There are two important factors to consider when choosing a business entity type. Those factors are tax treatment and separation of liability. Since this is a tax blog we will focus on the tax treatment of different business entity types. The following is a general overview of business entity tax treatment. It is not meant to cover everything.
(The members of our firm are EA’s. EA stands for Enrolled Agent and means we specialize in taxes and can represent our clients in front of the IRS. We are not attorneys. Questions concerning legal liability should be directed to your attorney. And, as always, since every tax situation is unique, we can only give general information here. Please call the office for questions concerning your specific business.)
Your business will probably fall into one of four main types of organization: sole proprietor, partnership, S corporation, and C corporation.
Sole Proprietor
This may be the simplest business form. One person owns the business and files the profit and loss, on a Schedule C, on his personal Form 1040 tax return. All income and expenses are claimed on the Schedule C. The business may receive 1099NEC‘s from clients who paid over $600 for services. (These 1099’s may not represent all the income received by the business.) The business owner does not receive a W2 at the end of the year. Net income over $400 is subject to self-employment tax. This is the Social Security and Medicare tax on the earned income of the business owner. The business owner may be required to pay quarterly estimated taxes under his/her Social Security number. There is no requirement to register a sole proprietorship with the Secretary of State in Georgia.
Partnership
If the business is owned by more than one person, the default business organization is a partnership. The income and expenses are filed on a Form 1065, which is a separate tax return from the owners’ personal returns. This return is generally due March 15 of each year which is a month earlier than the personal returns (unless a fiscal year is chosen for the business.)
A partnership is what is known as a pass-through entity. That means that in general, a partnership does not pay income taxes. The net profit is divided according to the partners’ percentage of ownership and is stated, along with other information, on a Form K1. Each partner receives a K1 with the information they need to include on the Schedule E of their personal tax return. A partner does not receive a W2. The partner’s share of net income (or loss) is taxable at the partner’s tax rate and may be subject to self-employment tax, depending on the type of partner.
It is possible for other businesses to be partners in a partnership.
Subchapter S Corporation
If a business has between one and 100 shareholders, it can choose to be taxed as a subchapter S corporation. The definition of an eligible shareholder for an S corporation is narrow compared to other entity types. In this case, shareholders must be persons (or certain estates and trusts), and not be other businesses. The business must be a US corporation and all shareholders must be US citizens or residents.
An S corporation is a pass-through entity that files a Form 1120S which is generally due March 15 of each year. Like a partnership, shareholders receive the information about their share of net profit (or loss) on a K1. That information should be included on the shareholders’ personal tax return. Unlike in a partnership, shareholders who work for the business must be paid a reasonable salary and receive a W2 for their services. This means that the profit on the K1 will not be subject to self-employment tax. It is generally considered passive income.
C Corporations
A C corporation pays tax on its own income by filing a Form 1120. This means there will be no K1. Those who work for the business receive regular wages and a W2 at the end of the year. Any profits distributed to shareholders are considered dividends and are reported to the shareholders on a 1099DIV to be included on the personal Schedule B.
What about an LLC?
I have new clients all the time who tell me that they are an LLC, but that does not tell me how they are being taxed. An LLC is a designation organized under state law and can choose to be taxed as any of the entity types above by filing the appropriate forms.
Which is the best entity for your business?
Deciding which type of business entity is best for you may be obvious, but it can also be complex. There may not be a choice. What are the circumstances dictating? How many shareholders will be involved? Are there any foreign partners? Where will your business be located? Though the IRS requires a certain level of diligence in bookkeeping, what is your tolerance for paperwork? Do you need a bookkeeper? Will you need help running payroll? What does tax compliance look like in your business?
How do you get started?
Start by getting some professional advice. A good attorney and reliable tax advice are invaluable. If you need help, please call our office at 912-335-5404 for advice on your next step.
Here are links to other blog posts in our Small Business Series: