It’s not uncommon for entrepreneurs that start a new business, to choose to or inadvertently operate under the wrong type of legal structure. It can cost the business owner plenty running an entity that is not best suited for their purposes. This occurs because of poor advice, not knowing their options and/or not understanding the tax consequences of their decision. It’s important to retain a good accountant versed in handling small business or a good tax attorney. Be careful that it’s a tax attorney and not a general attorney, including personal injury, trusts and estates, employment or any other type. Reason being that, it’s been my experience that attorneys usually set businesses up as LLC’s, only taking into account the limited legal liability benefits, while not taking into account the tax ramifications. You need someone well versed in tax matters as they relate to small businesses.
This short guide will explain the legal and tax implications of the different types of business entities you can choose from. Don’t assume that you’re done once your setup. Each option comes with its own set of requirements for maintaining its legal structure.
There are 6 main legal structures in which you can operate a small business:
- Sole Proprietor
- “S” Corporation
- LLC-Limited Liability Company
- LLP-Limited Liability Partnership
When you start a business, you are classified, for Legal and Federal Tax purposes as a Sole Proprietor.
When you start a business, you are classified, for Legal and Federal Tax purposes as a Sole Proprietor. A sole proprietor files its tax return on the owner’s personal, Federal Tax Form 1040 Tax Return, Schedule C.
There are 3 major disadvantages to doing business this way
- LEGAL – There is no legal protection-If your business is sued, you are being sued. All of your personal assets can be attached including your home, cars, jewelry, etc.
- IRS AUDIT – Sole proprietors are a lot more likely to be audited by IRS than a corporation or a partnership.
- SOCIAL SECURITY TAXES – Net profit from a Sole Proprietor is taxed at 12.4% (Social Security Tax) on up to $127,200 of your net earnings and a 2.9 percent Medicare tax on your entire net earnings.The positives, about being a sole proprietor is the simplicity of starting one. Once you decide to start doing business, you’re in business.
If Your net profit will be $10,000 or less being a sole proprietor may be your best choice. The cost of incorporating and having an accountant prepare your return may not justify the social security taxes cost. You have to judge based on your individual situation.
PARTNERSHIP – When 2 or more individuals go into business, a partnership is formed. A partnership files it Federal Tax Return on Form 1065. Just as with a sole proprietorship, there is no legal protection with a partnership, and net profits are subject self employment taxes. A written agreement should always be drawn up whenever 2 or more parties do business together.
Again, just as in a sole proprietorship, starting a partnership is very simple. After agreeing to being partners, all you need to do is obtain a federal tax identification number and open a bank account. Because of the lack of legal protection a better alternative to a partnership may be a corporation, LLP or an LLC.
CORPORATION – a corporation (or “C” Corp.) is a legal entity, separate from its owner or owners who are called shareholders. A corporation files its tax return on form 1120. Shareholders are shielded, with some exceptions from any legal issues that arise in the course of doing business. For instance, you will be held personally liable for not remitting payroll taxes withheld from IRS and NYS. The same is true with sales taxes. There are other situations where the “Corporate Shield” can be pierced that is beyond the scope of this article.“DOUBLE TAXATION”: Corporations pay a tax on profits, which can be distributed to shareholders and called dividends. Shareholders pay a personal tax on those dividends. This is where the term “Double Taxation” comes from.
“S” CORPORATION – An “S” Corp. initially starts as a “C” Corp. has had all of its shareholders elect to be treated as a different category from regular the original “C” corporation. All of the shareholders sign form 2553 Election to be treated as a small business corporation. Not every entity qualifies, such as corporations with more than XX amount of shareholder. An “S” Corp files its tax return on Federal Form 1120 S and is not subject to any tax on its net income. The profit or loss flows through to the shareholder and is reported on their personal, Form 1040 tax return
LLP – LIMITED LIABILITY PARTNERSHIP – An LLP provides a legal shield to partners, who are called “Members”. An LLP files its tax return on Federal Form 1065 Return of Partnership Income. To be eligible to file as an LLP, there must be 2 or more “Members”, similar to a partnership. LLP’s are not simple to form, requiring registration with the state or states you will be doing business in as well as a formal operating agreement between the members.
LLC – LIMITED LIABILITY COMPANY – An LLC has 1 or more owners who are called “Members”. The default tax classification for a single member LLC is Sole Proprietor (Member) and files schedule “C” on IRS form 1040, while 2 or more owners (Members) is classified as a partnership and files form 1065 Oddly enough, once you become a partnership by default you elect to be taxed a Corporation or as an “S” Corp, weather you have 1 or more members. Both an LLP, and an LLC require a Member agreement.
LLC VS. LLP – There are 2 distinct differences between an LLP and an LLC. An LLC can have as little as 1 member while an LLP requires more than 1. The default classifications are not the same either. There are also some other legal nuances that have to do with the personal liability each member incurs, as an LLP or as a LLC.
There are many instances where any of these structures make sense. For instance, a retired school teacher that does private tutoring from their home, and earns less than $10,000 per year may want to go the route of filing as a Sole Proprietor or an LLC. If 2 people go into business they can become an LLP, LLC, Corporation, S Corp or Partnership.
In my 35 plus years of experience, I would estimate the 98% of business owners have chosen to be classified as an “S” Corp. There are several reasons for that:
- The legal protection
- Being taxed at 1 level VS. 2 as a “C” Corp
- The savings on Social Security tax on profits
Here is an example: Assume a net profit of $20,000
Self Employment Tax: Sole Proprietor or Partnership $20,000 x 12.4 = $2,480
Self Employment Tax: S Corp $20,000 x 0 = ZERO
Assume a Net Profit of $40,000
Self Employment Tax: Sole Proprietor $40,000 x 12.4 = $4,960
Self Employment Tax: S Corp $40,000 x 0 = ZERO
In the end, I highly recommend talking to a CPA, EA or Tax Attorney
- Last but not least, the cost of incorporating is half of the cost to create an LLC. The reason being that, registering an LLC requires publication in a daily and weekly newspaper.
If the information here resonates with you, and you have questions I invite you click here for a free chat.