Selecting the right entity type for your business is a major determining factor in the taxes you will pay. There are many alternatives to choose from and each alternative has its benefits. Here is a brief look at the different alternatives and reasons why each entity type might be used.
- Sole Proprietorship – These entities are not very common anymore. There is no separate legal entity, and all income of the business is subject to income taxes and self-employment taxes (social security & Medicare taxes). In addition, there is also no legal liability protection between the individual and the business. This structure would be beneficial for a small business that is more of a hobby with no significant possibility of litigation.
- Single Member Limited Liability Company (LLC) – This type of entity provides limited liability protection to the owner of the company. Single member entities are treated as disregarded entities for tax purposes. As a result, they are taxed the same as a sole proprietorship and subject to the same taxes, but provide some protection to the owners from creditors.
- Limited Liability Company (with more than one owner) – By default, these entity types are taxed as partnerships, unless another election has been made. Partnerships allow the pooling of resources by multiple individuals or companies. This entity type does not pay any income taxes. The income is passed along to the owners of the partnership, who include it on their returns. An individual who owns and actively works in the business would include the income on his or her return and be subject to income taxes and self-employment taxes.
- Corporations – This type of entity can be taxed in multiple ways. A corporation is organized and taxed in two primary ways. It is important to review the company’s industry, financial position and projected income when deciding which type of entity to select. In both types of entities, the owners who are active in the company must receive reasonable compensation for the work they perform.
- S-corporations are flow through entities, similar to the partnership above. They are not subject to federal income taxes; but, they do pass their income along to the shareholder, who must include it on their tax return. Corporations must qualify to elect to be taxed as an S-corporation.
- C-corporations are separate tax paying entities. They pay federal taxes on their income. The tax is based on graduated rates starting at 15% and increasing to as high as 35%.