be rendered mute. With Double Taxation, the income gets taxed twice, once at the entity level and then again at the personal level when income is distributed as dividends or wages. There are other benefits to this entity type, such as the ability to raise capital and offer stock options. For some, these may outweigh the disadvantages of double taxation.
Limited Liability Companies
LLCs are a hybrid between corporations and partnerships. They are created through articles of organization filed with the state. For tax purposes, they are very flexible. The IRS disregards the entity for single-member LLCs, and the business income and expenses get reported on Schedule C of your personal tax return. For multi-member LLCs, they receive partnership tax treatment by default. And whether you have a single-member LLC or multi-member LLC, you can elect Corporation tax treatment or S Corporation tax treatment.
An S Corporation is not an actual legal entity. It is a tax election you make with the IRS. Corporations, partnerships, and LLCs can all elect to be taxed as an S Corporation. S corporations file their tax return, are pass-through entities, and are not subject to double taxation. One tax benefit of S corporations is that their net business income is not subject to self-employment tax. That can be huge tax savings. But there are limitations to consider. S corporations must also pay a "reasonable salary" if the owner performs services for the business. This means the business must administer payroll even if they have no employees. There are limitations on who can own an S Corporation. All shareholders are required to be U.S. citizens or permanent residents. That means corporations, partnerships, and certain trusts cannot be shareholders. There can only be one class of stock. And the number of shareholders cannot exceed one hundred. Violating these rules can result in the IRS terminating the S Election, causing the entity to revert to its default tax treatment.
If you are still unsure what entity may be the best for your business, DeBlanc, Murphy, and Murphy is here to help. Our expert accountants and business consultants can meet with you to discuss the optimal entity selection for your specific tax situation. Please contact us to get started.