I’ve often been asked by aspiring business owners how to start a business and what type of business entity to form. Sole proprietorship? Partnership? LLC? S corporation? C corporation?
It can seem daunting to someone who has never created a business, but I have laid out the most common business structures and mention some tax implications as well, to help you in your decision-making.
Remember, key factors to consider are financial, economic, legal, and tax business ramifications. Attorneys, CPAs, and other professionals can also help. And though there are DIY tools out there, forming your business can be a smart place to invest in professional advice.
Understanding Your Business Structure
Let’s start by briefly covering different business types. It might help to think about business structures in the same way you would think of different car models.
You want to pick the one that has the correct features for your specific needs.
With that in mind, let’s go through some of the most common business structures for you to consider on your entrepreneurial journey. I’ve also included links to the Internal Revenue Service (IRS) pages for each business type, in case you have more questions.
Any individual can start selling a product or service and be considered a sole proprietor. Meaning, you don’t need to take any formal action. If you are a freelance writer, sell crafts on Etsy, or are the lone recipient of your business’ profits, you are a sole proprietor.
That said, each state may vary in what it requires from a sole proprietorship, so check out the SBA Small Business tools to find out what federal, state, or municipal licenses you may need.
A sole proprietorship may be required to have an employer identification number (EIN). An EIN is similar to a Social Security number and is used for banking and tax purposes. An EIN can be obtained online through the IRS here. Think of an EIN as your business’ Social Security number.
A partnership is formed when two or more individuals decide to go into business together. A partnership must have at least two partners — and each person should contribute money, property, labor or skill, to the partnership. Partners share in the profits and losses of the partnership.
As with any business agreement you enter into, it’s essential to establish an operating agreement outlining the terms and conditions of a partnership.
It’s important to have frank, candid conversations with your business partners before your business formation.
Partnerships are also required to obtain an EIN. This link will help you find what your state requires to register your business.
Laws vary from state to state, but in general, to form a limited partnership (LP), limited liability partnership (LLP), limited liability company (LLC), S corporation, and C corporation, articles of incorporation must be filed with the state. Most states require articles of incorporation to be filed with the secretary of state.
Some states may have slightly different names for these documents — such as a “certificate of formation” — but regardless of the terminology, you’ll likely need to provide: the name and location of your business, the name and address of your corporation’s registered agent, a statement of what your business does and for how long you plan to file.
You will also need to include information about the number of shares and classes of stock you plan to issue (this is one area in which professional help can go a long way), and the names and addresses of all the officers of the company you are forming.
Also to consider: All new businesses should secure business liability insurance which varies by industry and state, obtain a business bank account, and keep separate accounting records.
Personal and business affairs should be clearly delineated. Also, just a note: Don’t think you will remember all of your business’ details. Keep notes of important milestones and conversations. You never know when they will come in handy.
How Are Different Types of Businesses Taxed?
A sole proprietorship is a business that has one owner, and the owner is self-employed and works for himself or herself. Sole proprietors can also have employees and hire independent contractors for jobs.
It’s essential as a small business owner you understand the difference between the two, and ensure you take the right steps. Independent contractors are often considered sole proprietors — so if you run a freelance business you are also a sole proprietor.
Sole proprietors are taxed once as an individual. They must file an individual income tax return, Form 1040, with the IRS. In addition, sole proprietors must also file a Form Schedule C to report business income and expenses. Sole proprietors are eligible for the qualified business income deduction on their individual income tax return.
To learn more about what is considered a qualified business income deduction, look here. Small business owners are encouraged to minimize their tax exposure as much as possible, and qualified deductions are a good way to start.
To find out what type of expenses qualify to be deducted from a Schedule C, the IRS provides guidelines. Sole proprietors are taxed on their business income — that’s where deducting qualified expenses can come in handy — and are also subject to self-employment tax, currently at 15.3 percent. Like income taxes, self-employment taxes should be paid quarterly.
For more information on self-employment taxes, the IRS provides information about the type of self-employment taxes and how often they should be paid here. If you are a small business that is struggling to pay the taxes you owe, the sooner you can reach the IRS to discuss options and demonstrate your good faith, the better off you will be.
Sole proprietors do not have a salary in the traditional sense. Since they are responsible for their own tax, sole proprietors should make estimated tax payments each quarter, typically on April 15, June 15, September 15, and January 15.
There are different types of partnerships. The most common type is a general partnership. A couple of other common partnerships that you may have heard offer limited liability.
A partnership — regardless of type: general partnerships, limited liability partnerships (LLP), and limited partnerships (LP) must file a partnership income tax return, Form 1065, with the IRS.
Partnerships are considered pass-through or flow-through entities meaning all partnership income and losses are passed through to each individual partner.
Each partner receives income and losses based on their percentage share of ownership.
As an example, if two business owners each own 50 percent of a partnership, and that partnership nets $100,000 a year before taxes, each person will pay tax on $50,000. This, of course, is after deductions.
The partnership entity itself is not taxed. The partnership tax return is an informational return only but must be filed. Like sole proprietors, each partner pays only one level of tax at the individual level. That means you will be taxed based on how much you earn. Ordinary income tax rates vary from 10 percent to 35 percent in 2020.
