Choosing a business entity is a discussion we have several times a week. When we are interviewing a new client, we ask what their current entity is and many times we get the response of “LLC.” LLC is a state recognized entity, but not an IRS entity. There are four types of entities that most businesses fit into: Sole Proprietor, Partnership, S-Corporation and C-Corporation. Let’s dive into each of these a little more!
Sole Proprietorship – This is a business which is owned and operated by one person and is not considered separate from the individual. All income and expenses are reported on a Schedule C, on the personal income tax return. The net income (income less expenses) is subject to self-employment taxes (FICA or Social Security and Medicare). This is the easiest entity to set-up and maintain. The largest downside is the business ends at the owners death, there is no way to pass on the business.
Partnership – This is a separate business entity used when two or more people own and/or operate a business. A partnership reports all income and expenses on the Form 1065, partnership tax return. The profit or loss is then divided among the partnership and reported on a K-1. These numbers are then carried onto the personal return. Each partner is then responsible for the taxes on their share of the income. One large downside to a partnership is that all partners are equally liable for all partners debts related to the partnership.
C Corporation – This too is a separate business entity. This is the only entity that pays taxes on the income rather than having it flow to the individual. Profits from the corporation are disbursed as distributions and are generally taxable as dividend income. The number of shareholders a C corporation can have is unlimited. One benefit to a C Corporation is the fringe benefits available.
S Corporation – This entity is a combination of a partnership and C Corporation. All S Corporations start out as a C Corporation and then elect to be taxed as an S Corporation. However, unlike the C Corporation, the profit and losses are passed through to the shareholders similar to that of a partnership. The S Corporation can only have up to 100 owners.
The bottom line is there are no two businesses alike and no two situations that are the same. We highly recommend meeting with us, our tax partner Aurora Financial Services and/or your CPA before forming a business. Some businesses have to remain for a number of years before changes can occur. You don’t want to lock yourself into the wrong entity.