Business Entities and their Tax Advantages
One of the first decisions you’ll have to make when starting a business is what type of business entity to form. There are several factors to consider when making a decision, from tax implications to liability protection.
There are a few types of entities that businesses can choose from when starting. These entities determine the rules and regulations your business must follow. It’s essential to select the entity that best suits your business’ needs. Here’s a look at the most common types of entities and how to choose the best entity for your business. This post also explain how to form a business structure, and their tax advantages.
What Is a Business Entity?
A business entity is an organization created to conduct business. Sole proprietorships, corporations, partnerships, and limited liability companies (LLCs) are the most common types. Operating as a business entity offers certain benefits, such as little personal liability for owners and the ability to raise capital.
Before we get into the different types of entities, let’s understand how it works.
How do Business Entities work?
The business entity determines the tax form you’ll file and whether or not the company could be sued. Many structures offer protection for personal assets if something goes wrong. However, only a few businesses will have this advantage, depending on which one you use!
Some people are new to the business world and may not know what type of entity is best for their company. There’s more than one option, but here we’ll go over some basics about each kind.
Types of Business Entities
A sole proprietor is an unincorporated organization that has one owner. The owner pays personal income tax on profits they receive from their company during the tax year. This type of entity is easy to establish and take apart because there’s no government regulation involved in this setup!
Although sole proprietors are one of the simplest entities to form, it has drawbacks. A sole proprietorship is a company structure not registered under the State’s Department of State. This means the company is not its own entity, but instead, the owner and the organization are considered the same.
For business owners, this is detrimental to their assets. Since the entity and the owner are treated as one, the owner is liable if the business gets sued. The Sole Proprietor must pay any payments due to the person or company that sued them, whether it’s coming from the business account or the sole proprietor’s account. Personal assets are also liable for seizure.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a business entity separate from its owner. The business has its own “social,” which is called an EIN and is registered under the State in which it conducts business. When a company is registered in its State, it allows the business owner to protect its assets in a lawsuit.
When it comes to the tax realm, LLCs have much flexibility. They can elect themselves as any entity for tax purposes. This means that if an LLC decides they want their business taxed as a C-corp instead, they can! We’ll get more into this in a few.
Partnerships are widespread in business. They can be seen as either informal agreements between two companies to work together or two or more individuals collaborating to form a joint venture.
Partnerships are stable relationships in which both parties contribute to the welfare of one another.
For example, Two friends start up a small farm together where one works during the day to produce food while the other takes care of the nightshift duties; during harvest time. It’s common practice for partnerships like these as it’s more efficient than having two separate entities.
Informal partnerships split their profit and loss equally and report them on each partner 1040; Schedule C. Doing so eliminates the burden of one individual paying self-employment tax by themselves. However, unincorporated partnerships can be risky since boundaries are not laid out with formal documentation. Many disagreements occur, leading to the separation of partners or time-consuming lawsuits.
Due to the formation of this business structure, one owner may be left feeling short-changed. They may experience being taken advantaged of or as if majority of the burden fell on them. Disagreements among owners can damage friendships and break up families.
Limited Liability Partnership (LLP)
A Limited Liability Partnership is an entity formed when two or more individuals are legally involved. The entity creates a sense of protection from one another. An LLP limits a partner’s liability to only the negligent partner and up to that partner’s share of the business.
In an LLP, each partner will pay their taxes for their portion or percentage of the company. Like an LLC, the entity is separate from the owner’s assets. However, unlike LLCs, an LLP can only file a partnership return and does not have the flexibility to select a different entity for tax purposes.
C Corporation (C-Corp)
C-corps are corporations formed to protect their owners or shareholders from their assets. The most a C-Corp member can lose is their initial investment in the company. This means if the C-corp owes a substantial amount of liabilities, it is not transferred to its owners.
When it comes to taxes, c-corps are double taxed. The cooperation files corporate tax returns in which the company pays taxes on its revenues. It is then taxed again as a second layer of income tax when the c-corps revenue is distributed to shareholders as Dividends.
