To incorporate or not to incorporate, that’s the question.
The business structure you choose – sole proprietor, LLC, S-Corp, etc. – has a tremendous impact on how your company operates and pays taxes.
The IRS requires you to select an entity type for your business. This choice determines the what, when, and how of your business taxes. It also determines the level of asset protection and owner liability you will be exposed too. The entity selection process is one instance where you must consult a professional.
If you’ve already formed a company and have been operating as one of these entities, you should periodically re-evaluate your status to make sure you wouldn’t benefit from an organizational entity change that could save you money in the long run.
Here are the most common business structures and some of their features.
Whether you’re selling handmade items on Etsy, creating + selling kick-ass content for other business owners to consume, or working as a solo professional such as a lawyer or real estate person you’re most likely a sole proprietor (though you have other options). While you may have taken this route so you could be your boss, there are drawbacks, including the fact that you are 100 percent responsible for your company’s liabilities. You may also find it difficult to get financing or will have to guarantee credit personally.
The IRS defines a sole proprietor as “someone who owns an unincorporated business by himself or herself.” If you fit this definition, and you netted (cash you brought in minus business expenses) more than $400 as a self-employed person for the year, you’re required to file a Schedule C with your Form 1040 (your personal tax return) that details your income and expenses for a particular business activity. If you are operating multiple businesses as a sole proprietor, then you must complete a separate Schedule C for each business.
Since you are your employer, you must pay Self-Employment Tax and Medicare and Social Security taxes that your employer would usually pay for its employee. You are also required to send in quarterly estimated taxes towards your next tax bill.
Your return is due April 15th, and you will only file one return for personal and business.
Note: Even if you have an employer who issues you a W-2 form, you must still complete a Schedule C for any side businesses you have.
Limited Liability Company (LLC)
Individuals (and other business entities) can also structure themselves as LLCs or Limited Liability Company. The regulations for LLCs vary by state, and tax obligations are a little more complicated than for a sole proprietorship.
LLCs are pass-through entities which mean the business does not retain any profits within the company. Any profits or losses pass through to the member(s). There is no tax imposed against the LLC at a Federal level.
A single member LLC (meaning one owner) will be treated by the IRS as a sole proprietor for tax purposes, technically termed a disregarded entity. You would follow the same filing requirements as a sole proprietor.
Conversely, a multi-member LLC (having more than one owner) will be treated as a Partnership for tax purposes. A partnership tax return, Form 1065, is required to be filed with the IRS by March 15th. Note this date goes into effect starting with the 2017 filing season. Each member will receive a Schedule K-1 listing their portion of net income or loss which is filed with their personal return.
Either way, an LLC can elect to be treated as a corporation by submitting the proper forms to the IRS.
Businesses that choose this structure are generally larger companies with many employees. Since the company functions as a separate legal entity, no individuals are subject to personal liability. They file the IRS Form 1120 (among other documents) and can sell stock in the company to raise revenue.
On the downside, C Corporations have complex administrative requirements. They must pay corporate tax, and their shareholders pay tax on dividends on their returns. Yes, double taxation exists in this structure. This is a very unusual entity choice for small business owners.
Another popular choice for a small business is an S-Corporation. The S-Corp, as it’s referred to for short, provides some of the same benefits of a regular or C Corporation such as being a separate legal entity. The shareholders or owners are not personally liable for business debts. Be careful not to pierce your corporate veil by commingling personal and business monies. An S-corp is a separate entity and should be treated as such. Separate bank accounts. No personal transactions in the business account. The owner is paid reasonable compensation if active in business operation. I can’t stress enough. Keep. It. Separate.
When it comes to taxes, S-Corps file a separate return called Form 1120S which are due March 15th. The corporation, itself, does not pay corporate taxes. Like LLCs, S-Corps are pass-through entities which mean the business does not retain any profits within the company. Any profits or losses pass through to the owner(s).
Partnerships – and there are multiple types – are very complex entities. They consist of two or more individuals who are not considered employees, but who are personally liable for the partnership’s debts and other obligations.
The partnership itself is not required to pay income tax like corporations. Rather, they file a Form 1065 to report income, deductions, etc. Profits or losses are then “passed through” to the partners, who file Form 1040 as if they were sole proprietors, but who must attach a Schedule K-1 to the 1065.
Time to Decide
I hope you were able to see in this brief post that the business structure you select has enormous influence on your income tax obligations and your personal liability. Before you make a decision, or if you’re considering changing an existing structure, let me walk you through all of the possible choices for your company.
Better yet check out LJ Consulting. This is his thing!
I’m curious to know how did you decide what entity to form your business? Let me know in the comments
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