My clients often ask me to help them choose the best entity for their business. Many just assume it should be an LLC, even when there is no good reason to have one. Others have been talking to relatives and friends who routinely recommend an S Corporation. Others don’t bother to ask me until they have already started an LLC or corporation. Here’s a brief overview.
What are the most common options?
- Sole Proprietor – just do business in your own name, or a DBA
- Partnership – assuming you have partners
- Limited Liability Company – LLC – with or without partners
- S Corporation
- C Corporation
I’ll outline the main considerations to keep in mind, then I will discuss each entity and its pros and cons.
MAIN CONSIDERATIONS
Separate entity
Partnerships, LLCs and corporations are separate entities that register with the state and file separate tax returns. As a sole proprietor, your business is not separated from your personal affairs – you file your business taxes as part of your personal tax return. The same goes for a single-member LLC, which is disregarded for federal tax purposes, although there may be a separate state tax or information return required.
Limited liability
As an individual or sole proprietor, you are liable for all of your debts and other liabilities, as are the partners in a general partnership. With a corporation or LLC, and some partnerships, though, your liability is generally limited to your investment in the business. There are exceptions, though, in the case of fraud or lack of separation of the business from your personal affairs. Remember that liability or E & O insurance can often serve the same function of reducing your liability.
Pass-through of income
Most of the entities discussed here result in business income being taxed on your personal tax return. Partnerships, LLCs and S corps are called “pass-through entities” because they don’t pay income tax. Rather, your share of the business income passes through to your personal tax return. Sole proprietor income is taxed directly on your personal return. C Corporations, however, do not pass through income, and they do pay tax.
Double taxation
Partnerships, LLCs and S Corps do not have double taxation, but it is an issue with C Corporations. The corporation pays tax, then it distributes its income to you, the shareholder, in the form of a dividend. You then pay tax on the dividend. This means that the same income of the corporation is taxed twice by the time you receive it. Generally speaking, the net tax rate is higher than if the income had passed through to you directly.
Deduction of expenses
You can deduct your business expenses in any of the entities discussed here. There is no real difference in this regard between sole proprietorship and the pass-through entities. Expenses may include automobile expenses, home office and health insurance. There may be an opportunity to deduct a few more expenses in a C Corp, such as medical expenses. S Corps are required to pay officers a reasonable salary, to ensure that payroll taxes are paid, while a C Corp can’t pay an excessive salary, because it would reduce double taxation.
This is a motivating reason to have your own business, as you can’t deduct any business expenses if you receive a W-2 salary from an employer. Classic examples of unfair results here include Uber drivers, who won’t be able to deduct gas or other costs of operating their vehicles if they are subject to California’s new law requiring that they be treated as employees.
Payroll tax / self-employment tax
The main payroll taxes are Social Security tax and Medicare tax. If you have received a W-2 from an employer, you will see that they deduct 6.2% for Social Security and 1.45% for Medicare from your paycheck. What they don’t tell you is that the employer also pays the same amount. When you have a business, you are responsible for paying the employer’s share as well as the employee’s share, for a total of 15.3%. A sole proprietor or single-member LLC pays this directly on the personal return in the form of “self-employment tax”, and you also would pay self-employment tax on relevant partnership or LLC pass-through income. With an S Corp, you pay payroll tax on the W-2 salary that you pay yourself, but not on the corporation’s pass-through income.
Retirement contributions
One of the big advantages of having your own business is that you can make much larger contributions to retirement plans, depending on your income. SEP IRAs and 401(k)s are the most common plans that can result in deductible contributions of up to $57,000 in 2020. For corporations, contributions are limited to a percentage of W-2 salary paid, and the other entities are limited to approximately 20% of their income. Partnerships and multi-member LLCs must establish the retirement plans, as partners can’t set up individual plans. Sole proprietors can set up plans for themselves.
