Business Owner "Cheat Codes" forming the Right Entity

As far as taxation is concerned. Different entities have different tax treatment. Corporations are taxed at the corporate and the individual level, often called double taxation. A Small Business Corporation, referred to commonly as an S-Corp, gives business owners the benefits of owning a corporation but eliminates double taxation by taxing the business owner (shareholder) directly instead of the Corporation. The shareholders of the corporation are liable for the business income, losses, deductions, and other tax items. 

There are a few different types of entities that we can easily break down to determine which will be best for you and your business. These include the LLC, S- and C- corporations which are the most protected and common entities. Other Entities like partnerships, and sole proprietorships offer less protections and usually a risky way to go if operating anything more than a “side hustle”. 

A sole proprietorship is a one-person business entity that does not need to register with the state, unlike other types. Anyone who runs a casual online small business on their own could be considered a sole proprietorship. Meaning, your friend with the successful Etsy business who works alone from home is actually, knowingly or not, the owner of a sole proprietorship! You might be wondering what I mean exactly when I say, “knowingly or not.” To clarify, a small one-person sole proprietorship business would not need to register with the state like an other type of entity would, meaning technically anyone can just start their own small business and this is just how the business would legally be classified. These are usually self-employed individuals who are the only owners of their business, and the entity is often called a “pass-through” entity because the income earned is usually available to the owners as income on their own tax return. Additionally, these business owners are liable for the business’s liabilities. In this case, unlike with corporations or LLCs, the owner and the business are considered the same person under the law. Therefore, if their company is served a lawsuit, the owners themselves would be legally responsible for the suit, rather than a different legal representative. 

The next type of business entity is the partnership. A partnership is similar to a sole proprietorship except for the fact that it is organized between two or more individuals. These are also considered to be “pass-through” entities, as income from the business is split between the partners and they will pay personal income tax. Partners will also be responsible for business liabilities. In the case of the business being served, both partners would be legally responsible, just as in a sole proprietorship, because the partners are not classified as different entities from their business under the law. Additionally, a partnership can end for a couple different reasons. If a partner dies or chooses to exit the partnership, the entire partnership is automatically dissolved. 

The fact that owners are liable can make partnerships and sole proprietorships a troubling choice for some business owners. If you are operating under either of these entity classifications, you are not separate from your business, and will be treated by the law as the same person. Therefore, if your business is to be sued, it is also YOU personally who is liable. 

Corporations are the next major category of business entity, and there are a few subcategories from there. A broad definition of a corporation is that it is an independent business entity in which the business is a separate person from its owners under the law. Owners of this kind of business are called shareholders. Typically, shareholders earn a share of the business’s profits in exchange for investing in the corporation. Corporations usually must follow certain expectations to maintain their status as a separate business entity, including but not limited to electing a board of directors, holding annual meetings, and creating articles of incorporation. Corporations undergo “double taxation” because they are taxed at an entity level as well as when profits are distributed. For example, if you have a corporation that makes $100,000 in profits, then that $100,000 would be taxed at the corporate level as an income tax. If you distribute the profits to the corporation’s shareholders, they will also be taxed at the personal level for taking the distribution.

Now that we understand some basic corporation rules, we can dive more specifically into subcategories of them. The Internal Revenue Code lists two types of corporations: C-corporations, which are taxed separately from their owners, and S-corporations, which are treated as pass-through entities for taxation purposes. S-corporations are not legal entities and are simply classification for tax purposes. Now, let’s look back on our earlier example. Recall the business that made $100,000 in profit? To apply it specifically to an S-corporation, instead of taxing the corporation when they make the $100,000, you’d tax the shareholder personally. When the shareholder takes the distribution of that money, they are not taxed once because they have been taxed personally. They get around the double taxation of the C-corporation. Therefore, the S-corporation is the more tax-friendly legal entity. 

What about LLCs? LLCs are very similar to S-corporations but are not recognized on the federal level, nor for tax purposes. Rather, they are recognized differently in every state, having different definitions of what they can and cannot do. You as the business owner can choose how you want to be taxed as an LLC. For example, if you are a single member, it is taxed like a sole proprietorship, while if your LLC is multi-member, it will be more like a partnership. You can also request to be taxed as an S-corporation by applying to the federal government, something many business owners opt to do as it is the most tax-friendly. LLC gives you the limited liability of the corporation but there aren’t as many rules to follow, making it easier to maintain.

There you have it! A quick(ish) guide to all things business entities. It’s important to note that this is a very general guide. Before deciding which entity is best for your business you should speak to a business attorney as well as a CPA. Not all entities are created for all businesses. For example different states have different rules regarding certain professions and certain business can become. For example, in California registered nurses are not allowed to create LLCs for their entitles, they must be professional corporations. Some states don’t allow attorneys to have LLC’s as their entity. Sometimes there are industry restrictions. This is common in the insurance industry where agents who wish to create an entity must follow certain rules passed down from their corporate headquarters.

We want to help you build the business of your dreams. That starts with having the right entity for your business. Give us a call at (855) 781-7705 to get started today. 

The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.