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Sole Proprietorship, LLC or Corporation? Minimize your Tax Liability Legal Entity
Posted by Buckenberger Christ Insurance Agency on
Should your business be a sole proprietorship, a partnership, an LLC, or a corporation (and if corporation, what type, “C” or “S”?). Most businesses are the entity the business started as and have never changed. But the economy, and the tax laws have changed over time. Your business may need to change as well. Don’t be a “C” corporation just because that’s what you have always been. Speak with your CPA and /or tax attorney to review your situation. Ask your trusted advisor not only how your legal entity affects you today but also how it will affect you in the future when you are ready to perpetuate your business.The type of entity you choose could significantly impact your liability exposure and tax issues. Choosing the wrong type could result in you paying additional tax (now or when you sell). From a liability standpoint, choosing the wrong type could result in losing not only your business but your personal assets as well.
The following is a high level overview of your options, the tax implications, and liability issues surrounding your choice.
Sole Proprietorship – As a sole proprietorship there is no differentiation between the business owner and the business. The owner has unlimited liability for any and all business obligations, resulting in the owner’s personal assets being at risk. All business income and expense flows onto the owner’s IRS Form 1040 schedule C. As a result, any profit is taxed at the owner’s personal tax rate which can be as high as 39.6%Partnership – A partnership requires at least two owners. Like a sole proprietorship there is unlimited liability for any and all business obligations for all the partners and their personal assets are at risk. So even if Partner #1 causes the liability, Partner #2 can be held fully responsible.The partnership is required to complete a Form 1065 (informational only – no taxes) which shows allocation of revenues and expenses between the partners. The proportionate share of income and expense for each partner flows onto the Schedule C of each partner’s IRS Form 1040.
Limited Liability Company (LLC) – An LLC, is not a corporation, but has the same limited liability characteristics of a corporation. An LLC has members, not shareholders or partners. The LLC can elect to be treated as a disregarded entity for federal income tax purposes. This means that all revenues and expenses flow onto each members’ Form 1040 Schedule C pro rata. LLCs can also elect to be treated as C-corporations or S-corporations for tax purposes.
C – Corporations – Corporations are formed under laws of a specific state. If there is more than one shareholder (there can be an unlimited number), the Corporation should have a Shareholders’ Agreement to address what happens when a shareholder dies, becomes disabled, retires, etc.One advantage of a C-corp is that the corporation pays a lower tax rate on the first $75,000 of net profit that is retained in the corporation. However, if the retained earnings are later distributed to the shareholders, it is taxed as dividend income which results in double taxation.Another tax problem can occur when it’s time to sell the business. Corporations do not enjoy capital gains tax treatment. If corporation itself is sold it results in capital gains treatment to the shareholders. However, if the assets are sold (which is more common), it can result in double taxation.
S – Corporations – A C corporation can elect to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. Like sole all the other entity choices (except C-corps), an S-corporation doesn’t pay taxes. It does however, have to file an IRS Form 1120-S, which is an informational return only. The business’ revenues and expenses flow from the 1120 S onto each shareholder’s Schedule K-1. That information is then included on the personal tax return of the shareholder. Unlike C-corps, if the assets of an S-corp are sold it will result in capital gains treatment for the shareholders (no double taxation).
Summary- Don’t stay as one type of entity just because you’ve always been that type of entity. Conversely, don’t change for the sake of changing. You need to carefully analyze your situation, both now and in the future when you sell your business. Even if you plan on gifting your business to family members, you need to review this important consideration. Speak with a knowledgeable CPA or tax attorney to review your options. If your business circumstances (or the tax laws change) your entity selection may need to change so don’t forget to review this regularly.