Operating costs
There are no particular costs directly related to being a sole proprietor. Corporations, partnerships and multi-member LLCs must file federal tax returns, and those returns are generally more expensive to prepare. Some states have reporting requirements and/or minimum taxes. California, for example, has a minimum tax of $800 on corporations, LLCs and some partnerships. S Corps are required to pay officers a salary, so there will also be payroll processing fees.
Type of business
Some businesses have special considerations. For example, I don’t think you would want to use an S Corp for a rental real estate business, because you would be required to pay yourself a salary and pay payroll taxes on what is really investment income. If you operate a day care business, or some other business with high potential for liability, I would suggest an entity that potentially limits that liability.
THE PROS AND CONS
Sole Proprietor
Generally, there are really no negative aspects to being a sole proprietor. You keep your business records separate from your personal finances, report your income and pay self-employment taxes. You can deduct all of your business expenses and make substantial retirement contributions. You can have employees and operate just as you would with an LLC or corporation. You don’t have additional state taxes or tax preparation fees, but you don’t have limited liability. Most businesses can make up for the lack of limited liability by purchasing insurance.
Partnership
If you do business with one or more partners, you are in a partnership. That will require a separate tax return, and if it is a limited partnership, there may be state filing requirements and minimum taxes. Married couples who operate a business together may elect not to be treated as a partnership. All expense deduction rules apply, including retirement contributions, and net income is divided between the partners and your share is reported on your personal return. You will pay self-employment tax on your business income, unless you are a limited partner, and there is generally no limited liability, unless you are a passive limited partner.
LLC – Limited Liability Company
You can elect to have an LLC taxed as an S Corporation. Otherwise, it is treated as a partnership. A single member LLC (owners are referred to as members in an LLC) is treated differently from an LLC with multiple members.
LLC- Single Member
Let me start by saying I generally don’t recommend forming an LLC if you are the only member. It is called a “disregarded entity” for federal purposes, so you file taxes exactly the same way you would if you were a sole proprietor. Limited liability may be beneficial, but it can be easily thwarted by a creditor if they can show that the LLC is not substantially separated from your personal finances, and there’s no chance anyone is going to lend you money or lease you a car without a personal guarantee. And for your trouble, you get to pay California a minimum tax of $800, although it is lower in most states.
LLC – Multiple Members
A multiple member LLC taxed as a partnership is, well… taxed as a partnership. See above.
S Corporation
An S Corporation can be a corporation or an LLC registered with the state. Either way you must file an election to be taxed as an S Corp. Like a partnership, revenues and expenses are reported, but the corporation does not pay tax. Net income passes through to your personal tax return (your share of the income if there are other shareholders) so the income is only taxed once.
The most important feature of an S Corp is that the corporation is required to pay its officers a “reasonable salary.” This is not defined, but a guide would be the salary you would have to pay someone to do your job. The purpose of this rule is to be sure that you are paying reasonable payroll taxes – Social Security and Medicare.
The profit passed through to your personal tax return is not subject to self-employment tax (as it is for a partnership), so if you pay a relatively low salary, and pass more income through, then you pay less tax overall. This is often used as a selling point on choosing to use an S Corp, but remember that Social Security and Medicare taxes are good taxes (if there is such a thing) because they are credited to your account for future benefits when you get older. Do you really want to cheat yourself on this valuable future benefit?
Your retirement contributions are limited to 25% of the W-2 salary you pay yourself, so this is another incentive to pay a larger salary.
There are restrictions on who can be a shareholder in an S Corporation. You must be a US citizen or resident, an individual and there can’t be more than 100 shareholders.
C Corporation
Most small businesses do not choose the C Corp as the ideal entity, because of the double taxation discussed above. The corporation pays tax, then the earnings are taxed again when they are paid to you as dividends. Before you jump on the obvious the loopholes, though, you can’t take an excessive salary deduction to transfer the tax to your personal return, and you can’t accumulate earnings without paying a dividend unless there is a good reason.
So next time a client asks me which entity is best for their business, I’ll be referring them to this article. Then we can have an informed conversation.
Bruce Critchley Tax 