Have you ever heard the words “entity” or “entity selection” thrown out at you? This is a common topic of discussion, especially with new business owners, but even the most seasoned business owners will still have questions around entity types and entity selection.
Understanding what type of business you’re running (or what type of business you should be running) will help you immensely when it comes to taxes and legal protection. And more importantly, you want to make the best selection for YOU!
Entity selection
Before you can know which entity type you should choose, let’s talk about what entity selection means for your business.
When you register for an LLC (Limited Liability Company), for example, with your Secretary of State, you are registering the business name. Once you have registered the business name, you can then apply for an EIN (Employer Identification Number) with the IRS. Your EIN is like a SSN (Social Security Number) for your business.
When you apply for your EIN, the IRS defaults you to a specific income tax return filing based on the information you have provided in your application. For example, one owner versus multiple owners could be the difference between defaulting to a Sole Proprietorship or a Partnership, respectively.
Entity Types: Small business entities
Let’s talk about the different entity types you can select. Some of the main terms you tend to hear thrown around are Sole Proprietorship, Partnership, LLC, Corporation, S Corporation… But why so many and what does each one mean?
Sole proprietorship
By default, if you start a business and do nothing formal, you are a Sole Proprietor. Sole Proprietors use Schedule C on their Form 1040 Individual Income Tax Return to report their business income and expenses.
Limited Liability Company
Did you know that an LLC does not exist from a tax filing perspective? This actually catches many business owners off guard when I first explain this to them. They tell me, “I’m going to file an LLC tax return” which unfortunately does not exist as an option.
Many business owners choose to become an LLC because an attorney (or a friend even) has told them to do so. From a tax perspective, it can be one piece of your overall tax strategy as being an LLC provides you with more filing options than being a sole proprietor.
If you go through the steps of registering your business with the Secretary of State and creating a Limited Liability Company (LLC) and you are the only owner, you will default to a Sole Proprietor as well.
Partnership
When there is more than one business owner, a Partnership has been created. If you’re going into business with a partner, you should definitely create a formalized entity with organization documents drawn up by an attorney. A partnership files taxes on Form 1065.
Entity Types: Larger entities
The other big tax word we hear thrown out is ‘Corporation.’ When you hear this word, you typically think of super large companies like Walmart, Amazon, Microsoft, Apple etc. But we are actually seeing a resurgence in Corporations, since the Tax Cuts & Jobs Act was passed in 2018 which lowered overall corporate tax rates.
It’s important to understand that there are essentially two different types of corporations - C Corporations & S Corporations. Most of those big companies you’re thinking about are C Corporations. C Corporations still have what we call “double taxation,” however, since dividends passed down to shareholders are taxed at individual capital gains rates even after the C Corporation has already paid its own taxes at corporate rates.
Small business owners, however, may benefit from electing to be treated as an S Corporation for tax purposes. This is considered a pass through entity meaning that the business taxes are passed through to the owners’ individual income tax return and paid at their individual rates.
One main caveat with the S Corporation is that owners need to be paid a reasonable compensation, and the IRS has been really cracking down on this. A qualified tax professional can help you navigate determining a reasonable compensation for your role.
You might have also heard about “the late S-election.” While this is an option, it is not guaranteed. Per the IRS, you have 75 days from the date of the election to file your Forms. This is the best case scenario if you want to ensure approval of your election request.
Working with a qualified tax strategist allows you to know exactly when it’s best to become an S Corporation and therefore timely file your S-Corp election paperwork.
There are so many benefits that business owners can have from choosing the right entity. But remember, what’s the ‘BEST’ entity for your friend’s business may not be the best entity for yours. Not only are your businesses likely different, but your personal situations are likely different as well.
There’s a wide variety of considerations when it comes to choosing the right entity structure for you and your business. We hope this quick overview helps make it a little easier to understand.
One of the best things you can do for your business is getting a set of expert eyes on it. Taking care of your business from a tax perspective will set you up for success and save you a lot of headaches in the long run.
Having a CUSTOMIZED tax plan for your individual needs is essential to your tax strategy success and the right entity selection is just one small part of tax planning!
You can download our service guide to see exactly how a CPA can help you in your business.
*Disclaimer: This article is not meant to be tax advice. This is not an all-inclusive list of business deductions. Different rules may apply to each individual taxpayer’s specific situation. Please consult with your accountant.