When you’re starting a business, choosing the business structure that you’ll operate under is one of the first important decisions you’ll have to make. It’s important to choose the right entity for your situation because there are different administrative, tax, and legal ramifications for each one.
There are over a dozen different types of business entities that are recognized by US state governments. However, most small business owners will likely choose between a sole proprietorship, LLC, partnership, S corporation, or C corporation.
The different types of business entities
- Sole proprietorship: A sole proprietorship is a business owned and operated by a single individual. The owner has unlimited liability for the business’s debts and obligations.
- LLC: An LLC is a hybrid entity that provides limited liability protection to its owners (known as members) while allowing for flexible management structures and pass-through taxation. LLCs can have one or multiple members.
- Partnership: A partnership is a business owned and operated by two or more individuals. There are different types of partnerships, including general partnerships (where all partners have unlimited liability) and limited partnerships (which have both general and limited partners).
- C corporation: A C corporation is a standard corporation subject to corporate tax at the entity level, and potential double taxation (profits taxed at the corporate level and again when distributed as dividends).
- S corporation: An S corporation is a corporation that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes, avoiding double taxation. There are certain eligibility criteria to qualify as an S Corporation.
Let’s dive deeper into each one below.
The sole proprietorship is the simplest form of business entity since you don’t even have to officially form it. As soon as you start doing business, you are a sole proprietor by default in the eyes of the IRS.
Get an EIN
To get started as a sole proprietor, you can either run your business with your social security number or go to the IRS website and get an EIN. It’s recommended to get an EIN in order to separate your business entity from your personal entity. Registering one is free, can be done completely online, and usually only takes around 10 minutes.
For a sole proprietorship, your income is taxed at two different levels. All of your business income is subject to self employment tax and ordinary income tax. Self-employment taxes consist of both employer and employee portions of Social Security and Medicare taxes. These are calculated on Schedule SE and added to your personal tax return.
For tax filing, you’re going to file your activity on your Schedule C, an extra form that you submit along with your 1040 tax filing. The Schedule C is your profit and loss statement and is used to report your business’ income and expenses, calculating the overall net profits or losses.
Depending on the circumstances, there may be additional forms or deductions that you have to submit as a sole proprietorship. For example, if your business has employees, payroll taxes and additional forms like Form W-2 and Form 941 may be necessary.
One of the biggest disadvantages of running your business as a sole proprietorship is that you don’t have any legal protection. A sole proprietorship is a tax designation, not a legal designation. If something happens in your business that someone wants to sue you for, all of your personal assets are up for grabs.
LLC (Limited Liability Company)
The LLC is the most misunderstood business entity because people think that an LLC unlocks tax deductions that you don’t normally get with a sole proprietorship. However, an LLC is a legal designation, not a tax designation.
As a sole proprietorship, you and your business are considered the same entity for legal and tax purposes. With an LLC, your business is a separate legal entity, separate from its owners. As a result, as the owner, your LLC provides you with limited liability protection, meaning that you’re not personally liable for the company’s debts and liabilities (except in cases of personal guarantees or misconduct).
How you file taxes as an LLC depends on whether you choose to file as a corporation, partnership, or pass-through business.
With a sole proprietorship, your business’ income and expenses are reported on your personal tax return. You pay income tax at your individual tax rate, and self-employment tax for Social Security and Medicare. An LLC has more flexibility.
By default, your LLC is treated as a “pass-through” entity, meaning your business’ income and losses pass through to your personal tax return. However, you can also make another election with your LLC to be taxed as an S corporation, C corporation, or partnership, each having different tax implications. Let’s go through each of them below.
An S corporation allows you to avoid double taxation at the corporate level. Unlike a C corporation, which is subject to double taxation (taxes paid at both the corporate and individual levels), an S corporation is a pass-through entity for tax purposes.
This means that the corporation itself does not pay federal income taxes. Instead, your income, losses, deductions, and credits of the S corporation “pass through” to the shareholders, who report them on their individual tax returns. The shareholders then pay taxes on their share of the S corporation’s income at their individual tax rates.
To become an S corporation, you must first incorporate under state law by filing the necessary formation documents. After formation, you must then file Form 2553 with the IRS to elect S corporation status. The corporation must also comply with certain ongoing formalities and governance requirements, such as holding regular shareholder meetings and maintaining corporate records.
Here are some additional rules and criteria:
- Must be a domestic corporation: The corporation must be a domestic corporation and cannot be a foreign corporation.
- Under 100 shareholders: An S corporation cannot have over 100 shareholders. Spouses and certain family members can be treated as a single shareholder for the purpose of counting the number of shareholders.
