By: Iliana Rozon-Liz and Beth Gaasbeck, CPA, MBA
When starting a new business, selecting the proper entity structure is one of the first, and most important, decisions a business owner must make. Converting an existing business to a different entity type could be time consuming, costly, and result in unintended negative tax consequences, so it is best to carefully consider your options up front. In today’s blog, we will explore some of the defining characteristics of common business entity types, including the number of owners the business can have, the degree of personal liability you will have from the business, and how you can fund the business.
A deeper dive into the different entity types leads to how your choice between these business entity types will affect the answers to these questions:
- How can I get paid from my business?
- How will my business’s income be reported and taxed?
- How will I fund my retirement or health insurance now that I own my own business?
Let’s begin by defining the common entity types:
As implied by the name, a sole proprietorship is a business with one owner. It is the easiest and most affordable way to organize a business because there is no separate legal entity created, and no other business owners to consider. With the ease of choosing this flexible structure comes drawbacks. Without a separate legal entity or other owners, the sole proprietor is personally liable for 100% of any business debts and could lose their personal assets to satisfy claims against the business unless they form a single member LLC (discussed further below). As the only owner, funding for the business is limited to personal income, assets, and debt, but it is easy to transfer assets in and out of the business.
A partnership is a business with more than one business owner. When forming a partnership, consult with an attorney to draw up a partnership agreement to document policies such as how income and losses should be allocated, who is responsible for the management of the partnership, what happens to the business and its debt if one partner wants to leave, how a partner may be fired or removed, how partners may be added, how partners get paid, and how the business would be divided if dissolved.
Partnerships can be limited partnerships (LPs), limited liability partnerships (LLPs), and general partnerships (GPs), each of which provide business owners with a different level of personal liability protection. General partners are usually involved in managing the business and are personally liable for the partnership’s debt and business activities. Limited partners are protected by limited personal liability, but they also have limited control over the business. Since partnerships must have two or more owners (or partners) that usually contribute cash or other assets in exchange for equity in the business, they offer more sources of capital than sole proprietorships. The rules for transferring assets in and out of a partnership are less flexible than they are for sole proprietors, but non-cash assets can generally be distributed out partnerships without the partnership recognizing a gain on the unrealized appreciation of the property.
A corporation is a legal entity that is separate and distinct from its owners. Ownership in corporations is issued to its owner(s), commonly called shareholder(s), in stock shares that can easily be bought and sold to raise capital or transfer ownership. While corporations offer the strongest protection to its owners from personal liability, they are the costliest and time-consuming business entities to form and maintain. Corporations must file articles of incorporation, elect officers and directors, hold annual board meetings, and document minutes. Further, non-cash assets cannot be easily transferred out of a corporation without recognizing income on the appreciation of the assets as if they were sold.
Corporations can be organized as either C-corporations (C-corps) or S-corporations (S-corps). While C-corps and S-corps share certain attributes, including the same level of personal liability protection, there are several important differences to consider when deciding which type of corporation is best for your business. For example, S-corps cannot have more than 100 shareholders, and those shareholders cannot be C-corps, other S-corps, LLCs, partnerships, or many types of trusts. C-corps can have an unlimited number or type of shareholders and can choose any fiscal year that best suits their business, but S-corps generally must use a calendar tax year.
Limited Liability Companies (LLCs)
Limited Liability Companies, or LLCs, are a popular entity choice because they offer limited liability to all owners and have flexible ownership structures. Businesses organized as LLCs could fall under several of the business entity classifications discussed above depending on the number of LLC owners (or members) and how the LLC elects to be treated for tax purposes. LLCs that have only one owner, which are commonly called single or sole member LLCs (SMLLCs), are generally classified as disregarded as entities separate from its owner and are treated like sole proprietorships for tax purposes. Multimember LLCs are generally classified as partnerships for tax purposes. Both multimember LLCs and SMLLCs can also elect to be classified as either C-corps or S-corps for tax purposes.
How Will I Pay My Business’s Taxes?
People often think starting your own business is difficult because of the tax reporting requirements, but that need not be the case. There are no separate income tax filing requirements for sole proprietors (and SMLLC owners taxed as sole proprietors). If you choose this entity type, you will report your business income directly on your personal income tax return in the year the income is earned. However, there is a catch. Because sole proprietors do not take wages (which we will get to in a moment), their business income is subject to an additional 15.3% self-employment tax (SE Tax) for contributions towards Medicare and Social Security.
Partnerships and S-corps must file a separate tax return to report income earned each year, whether or not any distributions are paid to the owners. These entity types are often called “pass-through entities” because the income (or loss) reported on the partnership or S-corp tax return is not taxed at the entity level when the business return is filed; instead, it is “passed through” to the individual partners or shareholders based on their ownership percentage (or, in partnerships and multimember LLCs, specially allocated based on the terms of the partnership agreement). Each owner then reports the business’s income and pays the tax on their allocated share of the partnership or S-corp income on their personal income tax returns. Like sole proprietors and SMLLC owners, partnership income for general partners and limited partners active in managing the partnership is subject to the 15.3% SE tax. S-corp earnings are not subject to SE tax.
