If you’re here because you’re starting a new business but don’t know what kind of legal entity to form, I salute you. Entity selection is very often overlooked by budding entrepreneurs, who, rightfully, are more focused on selling and building their businesses, but it is an extremely important consideration. Choosing the right entity can literally save you huge sums of money over the life of your business, and can also protect you and your family in the unfortunate case where disaster strikes your business. Think the benefits and drawbacks are worth examining for a few minutes? Then read on. The first thing you should know is that, in general, there are no perfect entities. Each type of entity has its benefits and drawbacks. But in most cases, the nature of the business and the number and participation of owners will usually lead to one entity that makes sense above all the others. Without further ado, let’s dive in.
SOLE PROPRIETORSHIP
A sole proprietorship technically isn’t an entity, it occurs when you don’t actually form an entity but still conduct business. In today’s gig economy, anyone considered a contractor who does not form an entity would by default fall into being a sole proprietorship.
Benefits
No Cost or filing requirements
No separate tax return required
Drawbacks
Self employed tax implications
Liability: in the event something bad happens and someone sues you, in the absence of insurance, both your business assets and your personal assets could be taken to pay a judgement.
This. Is. A. Big. Deal.
Taxation
Profits from a sole proprietorship are subject to both income tax and self-employment tax
Self-employment tax is an important concept to understand. SE tax is the equivalent of Social Security and Medicare taxes. If you get paid a wage, you pay half of these taxes and your employer pays the other half. As a sole proprietor, you pay both halves. The current SE tax rate is about 15% on the first roughly $133k of profit; it is approximately 3% on profits over that amount
Filing Returns
Sole proprietorships do not file separate tax returns for their business. Rather, the income and expenses of the business would be included on Schedule C of the owner’s individual tax return, Form 1040
LIMITED LIABILITY CORPORATION (LLC)
An LLC is a legal entity that you form by filing articles of organization with your secretary of state (‘articles’ may have different terminology depending on the state you are in). The LLC is a very flexible form of organization – so much so that you can start an LLC but for tax purposes elect to be treated in a variety of different ways. The owners of an LLC are called “members.” A key distinction must be made between a single-member LLC and a multi-member LLC
Benefits
Ease of formation
Flexibility
Generally, an LLC can allocate the income to its members any way it wants to
Generally it is very easy to admit new members or remove members
As mentioned, you can form an LLC but elect, for tax purposes, to be treated differently – as an S-Corporation or a C-Corporation
Drawbacks
Self employed tax for members that participate in the business
Requirement for a separate tax filing, Form 1065
Taxation
As mentioned, the LLC itself generally pays no tax. Each member receives a Form K-1, which is part of the tax filing, which tells them how much of the partnership’s profit belongs to them. Each member then combines this amount with the rest of their tax items (W-2 income, itemized deductions, etc.) to determine how much tax they owe on an individual level. Members that actively participate in the business must pay self employment tax on their allocation. Limited members (i.e. ones that provide capital but do not participate in the management or operations of the business) do not pay self employment tax
Filing Returns
Single-Member LLC:
Like the sole proprietorship above, a single-member LLC will file a Schedule C (or if the LLC is a rental real estate business, a Schedule E)
Multi-Member LLC:
Multi-member LLCs file a Form 1065 Partnership Income Tax Return. Generally no tax is due with this return. The purpose of the filling is to inform the government how much income and expenses the LLC had, and to allocate the net profit to the members
S-CORPORATIONS
An LLC is a legal entity that you form by filing articles of organization with your secretary of state (‘articles’ may have different terminology depending on the state you are in). The LLC is a very flexible form of organization – so much so that you can start an LLC but for tax purposes elect to be treated in a variety of different ways. The owners of an LLC are called “members.” A key distinction must be made between a single-member LLC and a multi-member LLC
Benefits
No Cost or filing requirements
No separate tax return required
Drawbacks
Self employed tax implications
Liability: in the event something bad happens and someone sues you, in the absence of insurance, both your business assets and your personal assets could be taken to pay a judgement. This. Is. A. Big. Deal.
Taxation
Profits from a sole proprietorship are subject to both income tax and self-employment tax
Self-employment tax is an important concept to understand. SE tax is the equivalent of Social Security and Medicare taxes. If you get paid a wage, you pay half of these taxes and your employer pays the other half. As a sole proprietor, you pay both halves. The current SE tax rate is about 15% on the first roughly $133k of profit; it is approximately 3% on profits over that amount
Filing Returns
Sole proprietorships do not file separate tax returns for their business. Rather, the income and expenses of the business would be included on Schedule C of the owner’s individual tax return, Form 1040
C-CORPORATIONS
An LLC is a legal entity that you form by filing articles of organization with your secretary of state (‘articles’ may have different terminology depending on the state you are in). The LLC is a very flexible form of organization – so much so that you can start an LLC but for tax purposes elect to be treated in a variety of different ways. The owners of an LLC are called “members.” A key distinction must be made between a single-member LLC and a multi-member LLC
Benefits
No Cost or filing requirements
No separate tax return required
Drawbacks
Self employed tax implications
Liability: in the event something bad happens and someone sues you, in the absence of insurance, both your business assets and your personal assets could be taken to pay a judgement. This. Is. A. Big. Deal.
Taxation
Profits from a sole proprietorship are subject to both income tax and self-employment tax
Self-employment tax is an important concept to understand. SE tax is the equivalent of Social Security and Medicare taxes. If you get paid a wage, you pay half of these taxes and your employer pays the other half. As a sole proprietor, you pay both halves. The current SE tax rate is about 15% on the first roughly $133k of profit; it is approximately 3% on profits over that amount
Filing Returns
Sole proprietorships do not file separate tax returns for their business. Rather, the income and expenses of the business would be included on Schedule C of the owner’s individual tax return, Form 1040