- Eligible shareholders: Shareholders of an S corporation must be individuals, estates, certain types of trusts, or certain tax-exempt organizations. Nonresident aliens, partnerships, corporations, and most types of trusts are generally not eligible shareholders.
- Only one class of stock allowed: An S corporation can have only one class of stock, meaning that all shares have the same rights to distributions and liquidation proceeds.
- Only US residents can be shareholders: All shareholders of an S corporation must be US residents or US citizens.
An S corporation has several parts to filing taxes:
Pass-through taxation: As an S corporation, the entity itself does not pay federal income taxes. Instead, the corporation’s income, losses, deductions, and credits “pass through” to the shareholders. The S corporation must provide each shareholder with a Schedule K-1 that reports their share of the corporation’s items of income, deductions, and credits.
Form 1120-S: While the S corporation does not directly pay federal income taxes, it’s required to file an informational tax return called Form 1120-S with the IRS. This form provides details about the corporation’s income, deductions, and other financial information. The filing deadline for Form 1120-S is generally the 15th day of the third month after the end of the corporation’s tax year (March 15 for a calendar year-end corporation).
Individual tax returns of shareholders: Each shareholder of the S corporation must report their share of the corporation’s income, losses, deductions, and credits on their individual tax return. As mentioned above, shareholders receive a Schedule K-1 from the corporation, which provides the necessary information to complete their personal tax filing.
Employment taxes: S corporations are responsible for paying employment taxes, including Social Security and Medicare taxes, on wages paid to employees. The corporation must withhold these taxes from employees’ wages and also contribute the employer’s portion. The corporation must file employment tax returns, such as Form 941, to report and pay these taxes.
Unlike an S corporation, a C corporation is subject to double taxation. The corporation is taxed on its profits, and the shareholders are taxed again on any dividends received.
In addition, a C corporation does not have any additional eligibility requirements like an S corporation does. For example, it does not need to be a domestic corporation, does not require that shareholders are US citizens, and does not require having only one class of stock. They can also have an unlimited number of shareholders, and they can be individuals, other corporations, partnerships, or trusts.
As a result, C corporations are generally more attractive to outside investors, such as venture capitalists and angel investors, as they allow for multiple classes of stock, different voting rights, and potentially easier transfer of ownership. S corporations may face limitations in attracting such investors due to their restrictions on shareholders and stock classes.
Form 1120: C corporations file their income tax returns using Form 1120 to report their income, deductions, and tax liability to the IRS. It includes sections for providing information about the company’s revenue, expenses, net income, and various tax calculations. The deadline for filing Form 1120 is typically the 15th day of the fourth month following the end of the corporation’s fiscal year. For example, if the fiscal year ends on December 31, the filing deadline would be April 15 of the following year.
Additional forms: Depending on the corporation’s activities and specific circumstances, additional forms and schedules may be required to report certain types of income, deductions, or credits. For example, if the C corp has foreign activities, it may need to file Form 5471 or Form 8858 to report those activities.
A partnership involves two or more partners who contribute capital, resources, or skills to the business. Partners can be individuals, other partnerships, corporations, or other types of entities. In many ways, partnerships can be viewed as a sole proprietorship with multiple owners. The entity is not considered separate entities from their owners, meaning that the owners have unlimited legal liabilities for the debts and obligations of the business. Like a sole proprietorship, if anyone were to sue the company, the owners’ assets would also be up for grabs.
Form 1065: Partnerships file their annual income tax returns using Form 1065. This form is used to report the partnership’s income, deductions, and tax liability to the IRS. It includes sections for providing information about the partnership’s revenue, expenses, net income, and various tax calculations.
The deadline for filing Form 1065 is typically the 15th day of the third month following the end of the partnership’s tax year. For example, if the partnership’s tax year ends on December 31, the filing deadline would be March 15 of the following year. Partnerships can request a filing extension using Form 7004, which typically provides an additional six months to file the return.
Schedule K-1: Each partner in the partnership receives a Schedule K-1, which reports their share of the partnership’s income, deductions, and other tax items. The partnership must prepare and distribute a Schedule K-1 to each partner, and the partners use the information on their respective Schedule K-1s to report their share of the partnership’s income on their personal tax returns. The partnership agreement determines how the partnership’s profits and losses are allocated among the partners. Each partner’s share of the partnership’s income and deductions is reported on their Schedule K-1.
Additional forms: Depending on the partnership’s activities and specific circumstances, additional forms and schedules may be required to report certain types of income, deductions, or credits. For example, if the partnership has foreign activities or has certain types of investments, it may need to file additional forms such as Form 8865.
Also read: The 30 Biggest Business Tax Write-Offs
Learn more about choosing the best entity for your business
Learn more about structuring your business, avoiding audits, tax deductions, and different accounting systems in my course: Taxes & Accounting Foundations For Business Owners.