Are you starting a business? As we talked about in our last blog, there are many considerations you need to keep in mind when launching your own endeavor. If you’ve thought about all those aspects and still want to move forward, you next need to look at business entity selection. We have written blogs about business entity types in the past, but it’s always a good idea to revisit this information. Understanding the different business entity types is important to help you make the best decision for your business. Here are some of the options:
The most common business entity type is a sole proprietorship. As a kid, if you mowed lawns for your neighbors (and they paid you), you had a business and you were a sole proprietor. That’s how simple it is. There are no legal documents required and no separate tax return. You report your business income and expenses on Schedule C of your individual tax return.
There are some disadvantages, though, to owning a sole proprietorship. The biggest disadvantage for most folks is the liability. If someone is injured on your business premises or because of actions by you or your employees, you can be held personally liable for the injury. The injured person can take not only all your business assets, but your personal assets until the judgment against your business is satisfied.
The second disadvantage is self-employment tax. Most everyone understands that their business net taxable income is subject to income tax. Many, however, do not realize that their self-employed business taxable income is also subject to a 15.3% self-employment tax. If you are in the 25% federal tax bracket, your total federal tax rate will be over 40%.
On the other end of the spectrum, the C corporation is the most complicated type of business entity. Legal documents are required when starting the business. There are also annual and biennial reporting that may be required. The income and expenses of the corporation are reported on a separate tax return (Form 1120). The corporation pays the income tax on its taxable income. The owners (shareholders) are not taxed on the income that remains in the corporation. When the owners receive dividend distributions from the corporation, those dividends are taxed. Consequently, the income that is distributed out to the shareholders is taxed twice—once at the corporate level and again on the shareholder’s personal tax return.
There are, however, advantages to being part of a C corporation. There is no limit on the number of owners. There is also no personal liability to the owners for actions taken by the corporation or its employees. The owners’ maximum loss is the amount they paid for the stock. Second, the corporate income is not subject to self-employment tax. In addition, the maximum tax rate for corporations is now 25%, quite a bit lower than the maximum individual income tax rate of 37%.
A partnership is the simplest form of business entity available to a business with more than one owner. Legal documents are necessary to memorialize the expectations of the partners. A separate tax return (Form 1165) is required and all ordinary business income is subject to self-employment tax. The partners pay tax on their individual tax returns for their share of the partnership income even if the income is not distributed to them. Unlike distributions from the C corporation, distributions from the partnership are not taxed.
Personal liability is still an issue for partners unless the partnership is set up as a limited partnership. Even with a limited partnership, there has to be a general partner who has unlimited liability.
None of these seem like the right fit for you? In our next blog, we’ll talk about more entity types including S corporations and LLCs. Have questions about what type of business you should start? Please reach out! I’d love to talk more.Judith Ackland has more than 26 years of experience in accountancy and financial planning, including seventeen years as a CFO of a diverse business. She started Crystal Financial in 2010 to help a wide array of individuals, families, and business owners better understand their finances and how good financial management could help them achieve their goals. Judith has an MA in Professional Accountancy from the University of Nebraska at Lincoln as well as a Certified Public Accountant Certificate and a Certified Financial Planner designation.