Choice of Entity
Every year many new businesses commence operations and their new owners invariably must ask hopefully sooner rather than later, what type of entity should I choose? And in particular, which one provides the most benefit in terms of positioning my company as it relates to my personal taxes? The list of choices for business entity types are relatively small but the tax implications and differences are fairly huge. When most people think of a choice of entity they think of a corporation taxed as a C corporation or maybe an S corporation.
Everyone has heard of an LLC, a limited liability company, but how are they taxed by the IRS? Partnerships are well known too and established since the sun first rose. This business arrangement type provides beneficial flexibility for individual owners since a good operating agreement provides tax characteristics at the wishes of each partner. The IRS regulates how business entities are taxed under federal law and how income and deductions are apportioned to the corporation, shareholders, members, or partners in a predetermined manner.
A sole proprietorship is solely owned by one owner. Contrary to common thought a sole proprietor can have employees the same as any other entity type. For the sole proprietor a separate business bank account is a matter of convenience to help with bookkeeping and tax or payroll which isn’t the case for the other business types. For the other business types a separate bank account is a matter of legal protection.
Read a quick definition of Piercing the Corporate Veil found on Cornell University’s legal website to help understand how significant intermingling personal and corporate assets can be(see link below). A sole proprietorship doesn’t have the same legal protection as the other entities so the owner can use one bank account for both personal and business needs. If a creditor or customer sue the business, they can come after the personal assets or income of the owner. Risk mitigation for a sole proprietorship necessitates the services of a good insurance broker.
A sole owner of an LLC is also considered to be a sole proprietor for tax purposes. LLC’s afford more protection from a legal standpoint so a separate bank account is no longer optional in order to preserve the protection. In this regard, a sole proprietor LLC should keep all funds business and personal separate to preserve their limited liability corporate protection. A single owner LLC will typically file a schedule C with their 1040 personal return.
S corp vs. LLC
An LLC with more than one member can be taxed as a partnership or as a corporation. Generally an LLC taxed as a corporation will be taxed at the state level so it is important to take this into consideration before electing to be taxed as a corporation. The IRS will automatically consider an LLC to be a partnership if it has more than one member. A business must file form 8832 to elect the LLC to be treated as a corporation. As a general rule regarding state taxes and LLC s, if your income passes through to you then depending on your state of registry it will at the very least be subject to personal state taxes.
It is important to cover all your bases in the first year the business starts so talk to a tax professional. An LLC taxed as a partnership provides flexible allocation of revenue and expenses as discussed later. An LLC taxed as a corporation provides good legal protection for the owners but a corporation taxed as a corporation provides the best form of legal protection.
In general, an S corporation is registered with the state as a corporation. It is possible to be an LLC and elect to be taxed as a corporation and then elect to be taxed as an S corporation by filing form 2553. An LLC taxed as a corporation can have unlimited members so electing to be taxed as an S corporation will limit total owners to 100. For small business LLC s it is most likely preferable to elect corporate and then S corporation status. An attorney would be the best choice to help decide between registering as a corporation or as an LLC to elect S corporation status with the IRS or possibly as a partnership.
S corp vs C corp
An S corporation is a small business entity properly registered as a Corporation with a state agency. A Corporation only elects to be taxed as an S corporation with the IRS. An S corp vs. C corp differ in how they are taxed. With an S corporation income, deductions, gains, and losses pass through to the owners so they are included on the shareholder tax returns. The shareholders will pay the shared corporate net income on their individual tax returns at more favorable tax rates.
The S corporation itself will not observe tax at all in almost all cases; whereas, the C corporation will pay tax at corporate rates. While an S corp sounds enticing, an S corporation must meet certain requirements that will prove too limiting to a larger Corporation. When a corporation taxed as an S corporation becomes too large it will eventually lose its S corporation status. One limiting factor for example is an S corporation can only have 100 shareholders. Further limiting, it can’t have another corporation as a shareholder.
An unincorporated business that has 2 or more owners generally will be taxed as a partnership but certain exceptions do exist in the Internal Revenue Code. Partnership tax is in general more complex than that for any of the other entities so administratively it can be more expensive to maintain. In most cases the partnership will be a limited, general, or limited liability partnership. A forth partnership not yet legal in all states is the limited liability limited partnership. More information on LLLPs is on Wikipedia.
All of these are legal terms with definitions determined by law. Some good legal definitions for these entities are here on TransLegal. A partnership will determine its distributions, allocations, capital contributions and decision making with an operating agreement. The agreement can be oral or written. Written is always better, and where the agreement is silent, state law usually dictates. A partnership is flexible in this regard. An S corporation on the other hand for instance must allocate income, deductions, gains, and losses according to each shareholder stock percentage ownership. Article link to Piercing the Corporate Veil on Cornell's legal website.
Ok, End it Already!
Everyone has heard in general terms what is written here but it becomes more difficult and time consuming to navigate the details. This article covered the tip of the tip of the iceberg tip. The first year of business is the most important. Ever more diligent business owners will start the tax planning process with a professional before they begin. Most likely most of us will be too eager to get going to plan accordingly and the next best time to start is the first year. If a business owner hasn’t started then the next best time is now. An owner needs to overcome the fear and discomfort of dealing with tax issues to survive. Taxes will kill a business if they aren’t dealt with properly and early. The rabbit hole will only get deeper over time.
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