Starting a business and seeing it ramp up is a stressful but exciting process! Exciting because you’re probably very passionate about what you do and excited to serve your clients and generate income for you to achieve your personal goals and lifestyle.
It is stressful because now you are faced with decisions like whether to form a corporation or LLC and when to do this.
The goal of this resource is to help you understand some fundamentals around:
Let’s get started.
This decision for what type of entity you should or should not form goes far beyond initial paperwork that needs to be filed. The type of legal structure you have significantly impacts your tax obligations, the protection of your personal assets, and even the potential for future growth.
Before making the decision on what type of entity is needed, you should fundamentally understand and be able to share with a qualified professional these things:
Will this be for rental or passive income? Will this be for active income (service based business such as consulting, construction, medical services, etc.)
Full disclaimer (again) here: We are not attorneys and this is a conversation best had with an attorney who specializes in business entity formation and compliance. To help you prepare for this conversation, you should have a list of things that you are concerned about for liability and be able to articulate that to the attorney to get their opinion on how a legal entity may or may not provide that protection you are seeking.
Are you growing a business that will be scaled and grow beyond yourself and a small team? Are you building a business that will seek outside investors? Are you intending on having business partners? Understanding the general scope of how you are growing your business can impact what type of business entity you choose.
Different business entities come with unique tax implications, liability protections, and regulatory requirements. Here’s an in-depth look at the most common types:
The simplest and most common business structure, a sole proprietorship, is owned by a single individual. There are no requirements for filing paperwork with your Secretary of State and you can even use your social security number as the business tax identification number. There is no legal separation between the individual and the business and while this simplicity is appealing, it also means that you are personally liable for all business debts and obligations. You report your business income and expenses on your personal tax return using Schedule C.
The net profits of the business are included in your total income to be taxed at your marginal tax rate. Additionally, all profits are subject to self-employment tax, which includes Social Security and Medicare, currently totaling 15.3%.
Example: If you’re a freelance graphic designer operating as a sole proprietorship, your earnings are taxed as personal income, and you’ll pay self-employment tax on the entire amount.
If you were single with no dependents on your tax return and your net profits were $80,000 then your tax situation would look something like this (based on 2024 tax rates & standard deduction amounts):
|
Marginal Tax Rate |
||
|
Taxable Income |
60,030 |
|
|
Federal Income Tax |
9861 |
22% |
|
Self Employment Tax |
12240 |
15.30% |
|
Total Taxes |
22101 |
|
|
Total Income |
$80,000 |
|
|
Less Taxes |
-$22,101 |
|
|
Net Profits Left |
$57,899 |
That’s a very large tax bite! And that does not include any State Income Taxes if you live in a state that has an income tax.
As your business grows, this structure could become less tax-efficient, prompting you to consider other options. However, there are instances where staying a sole proprietor is either required by your state laws or makes the most sense for the business niche.
A partnership involves two or more people who share ownership of a business. Partnerships file an informational tax return (Form 1065), but the business itself doesn’t pay taxes.
Instead, income and losses pass through to the partners, who report their share of the profits or losses on their personal tax returns using Schedule K-1.
This pass-through taxation is beneficial, but partners must pay self-employment tax on their share of the income unless the income is classified as passive.
Generally speaking, a partnership is best suited for passive income sources such as rental and investment properties, etc.
Example: If you and a colleague form a law partnership, the firm’s income will pass through to both of you based on your ownership percentage. This income is subject to self-employment tax, which can be substantial if the firm is profitable.
The example provided above in the Sole Proprietorship illustration of the tax burden is identical to how a partnership tax scenario would play out.
An attractive feature regarding partnerships is that the partnership structure can allow for flexibility in income distribution among partners, which can be beneficial for tax planning. These can be done through special allocations as agreed in certain circumstances and scenarios.
Limited Liability Companies (LLC’s) fall into the classification of either “Single-member” meaning there is only one member or owner of the LLC or Multi-Member meaning there is more than one member or owner of the LLC
A Single-member LLC is treated as a “disregarded entity” for tax purposes, meaning the IRS views them similarly to sole proprietorships, with income and expenses reported on Schedule C.
Multi-member LLCs are treated like partnerships for tax purposes, filing Form 1065 and distributing income to members via Schedule K-1.
Both single and multi member LLC’s income are subject to the Self Employment tax (unless that income is passive income) and the tax illustration provided above for Sole Proprietors and Partnerships is the same for LLC’s (both single and multi-member).
Personal Liability protection is one of the main advantages of forming an LLC is the limited liability protection it can provide. Members are generally not personally liable for the LLC’s debts and obligations, although they are still liable for their personal actions and any negligence.
A C-Corporation is a separate legal entity from its owners, meaning it pays corporate taxes on its profits.
Shareholders then pay taxes on dividends received, resulting in double taxation. However, C-Corporations can offer more significant tax benefits, such as deducting a wide range of employee benefits and reinvesting profits into the business.
Example: A tech startup that plans to reinvest its profits into research and development might choose to operate as a C-Corporation. By reinvesting earnings, the company can reduce or even eliminate its taxable income, potentially deferring taxes and allowing for rapid growth. However, the double taxation of dividends must be carefully considered.
The Federal Corporate Income Tax is currently a flat 21% and has historically fluctuated from as low as 1% (1910) to as high as 52.8% (1968).
This means that if your Corporation has a net profit of $100,000, then there is a $21,000 tax bill due to the IRS plus any State Taxes that may be due to the respective state where your business operates.
