Is It Time to Move Past a Sole Prop? Different Entities Explained

The Basics

You have likely heard mention of LLCs, corporations, and S corps. Have you wondered what these are, which to choose, how much they cost, and what they do? Don’t sweat it, I’m going to break that down in this post.

Each entity has its benefits. When considering which entity to choose, think about:

  • Tax consequences

  • Liability protection

  • Ease of management

  • Flexibility

  • Ability to raise capital

  • Ease of formation

Some types of entities are easy to form and manage but offer little protection for liability. Other entities offer great protection but may not have the best tax consequences nor be as flexible. This is why the choice of entity is highly specific to each individual business’s needs.

The most common form of (for-profit) business entities are:

  • Sole proprietorship & general partnership

  • Limited Liability Company (LLC)

  • C-Corporation

  • S-Corporation

 

Defining Some Key Terms

LIABILITY

The need for liability protection is often overlooked by new business owners. For legal purposes, liability means being responsible for the consequence resulting from failure to meet a legal obligation. For example, we all have a legal obligation to drive safely. If a driver runs a red light and hits a pedestrian, the driver would be responsible for any injuries or damage. Liability may also stem from a failure to pay on contracts or from giving bad professional advice to a client that results in financial harm. Lawyers will commonly state ways to protect oneself from liability. In other words, there are ways to shield you from being held responsible for the consequences of particular occurrences.

The real-world implications involve which assets are available to a party suing the business. When your entity is shielding you from liability, a suing party may only go after business-owned assets. The entity protects your home, retirement account, and other personal assets. You don’t want a business dispute to hurt both your business and your personal finances. There are exceptions to the liability protection when you do not fully separate yourself from the business. These details are best left for another post, but keep in mind, there are compliance requirements. Most business owners should choose an entity that provides liability protection; it is often essential.

In a sole proprietorship and general partnerships, do not offer personal liability protection. Conversely, LLCs and corporations do protect individuals, in most cases, from personal liability. However, in states such as California, these entities are subject to a minimum tax and an owner of a C-corporation is subject to double taxation.

DOUBLE TAXATION

Businesses subject to double taxation are treated as entirely separate entities from the individuals that run them. C corporations operate for profit and the corporation pays corporate tax on its earnings. If the corporation has one owner, the corporation may then pay the owner a salary and/or dividends. The individual must pay income tax on the money from the corporation. Therefore, the money is taxed two different times. Other entities are not double taxed because they operate as “pass-through entities.”

PASS-THROUGHS

This type of business is not subject to double taxation because (for tax purposes) the entity and individual owner are treated as one taxpayer. All income, losses, and deductions pass through the entity on to the owner. In most pass-through entities, owners will be subject to income tax as well as self-employment tax on all net income. This is, for the most part, a good thing for small businesses because the owners are not subject to double taxation and the tax return remains relatively simple.

SELF EMPLOYMENT TAX VERSUS INCOME TAX

The majority of people are most familiar with income tax. The tax brackets you have seen are for income taxes where the higher your income, the higher your tax bracket. U.S. individual taxpayers pay an additional tax to fund Medicare and Social Security. The tax for both totals 15.3% of your income (up to certain thresholds). Typically, as a wage employee, the taxpayer pays half of that amount and the employer pays the other half. However, self-employed individuals must pay the full 15.3% on their own. This is called self-employment tax, which is in addition to any income tax you may owe. This concept is important for understanding S corporations. 

THE DBA

Some people confuse the concepts of DBAs and business entities. DBA stands for “doing business as” and is required when you are operate business under a name separate from your full name, if a sole prop or general partnership, or different from your registered business name if you have an LLC or corporation. For more info on DBAs, check out this blog.

 

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The Nitty Gritty – Understanding Each Entity

THE DEFAULT ENTITIES - SOLE PROP AND GENERAL PARTNERSHIP

If you earn self-employment income, have no business partners, and have not formed any legal entity, you are a sole proprietor. Forming a sole proprietorship is easy and flexible because the law places few rules on the management of sole proprietorships. However, sole proprietorships offer no liability protection, so this default option is generally not advisable. Like a sole proprietorship, a general partnership is a default entity. The difference is a partnership involves more than one person. Both of these are pass-throughs, which means the business income carries straight to the individual owner/s’ tax returns. 

