Choosing Your Legal Entity

Other than deciding to go into business, the first and most important decision a new businessperson can make is choice of entity. By this I mean, do you want or need to operate your business as a sole proprietorship, partnership, C Corporation, S Corporation, or Limited Liability Company. Which one your decide is based on the number of owners, your exposure to liability, simplicity, and need for tax savings.

A sole proprietorship is the simplest form of entity. Only a business with one owner can operate as a sole proprietorship. It usually takes no licenses or legal involvement to start a sole proprietorship. Any income and expenses from this form of business are reported on the owner’s individual tax return using Form 1040 Schedule C. While it simple to start, it gives no protection from legal liability and is perhaps the most costly from a taxpayer’s point of view. Everything you earn as a sole proprietor is subject to self-employment tax (15.3% of your net income). I advise my clients who operate as a sole proprietor to plan on giving about 1/3 of their net earnings after expenses to the government in the form of taxes.

A partnership operates very much like a sole proprietorship, except for these differences. To have a partnership, you must have two or more owners., and partnership papers must usually be drawn up. While this can be done by the partners, it usually requires an attorney to do it right. The partnership must file a Form 1065 annual to report its income and expenses. Partnerships require more sophisticated accounting and this adds to the cost of tax preparation. The exposure to liability is the same as in a sole proprietorship and most all income earned by a partnership’s operations is subject to self-employment tax. One other point to remember is that if a partner dies, the partnership ceases to exist, an occurrence, which can have major tax consequences.

With a corporation, there is a continuous life even if shareholders die or otherwise come and go. Like a partnership, corporations are usually best set up by an attorney but you can do it yourself if you are so inclined. Corporations give protection from liability but do require sophisticated double entry bookkeeping and can be costly to prepare.

All corporations are set up and operated the same, but how they are taxed depends on your choice. A C corporation pays taxes on its earnings at the corporate level. If it has losses in its first years, it can’t use them until it makes a profit. It can be difficult to get money out of a C corporation, but the C corporation offers a chance to pay and deduct employee benefits and perks.

An S corporation does NOT pay taxes itself. It’s income flows through to the individual shareholders and is reported on their individual tax returns. If there are losses in the early years (or later years), these losses can be offset against the other income the individual might earn (with certain restrictions). The primary benefit to an S corporation other than the above is that you can limit and manipulate the amount of taxes subject to payroll taxes and/or self-employment taxes. By paying charitable contributions, health insurance and retirement plan contributions out of the S corporation, you get deductions but avoid paying self-employment taxes like you would in a sole proprietorship. You can also control payroll taxes by splitting income in wages and distributions of profits. Distributions are similar to partner or sole proprietor draws but are not subject to payroll taxes.

A limited liability company (LLC) can be either operated as a partnership or as a C corporation. This entity was invented mainly to give protection from liability for its members (similar to a corporation) but allow a large number of members to participate. They are expensive to set up and have a limited life.

To choose the best form of entity for your requires much thought as to your priorities. Each entity has its benefits and drawbacks. Some are simple, some are costly to setup and operate. Some give protection from liability and some don’t. When it comes time to set up your new business, I recommend visiting with a CPA with experience with small businesses or an small business attorney. Shop around. It’s worth it.

-Mark E. Edgar, CPA