At Incite Tax, we do our best to not use acronyms or industry jargon that others won’t understand. After all, we are tax geeky and we spend all day doing this stuff. Our clients spend all day running their business.
When it comes to the type of business structure you should have, also known as entity type, there are some terms you need to know even if they sound like jargon at first. So we are just going to go over the basics of the common ones. It isn’t our intention in this post to discuss the in’s and out’s of the tax consequences of each type.
It’s also important to note that you setup your business with a state and you get an EIN (Entity Identification Number) from the IRS. Those are two separate systems that don’t talk to each other very well.
Sole Proprietor – This is the default status given to you by the IRS if you go into business without setting up any other type of entity. In this scenario, you are operating your business under your SSN. There are no advantages to this structure. It’s the dumbest thing you could do as a business owner because it’s the worst tax outcome and your legal risk is not protected at all. Your business activity is filed on Schedule C on your 1040 personal return.
Single Member Limited Liability Company (SMLLC)– A SMLLC is when you setup an LLC with a state and you are the 100% owner of the LLC. So there is only one single member (member is a common way to refer to an owner of an LLC or Partnership), as opposed to two or three owners. The “single” doesn’t refer to your marital status. So it is essentially an LLC with a single member, thus its name. You do apply for an EIN with IRS for this one and all the others described below. (Here’s the IRS website if you want to do it right now. https://sa.www4.irs.gov/modiein/individual/index.jsp)
From a tax standpoint, the outcome is not that different from being a sole proprietor (which isn’t a good outcome). You file on a Schedule C on your 1040 personal return. But you do get better liability (legal risk) protection. Some tax strategies work very well with a single member LLC so they aren’t all bad.
Limited Liability Company (LLC) – An LLC is only different from a SMLLC in that it always has more than one member (owner). It can have two or more. And by more, we mean as high as or higher than billions. We personally wouldn’t want to go into business with a billion partners though so you should always keep that in mind. (Too many chiefs and not enough Indians probably.)
For tax purposes, an LLC by default will file a 1065 partnership return. The LLC doesn’t pay income tax. The members claim their portion of the taxable income on their personal returns and pay income tax based on their individual income tax bracket.
Partnership – Very few people set up an actual partnership these days. When you hear someone say a partnership, they are probably referring to an LLC which we described above.
S Corporation – An S Corporation is called an “S” Corporation because Subchapter S of the tax code defines its tax rules. An S Corporation can have only one shareholder or have up to 100 shareholders. (LLCs have members and Corporations have shareholders. Both refer to owners).
To complicate matters, you could actually setup an LLC with the state, but still file as an S Corporation with the IRS. (What the bananas? If this is the first you are hearing about it, the tax code is confusing and in some places has no rhyme or reason or logic to it.) The reason is that there is no direct way to setup an S Corporation with the IRS. You either setup an LLC or you setup a C Corporation and then file a form with the IRS telling them you want to be treated as an S Corp.
An S Corp files an 1120S form. The S Corp doesn’t pay income tax either. The members claim their portion of the taxable income on their personal returns. S Corps are more complicated than an LLC because a shareholder-employee (a term IRS uses to describe an owner who works in his business) HAS to receive a reasonable wage. This means quarterly payroll tax return filing.
In my experience, if your business net income is more than $5,000 per year, the extra complication for having an S Corp is worth it. Sometimes I’ll have a new client come in and say their previous accountant told them the net income should be $40,000 or $50,000 before an S Corp makes sense. HORRIBLE ADVICE! FIRE THAT ACCOUNTANT IMMEDIATELY!
All the entities described above are known as flow through entities. They are called “flow through” because the income tax responsibility flows through to the owners at an individual level.
C Corporation – Also known simply as a corporation. A corporation can have unlimited shareholders like an LLC can. The biggest thing that sets apart a corporation is that it pays its own income tax. (Which can be a very high tax bracket.) If the shareholders want to distribute profits, the owners then pay income tax on what they received. This is known as double taxation. A corporation files an 1120 form.
An example. The corporation made $75,000 profit. It pays corporate tax on $75,000. Then it distributes this profit to the shareholders. The shareholders than pay capital gains tax on the $75,000 dividends. This can put the tax burden on this money at 50% tax.
For most small businesses, a C Corporation doesn’t make sense. But there can be situations where a C Corp is a great idea.
If you have questions about any of these entities and how they relate to your specific situation, call us at 801.999.8295 or email us at email@example.com