Probably the most important thing that you can do in your business is structuring correctly. Luckily for you, there are a plethora of choices that you can make on how you structure your business. In this post I would like to demystify the different entities you can choose from. We’ll start with basic structures, and then get into more complex structures.
The first most basic entity we start with are sole proprietorships. Sole proprietorships are very easy to form, and maintain. All you have to do is have an idea, and maybe get a business license, and you’re in business. The tax filing requirement for a sole proprietorship is just adding a separate schedule to your 1040 form. The problem with a sole proprietorship is that you have full legal liability, and taxation. For instance if somebody sues your business, they would be suing you. There’s no separation between the business and you personally. Then when it comes to taxation, you have to pay self-employment tax on your earnings in addition to income tax. Self-employment tax is 15.3%. As you can see, it’s not the best of scenarios.
Partnerships, would be another entity choice if there is one or more person. Partnerships don’t pay tax. They file a tax return, but they are known as pass-through entities. The income, or the losses pass through to the partners to be claimed on the partner’s income tax return. When it passes through, it is subject to self-employment tax in addition to income tax. Further, there is full legal liability in a partnership. Like a sole proprietorship, there is no separation between you and the business.
Corporations are another entity choice. With the corporation you enjoy limited legal liability. What that means, is that if somebody sues the corporation, they can only go after the assets of the corporation and not your personal assets. When it comes to taxation, you can choose between a C-Corporation or an S-Corporation. C-Corporations pay tax at the federal, and sometimes state level. When you take money out of the corporation, you are taxed again. This is known as double taxation.
S-Corporations don’t pay tax. The profits and the losses flow over to the shareholder to be claimed on the shareholders personal tax return. Much like a partnership. However, when the income flows over, you don’t pay any self-employment tax on the earnings. That is the main benefit to an S-Corporation. The problem with corporations is that they are very rigid and there are rules you have to follow. For instance, every year you have to have a Board of Directors meeting, and follow certain guidelines and running your Corporation. That is the downside to forming a corporation.
Limited Liability Companies (LLC), are a hybrid between a partnership and a corporation. LLCs enjoy limited legal liability, meaning if the LLC is sued, just like a corporation, they can only go after the assets of the LLC, and not your personal assets. The best part of an LLC, is that it is very flexible, unlike a corporation. With an LLC, you don’t have meetings every year, and you have a very powerful document called an operating agreement where you can set guidelines on instructions of how to run your LLC. When it comes to taxation, LLCs are very flexible. You can be taxed as a sole proprietorship, partnership, C-Corporation, or S-Corporation, and it doesn’t change the fact that you are an LLC.
These are the basics of entity structuring, in my next post tomorrow, we will get into the intricacies of how these entities work with each other, and where to incorporate.
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