C-corps also must file a separate tax return to report the income earned each year. Unlike the pass-through entities described above, C-corps are subject to tax on the business’s earnings at the entity level. A C-corp shareholder will not be subject to tax at shareholder level unless they receive a distribution of the corporation’s earnings, as we will discuss in the next section. Most publicly held companies are C-corps.
How Can I Get Paid?
How will you get paid now that you are a business owner? Since sole proprietors (and SMLLCs) are not recognized as entities separate from their owners, business owners that choose that structure cannot pay wages to (or receive wages from) themselves. Instead, they are paid by taking distributions of taxable income from the business. The distributions are not separately taxable.
As a partner in a partnership (or a member of a multimember LLC taxed as a partnership), you are entitled to tax-free distributions of earnings if you have basis in your partnership investment and the terms of the partnership agreement allow for you to receive distributions. Partners that perform services for the partnership can receive compensation besides distributions, but IRS rules do not allow for payments to partners in the form of wages; instead, partners are paid “guaranteed payments” as taxable compensation. Like the income of a sole proprietor and a partner that is active in managing the partnership, guaranteed payments are subject to the 15.3% SE Tax in lieu of contributions towards Medicare and Social Security.
An S-corp shareholder also may receive tax-free distributions of earnings if they have basis in the S-corp stock; but unlike partnerships, distributions must be paid to all S-corp shareholders based on their pro-rata ownership percentage. S-Corps also differ from partnerships because shareholder/owners actively involved in running the business must take a reasonable salary. This is why a shareholder’s allocated share of S-corp earnings is not subject to SE tax like it is for a partner that is active in managing a partnership.
Like S-corp owners active in management, C-corp owners also may take wages as compensation for services provided. Unlike S-corp owners, C-corp shareholders are NOT entitled to tax-free distributions of earnings. Most people have probably heard the phrase “double taxation” used when referring to C-corp taxation. Double taxation occurs because the business’s income is first taxed at corporate or entity level at a flat rate of 21% under the current law. Earnings are taxed a second time when paid out to C-corp shareholders in the form of taxable dividends. An S-corp is often favored over a C-corp because of this double taxation, but consider how your tax rate as an individual shareholder (for S-corp income allocated to owners) compares to the flat 21% tax rate of a C-corp.
What About Health Insurance and Retirement Plans?
If you are used to getting paid wages from your employer, you probably participate in health insurance and retirement plans sponsored by your employer. Now that you will be the business owner, what are your options for funding your health insurance and retirement?
For sole proprietors, partners in a partnership, and shareholders that own over 2% of an S-corp, health insurance premiums are not a direct deduction against business income. Sole proprietors can deduct the insurance premiums on their personal income tax returns to the extent of their wages or self-employment (SE) income. Health insurance premiums paid by a partnership on behalf of a partner are treated as (taxable) guaranteed payments to the partner. If the partner is not eligible to participate in any subsidized health plan maintained by any employer of the partner (or partner’s spouse) and that partner has net SE income on their personal tax return, he or she can also deduct 100% of the health insurance premiums paid by the partnership on their individual tax return. Health insurance premiums paid by an S-corp on behalf of a greater than 2% S-corp shareholders can also be deducted on their individual tax return if the cost of the premiums is added to the shareholder’s W-2 as taxable wages. Conversely, a C-corp can deduct the health insurance premiums paid by the corporation for a shareholder, including the shareholder’s spouse and children, without the shareholder being taxed for the payments.
How can you save for retirement once you own your own business? Business owners can fund their retirement by establishing several types of retirement plans, including 401(k) plans, a Simplified Employee Pension (SEP) or SIMPLE IRA plans, and a cash balance plans. Sole proprietors who establish a SEP IRA, a SIMPLE IRA, or an individual 401k plan can contribute to their plan are based on a percentage of their net SE earnings (capped at a certain amount).
Partnerships and corporations (S-corps and C-Corps) can establish various types of retirement plans that both qualifying owners and employees of the business can participate in. It is important consider the number of eligible employees your business has when choosing the right retirement plan. Partners and shareholders cannot set up their own qualified plans independent of the partnership or corporation, so company plans must allow all eligible employees of the partnership to participate in the plan and receive employer contributions. Since a partner cannot receive wages from the partnership, retirement plan contributions for a partner are based on their net self-employment (SE) income from the partnership, which can come from either guaranteed payments for services or allocations of partnership income subject to SE tax. Shareholders in a corporation must receive wages as employees to contribute to their retirement plans.
While there are other factors to consider when deciding which entity is right for you, we hope this primer gives some insight on the important topics to consider when choosing which entity will benefit you the most. If you are a business considering an entity choice change, call on us as this road can be particularly tricky. The Tax Warriors® at Drucker & Scaccetti are always prepared to help.