Choosing an entity type is a crucial early decision for your new business. The best choice depends on the nature of your business, whether you now have or plan to have partners or shareholders, your long-term goals, and the balance of tax-savings, liability protection, flexibility and control that you’re most comfortable with. Changing entity types, later on, can be expensive, so it’s best to choose wisely from day one.
The default choice for a new business with one owner is a sole proprietorship. However, operating your business as an unincorporated sole proprietorship offers zero protection from liabilities, making this a poor choice for many businesses.
You’ll file your taxes on Schedule C of your personal tax return. You will owe both income tax and self-employment taxes on your net profit. Self-employment taxes (SE taxes) are the means by which self-employed individuals pay into the Social Security and Medicare systems. SE tax is levied at a rate of 15.3% on self-employment income.
Limited Liability Corporations
A limited liability corporation (LLC) is the most flexible of business entities. An LLC may be taxed as a sole proprietorship (if there is only one member), a C-corporation, an S-corporation or even as a partnership if there are two or more members. We’ll discuss these options below.
A chief benefit of LLCs is that all members are protected from claims of outside creditors to the extent of their investment in the business. They are also protected from liabilities arising from the actions of employees or other members of the LLC.
Like an LLC, this entity type provides liability protection to the owners to the extent of their investment. However, this liability protection requires certain legal formalities: a corporate charter, bylaws, a board of directors that holds regular meetings, as well as regulatory reporting requirements. Compliance with these formalities may come with significant legal costs, which can be daunting for a startup company.
Tax considerations for C-corporations
Corporations can be taxed either as C-corporations or as S-corporations. A C-corporation is a separate tax-paying entity. Net income is taxed at graduated rates, from 15% to 35% at the highest bracket.
Owners receive a salary and cash distributions. Cash distributions are taxed as dividends on the owner’s personal tax return, which means that the same earnings are taxed twice.
Tax considerations for S-corporations
Double-taxation of cash distributions can be avoided by electing S-corporation status. S-corporations are pass-through entities. That is, the net income passes through the corporation to be taxed at the shareholder level.
At the shareholder level, net income is taxed on your individual tax return. Cash payments to S-corporation shareholders can be split into two buckets: cash distributions and wages. Cash distributions are not taxable, but wages are subject to payroll taxes at 15.3% and to income tax at your marginal tax rate.
In contrast to partnerships, as we’ll see below, the net income passed through to the shareholder’s individual tax return will not be subject to SE taxes. Only the payments classified as wages are subject to SE taxes.
This combination frequently results in the lowest total amount of taxes paid. Because only wages are subject to payroll taxes, this creates an incentive to keep wages low and tax-free distributions high.
Reasonable compensation is required
The IRS requires that compensation be “reasonable” relative to the level of services provided by the shareholder and comparable to market rates for the same services.
Distributions must be pro-rata
Net income and cash distributions are distributed to shareholders according to their ownership percentage. This can cause conflict when two or more shareholders have different needs for cash.
Partnerships, like S-corporations, are pass-through entities. A partnership must have at least two members. In contrast to S-corporations, cash distributions to the partners need not be pro-rata, but can differ according to the partners’ needs.
Flexibility is a key benefit
Income allocation schemes can be flexible, although they must reflect the partners’ underlying economic risk. For example, a partner who provided a significant portion of the company’s start-up costs and who provides ongoing financial support may be allocated 100% of the loss when the company has a net loss.
Types of partnerships
In a general partnership, all of the partners are general partners. Only general partners can manage a partnership. However, general partners are personally liable for all partnership debt.
A limited partnership is the next level of liability protection. A limited partnership must have at least one general partner. The remaining partners are limited partners. Management of the partnership is restricted to the general partners, who are also personally liable for all partnership debt. Limited partners are liable only to the extent of their investment in the partnership.
A limited liability corporation taxed as a partnership combines the liability protection of an LLC with the flexibility of a partnership.
Cash distributions and compensation
The partners of a partnership are not considered to be employees of the company, so they don’t receive wages for their service. Instead they receive guaranteed payments: distributions of cash that are subject to self-employment taxes on the partner’s individual tax return. Fringe benefits are generally taxable to partners as part of their guaranteed payments.
Like an S-corporation, the net income of a partnership is passed through to the partners to be taxed on their individual tax returns. General partners pay self-employment tax on both their guaranteed payment and their allocated share of income. Limited partners pay self-employment tax only on their guaranteed payments unless they also provide services to the partnership. This may mean that a partner in a partnership pays more in tax than a shareholder in an S-corporation.
Changing tax entity type may be as simple as checking a box, or filing a simple form with the IRS. Or it may require owners to recognize a capital gain when they change to a new tax type. Before committing to a particular entity type and a tax choice, it’s best to consult with your accountant and attorney.
Need help deciding which option is best for your business? Call our office today at 561-624-2118 to discuss your options.