The information regarding income and losses is reported to each partner through Form K-1. I like to explain it like this: An employee receives a Form W-2 from their employer and reports the income on their individual income tax return.
Each partner receives a Form K-1 from the partnership and reports the information on their individual income tax return. Each partner must also file a Schedule E reporting the partnership income or loss along with Form 1040.
Partners do not take a salary. They take distributions. Partners may be subject to self-employment tax depending on the type of business activity. Each individual partner is responsible for making estimated tax payments.
Partners are potentially eligible for the qualified business income deduction on one’s individual income tax return, but there are some exceptions, so it’s good to check with your tax advisor.
Limited Liability Company
An individual or multiple individuals can own an limited liability company (LLC). Owners of LLCs are called members. When one member owns an LLC, it is referred to as a single-member LLC.
When multiple members own an LLC, it is referred to a multi-member LLC. We generally refer to a multi-member LLC as an LLC and a single-member LLC as a disregarded entity. What’s that, you may ask? Read on!
A single-member LLC is taxed nearly identically to a sole proprietorship and pays tax at the individual level.
A single-member LLC reports business income and expenses on a Schedule C. Along with the Schedule C, the owner must also file Form 1040. If the single-member LLC engages in a passive income activity like renting real estate or collecting royalties, it must file Schedule E instead of Schedule C.
One other thing to consider, a single-member LLC can elect to be taxed as an S corporation. (To learn more about an S corp, read below.)
When two or more members own an LLC, the entity is classified as a multi-member LLC or just an LLC. An LLC is initially classified as a partnership and must file a partnership income tax return, Form 1065.
Similar to a single-member LLC, an LLC can elect to be taxed as an S corporation. The main advantage to being taxed as an S corporation is that business profits are not subject to self-employment tax.
For example, let’s say a business has a profit of $100,000. If the business were taxed as a partnership, the owner would pay income tax on $100,000 and self-employment tax on $100,000.
Now, let’s say the same business is taxed as an S corporation. The business still has a profit of $100,000 and the owner determines a reasonable salary is $50,000. The salary is subject to income tax and self-employment tax. The business profit of $50,000 is subject only to income tax, not self-employment tax.
An LLC is a flow-through or pass-through entity. Items of income and loss are passed through to each individual member. The information is reported to each partner through Form K-1. The information on the Form K-1 is reported on Schedule E and the individual income tax return, Form 1040.
The LLC entity itself is not taxed, and the business’ tax return is an informational return only, but must be filed. Disregarded entities and members do not take a salary; they can elect to take distributions, providing their entity is profitable, of course.
Members may be subject to self-employment tax and should make estimated tax payments. Just as with a partnership, members are potentially eligible for the qualified business income deduction on the individual income tax return.
The owners of S corporations are called shareholders. Similar to a partnership and LLC, an S corporation is not taxed at the corporate level. Like partnerships and LLCs, S corporations are flow-through or pass-through entities. An S corporation is required to file Form 1120S with the IRS. Like a partnership tax return, an S corporation is an informational return.
Each shareholder receives a Form K-1 from the corporation, which reports items of income and loss on a pro-rata basis. The shareholder is required to report these items on their individual income tax return, Form 1040, and Schedule E.
S corporation shareholders may take a salary. An advantage of an S corporation is that an officer can potentially pay less self-employment tax. Unlike partnerships and LLCs, business profits are subject only to income tax not to self-employment tax.
S corporation shareholders are potentially eligible for the qualified business income deduction on the individual income tax return and should consult their tax advisor.
Almost all publicly traded companies are C corporations, and they can incorporate in their state. Many corporations incorporate outside of their home state.
For example, many corporations incorporate in Delaware due to generous laws that favor corporations.
Unlike the other entities we have discussed thus far, C corporations are subject to double taxation: once at the business entity level and once at the individual level.
C corporations must file a corporate income tax return with the IRS by filing Form 1120. The corporation is responsible for paying any taxes. If a C corporation pays a dividend to its shareholders, the shareholders may be subject to tax on the dividends paid by the C corporation.
The corporate income tax rate is currently 21 percent, per the IRS. Ordinary dividends are taxed at ordinary income tax rates while qualified dividends are taxed at capital gains tax rates.
A shareholder could pay zero percent, 15 percent, or 20 percent tax on the dividends received, depending on the tax bracket in which the individual falls.
A C corporation is taxed on all business income at the entity level. Like individuals, C corporations should make estimated tax payments. Dividends are taxed at the individual level when paid to shareholders. C corporation shareholders are not eligible for the qualified business income deduction on the individual income tax return.
From a tax perspective, sole proprietorships, partnerships, single-member LLCs, LLCs, and S corporations are similar. They avoid double taxation and are taxed only once at the individual level. C corporations are subject to double taxation. They pay two levels of tax: once at the entity level and once at the individual level.
The Bottom Line on Business Structures and Taxes
As you can see, there is a lot of information to digest. It can seem overwhelming at first, but the more you read and research, the more you will learn and more comfortable you will become.
I encourage you to consult with professionals so you can make informed decisions. Be on the lookout. It may be the subject of an upcoming column!
Next week we’ll delve into common business expenses.