Any funds distributed to the shareholders of your C-Corporation are also taxed as dividends to the individual shareholders. Those dividends can be taxed as “ordinary income” at normal tax rates (anywhere from 10%-37% depending on your other income and what tax bracket you fall in) or as “qualified dividends” if those dividends meet special requirements and can then qualify for a lower tax rate at the individual level.
There is no such thing legally as an S-Corporation which can be confusing. If you approach an attorney and ask them to create an S-Corporation they will ask you if you want to be created with the Secretary of State as an LLC or a C-Corporation.
Then an S-Corporation is created by making an “election” for your LLC or S-Corporation to have your LLC or C-Corporation have the “tax status” to be treated as an S-Corporation.
This “election” is made with the IRS by filing the Form 2553.
To be an S-corporation means being granted a special status that allows profits, losses, deductions, and credits to pass through to shareholders, avoiding double taxation.
The profits of an S-corporation are also exempt from Social Security and Medicare taxes (aka self-employment tax), which makes it a popular choice for many business owners seeking to pay less in taxes.
However, shareholders must be paid a “reasonable salary" if they are involved in the business and those W-2 wages are subject to employment taxes.
This is an often overlooked area for S-Corporation owners. Many are not aware of this requirement and, therefore, fail to pay themselves the “reasonable salary” as a W-2 wage.
Example: A marketing consultant operating as an S-Corporation can pay themselves a reasonable salary, which is subject to FICA, and take additional profits as distributions, which are not subject to self-employment tax. This structure can save the consultant thousands of dollars in taxes each year compared to a sole proprietorship or LLC.
WARNING: The issue of paying a reasonable salary can be tricky to navigate and there are many misconceptions around what constitutes a reasonable salary.
As such, we have dedicated an entire resource to the issue of REASONABLE COMPENSATION, which can be found at MakeTaxesFair.com/Resource-Center. We invite you to check that resource and the associated playbook out there!
If the IRS deems your salary too low, you could face penalties, additional taxes assessed on distributions, and the danger of having your S-Corporation status revoked. These can all be ticking time bombs that you may not be prepared for. As such, it is essential to balance salary and distributions to optimize tax savings while staying compliant.
Selecting the right business entity depends on your goals, risk tolerance, and plans for the future. Here are some additional factors and situations to consider when making this decision.
A sole proprietorship might be the best choice if you’re launching a new venture and want to keep things simple. It’s a common misconception or myth that you have to have an LLC in order to deduct expenses for a business. That is simply not the case.
If you’re starting a business from the ground up, it can be a struggle to gain traction, build a client base, manage expenses associated with growth, and ultimately turn a profit.
Making the move to form an LLC can mean investing in legal formation fees (to an attorney and/or to the Secretary of State for the formation). Forming an LLC or Corporation also means incurring the expenses of the additional requirements necessary to maintain Corporate Compliance.
Once you have a business up and running, it can be relatively easy to pivot into an LLC or C-Corporation to make the S-Corporation election if that is the right move. As your business grows, the tax and liability benefits of forming a multi-member LLC or S-Corporation may become not only more appealing but also make more sense from a common-sense and dollars-and-cents perspective.
Tip: Think about where you see your business in five years. If you have strong evidence and expectation of rapid growth, it might be worth the upfront effort to form an LLC or corporation now.
A partnership or LLC is likely the best structure if your business is focused on holding and generating income from passive assets like real estate or investments.
These entities offer pass-through taxation and liability protection, making them well-suited for asset management.
Consulting with a qualified tax professional is always wise to determine whether a partnership, LLC, or S-Corporation is the best vehicle for holding your assets based on your income and liability situation.
If you’re running a business that generates active or non-passive income and generate significant net profits income, an S-Corporation can help you minimize self-employment tax while providing liability protection.
Depending on your business niche and the restrictions imposed by the Secretary of State or other governing agencies, you may have the flexibility to form an LLC or a C-Corporation to then make the S-Corporation election.
Warning!
The S-Corporation’s tax advantage is that the corporation's net profit is exempt from Self-Employment tax (the Social Security and Medicare Taxes), but you should be mindful of the IRS’s requirements regarding reasonable salaries.
The bottom line is that the IRS wants and needs to collect these payroll taxes as the government needs those dollars to fund the current recipients of Social Security benefits. Don’t fall victim to a compensation audit and make sure that you have examined the compensation of the active owners of the business through a compensation study.
While C-corporations come with the “price tag” of double taxation, there are some scenarios in which they could be the right fit for your business.
If you plan to offer comprehensive employee benefits or need the flexibility to retain and reinvest profits, a C-Corporation might be the best choice, despite the double taxation. This structure also allows for more complex ownership arrangements, which can be beneficial if you seek investors.
Tip: If you seek outside investors or eventually go public, a C-Corporation might be your best bet. However, the regulatory requirements and potential tax burden must be carefully evaluated.
Choosing the correct business entity is a crucial decision that impacts your taxes, liability, and overall financial strategy. The best structure for your business today might not be the best structure a year from now, so it’s essential to regularly review your entity choice with a tax professional to ensure it still aligns with your goals.
I once heard this: What gets inspected gets respected.
While this seems simple and maybe a little cliche, that statement has a lot of power.
As part of our standard operating procedure at MakeTaxesFair.com, we review a business owner's entity structure at the beginning of our engagement with their case, and we examine their business quarterly as part of a quarterly touchpoint system.
Where most CPAs intend to examine their client's information, we pre-set our meetings with our clients at the beginning of the year for the FULL YEAR, and the agenda for our meetings is shared with our clients ahead of time to allow time for preparation and thought to go into the meeting.
Takeaways & Action Items: