Article By: Jeffrey Skolnick, CPA, M.S. Taxation
Choosing an entity structure is very important. Although it is possible to change from one structure to another there may be unintended tax consequences, therefore it makes sense to get set up correctly from the start.
Sole Proprietorship:
This is the most basic and easiest business entity to create. There is no paperwork required to file. You don’t need an Employer Identification Number (EIN) unless you have employees. This is the only entity that I will discuss where no EIN is required. The income and expenses of your business are reported on Schedule C of your Federal Income Tax Form 1040. The downside to this type of an entity structure is that the owner is personally liable for the debts and potential lawsuits of the business. In other words there is no legal protection for the owner as there is in other entities (such as a corporation). Additionally certain items such as medical expenses are reported in separate parts of the personal income tax return and may not yield the same benefits as if they were allowed as a deduction in your business. Lastly, this type of entity is subject to self-employment tax and most likely if you have a Schedule C you will be required to make Estimated Income Tax Payments.
Partnerships:
Think of a general partnership as a multi member sole proprietorship. The reason I say this is because there once again is very little if any paperwork required to create a partnership. As with a sole proprietorship the owners are personally liable for the debts and potential lawsuits of the business. The legal language used is jointly and severally liable. This means the owners are liable but not necessarily for just their portion. If one of the partners cannot pay his/her fair share of a liability, a creditor may go after any other or all other partners. In other words there is no legal protection for the owner as there is in other entities (such as a corporation).
A limited partnership is generally made up of at least one and possibly several general partners. These partners would have all of the same benefits and disadvantages as discussed in the previous paragraph. Limited partnerships also have limited partners which may have limited liability (similar to a corporation) depending on state law.
Partnerships are required to file a Partnership Form 1065; however no tax is paid at the entity level. Instead, a partnership is considered a “flow through” entity meaning the income flows from the partnership to the individual partners who report this income on their individual Forms 1040. As with sole praetorships this income is subject to self-employment tax and again the partners would most likely be required to make Estimated Tax Payments.
Corporations:
Certainly the most formal entity structure, corporations must be formed under State law. I am only going to touch on “C” corporations because for the most part this structure is for larger organizations and most small businesses if they incorporate will elect “S” corporation status.
“C” corporations are entities that pay their own income tax and is the only entity I am discussing where nothing flows through to the owners (called either shareholders or stockholders). Stockholders of corporations typically receive money in one of two ways; either through wages (deductible as an expense to the corporation) or as dividends (not deductible to the corporation). Again since this is geared toward small businesses I am not going to expand on this definition at this time.
“S” corporations are entities that are either entities formed as corporations that elect to be treated as “S” corporations or LLCs (which I will discuss shortly) that elect to be taxed as an “S” corporation. An “S” corporation is also a “flow through” entity and is required to file Federal Form 1120S. As with partnerships income earned by an “S” corporation flows through to the individual owners who report this income on their respective income tax returns. The difference between “S” corporations and other entities is that while a sole proprietor or partner of a partnership is precluded from paying themselves through wages, S corporation shareholders are required to pay themselves through salary. “S” corporation owners pay income tax on their wages earned and on the profits reported to them on by the corporation. Once again if shareholders receive profits from the corporation then they will most likely be required to make Estimated Income Tax Payments. One difference between “S” corporation profits and partnership profits is that “S” corporation profits are not subject to self-employment tax.
LLCs
I chose to address this entity structure last because, for tax purposes, an LLC is not really anything. It is considered a “disregarded entity” which means that it is looked through as if it were invisible. In other words, the default position of a single member LLC is that for tax purposes this entity would report on Form Schedule C. If an LLC is made up of multi members, then the default position is that the entity would be taxed as a Partnership. I know you are probably asking why bother forming an LLC if the tax filings are the same as either a sole proprietorship or partnership? The answer is the LLC structure does afford owners limited liability similar to a corporation. LLCs are formed with the State, very similar to corporations. While an LLC has default positions as I’ve outlined also keep in mind that an LLC can choose to be taxed as an “S” corporation.
Conclusion:
Although it is possible to change entity structure after the initial formation of a Company some changes are easier than others (LLCs to “S” corporations), others are either not possible or could have other potential adverse tax consequences. It is therefore very wise to consult with a tax professional and to be set up correctly from the start.
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