 

LIMITED LIABILITY COMPANY (LLC)

 

LLCs are hybrid entities. – they take some of the good parts from corporations and combine them with the favorable aspects of sole proprietorships and partnerships. An LLC can be owned by one individual (typically called a single-member LLC) or it can be owned by multiple individuals. Income from an LLC is taxed in the same manner as sole proprietorships and partnerships. It is a pass-through entity, so there is no double taxation. LLCs are the most popular choice for small businesses because it offers personal liability protection.


SIDE NOTE - DETAILS FOR TAX SEASON

When it comes tax time, single members LLCs are quite simple as the process is nearly identical to that of a sole proprietorship. Income and expenses go onto an IRS Form Schedule C. Multi-member LLCs and partnerships are a bit more difficult. Unlike the single member businesses, these entities must first complete a business/partnership return. 

The reason why is that the owners need a way to split up the income and expenses between themselves. That is done through issuance of a form K-1. These are like 1099s or W-2s but for owners of co-owned businesses. The business return will show total income and expense. Each of those items is then split according to each owners’ percentage ownership in the biz. Then, those shares get put on a K-1. Each owner takes their K-1 and inputs that info onto their return.

Example: Lauren, Braden, and Michelle are each 1/3 owners of Start Up Guide. Start Up Guide nets $9,000. The business tax return shows $9,000 of income and issues three K-1s, each with $3,000 of income attributed to the one-third owner. Lauren, Braden, and Michelle then input that K-1 on their personal tax returns showing $3,000 in income from Start Up Guide.


C CORPORATIONS

C corporations provide liability protection and offer the best means of raising capital through investors and/or stock sales. Another benefit is the ability to cover stock options for employees. However, C corporations are subject to double taxation and also require each of the corporate formalities noted earlier. For example, forming a corporation may be a good choice for a product-based startup that needs to raise significant capital for manufacturing. The formalities include things like bylaws, annual meetings, and stockholder requirements. These are not too cumbersome but generally do require professional legal help.


S CORPORATIONS

It is helpful to think of an S corporation as a tax status instead of an entity. First, you select a type of entity (LLC and C corp). Then, you can elect to be taxed according to “subchapter s” of the tax code. The business will get the liability protection provided by the underlying entity, but receive the tax treatment of an “S corporation”. An S corporation can also be termed a business that makes an S-election. (Personally, I think we should call them S LLCs and then S Corps to distinguish, but I digress).

Choosing the S election may save you tax dollars, specifically self-employment taxes. As an owner of an entity making an S-election, you are treated as both an employee and shareholder of the business. As an employee, the entity pays you a salary, and as a shareholder, the entity pays you distribution. The salary is subject to both self-employment and income tax while the distribution is only subject to income tax – dividends are not considered self-employment income.

For multi-member businesses, there are some complicating factors with S corps dealing with “different classes of stock.” S corps also require payroll, so there are some important considerations to make before making the S election decision.

I have a comprehensive blog post on when it’s the right time to consider forming an S corp. You can check that out here.

 

Operating Agreement

Many business owners are beginning to use services like Legal Zoom or going with a DIY method to form their entity. However, most online services do not include operating agreements, which are an important part of forming your entity. At a minimum, I would recommend paying to consult with an attorney on which entity to choose and what you can do on your own. My recommendation to save some $$$, but get everything you need would be to grab chapter two of SBSUG. Read the chapter and create an action plan. Then, consider consulting a lawyer. If you want to chat with me, you can find my legal services and fees here.

Conclusion

Ultimately, choosing an entity is a specific and personal decision. First, you should consider your business goals and do a formalized planning process. Be sure to consider the following factors:

  • Your liability risk tolerance and exposure

  • Whether you plan to have employees or business partners

  • Whether you will need investors or loans

  • Your overhead and startup costs

  • Which tax classification is best

  • Whether you are willing to meet many formal requirements and do paperwork

  • How do you plan to scale your business?

A business plan aiming to manufacture and sell luxury handbags nationwide will have very different demands than a plan to sell homemade cookies that you bake on the weekend. In order to ensure you have the correct entity, complete a thorough business planning process and consult an experienced attorney.

 
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