To comply with regulations, C- Corps must hold yearly meetings with its shareholders and Directors; they must keep a list of Directors’ names and percentages. C-corps must also file annual reports, provide financial statements, and have accurate and full disclosure of their financials.
C Corps are best for companies who want to grow big. They have the opportunity of getting more funding as their growth continues and can add members at any time without limits by being a publicly held company!
S Corporation (S-Corp)
S-Corps are similar to C-Corps with a few differences. Like C-Corps, S-Corps have a Board of Directors and must file annual reports. Unlike C-corps, S-corps limits the number of members that can be a part of the company, and they’re only allowed to have up to 100 members.
In the tax world, S-Corps have better tax benefits. Although S-Corps are required to file a corporate tax return, S-Corps are tax-free on the corporate side. This means that S-corps does not pay corporate taxes, but instead, income or loss flows through to the shareholder on a Schedule K-1. The shareholder then uses the distributed profit or loss and reports it to their 1040 tax return.
If the business earned income from the S-Corp, the owner could deduct up to 20 percent of the revenue on their 1040 tax return. This is called the Qualified Business Income (QBI) deduction. If the S-Corp has a loss, the owner could report the loss on their return to reduce their taxable income. This could be the difference between owing the IRS or receiving a refund.
Which business entity is best for tax purposes?
The best business entity for tax purposes depends on the business’s circumstances. For example, a sole proprietorship might be better for a small business with low income and no assets. In contrast, a corporation might be better for a larger company with high income and many assets.
A sole proprietorship is a good option for businesses with low startup costs and doesn’t plan to grow too big. This type of business is really simple to set up and doesn’t require the formation of any special entities. Additionally, sole proprietorships are taxed at the individual level, which can be advantageous if the owner is in a lower tax bracket.
Generally, however, a limited liability company (LLC) is often the best option because it offers more tax flexibility than other business entities. For example, an LLC can be taxed as a C corporation, S corporation, partnership, or sole proprietorship, depending on the circumstances.
C-corps may be the best if you want to grow your business. This type of entity can enjoy special tax rules that don’t apply to others. C-corporations can carry forward income and losses while also enjoying the flat rate of 21 percent tax rate. C-corps can also avoid double taxation by retaining earnings; however, it must be for a good cause, such as acquiring a new location or re-investing to grow the business.
Each type of entity has its own set of tax advantages and disadvantages, so it’s essential to consult with a tax professional to find the best option for your specific situation.
What Are ‘Disregarded’ Business Entities?
A disregarded entity is a business entity that is not separate from its owner for tax purposes. That means the business’ income and expenses are reported on the owner’s tax return.
There are several disregarded entities, but single-member LLCs and sole proprietorships are most common. For example, if you have a one-person LLC business, the LLC is a disregarded entity because taxes will be reported through their 1040 tax return. The IRS doesn’t treat it as a separate taxpayer, and this can be advantageous because it simplifies bookkeeping and tax paperwork.
Which entity is best for Business owners?
You can choose between any entity depending on your needs and wants; however, the business entity that single member-owners have widely used is an LLC. The reason behind it is the protection that LLC’s hold and the tax flexibility. As mentioned previously, an LLC can be taxed between any one of the above entities, and LLCs can benefit from many different tax elections.
As stated above, another widely formed entity is partnerships. Partnerships can be formed as a Multi-member LLC, an LLP, or an unincorporated association. Since unincorporated partnerships are established verbally with no legal documents, it’s usually frowned upon due to its risks. Both partners are equally liable for the business.
How to form a business entity?
The first step in forming a company in the US is deciding which entity best fits your business goals. Once you’ve chosen your entity, you’ll want to visit your State’s website and search Articles of Organization. You may need to hire a Registered Agent or use an individual you already have.
The next step is obtaining an Employer Identification Number (EIN) through the IRS Website. This is needed to separate your social from the business and allow the company to have its unique Federal Tax Identification Number. An EIN is used to identify your company.
In addition, the best practice in complying with your legal business entity is avoiding co-mingling funds and opening a business bank account. This helps run your business smoothly and prepares you in case of an IRS audit. You’ll want to ensure that all business transactions flow through the business account.
Lastly, file your taxes annually. If you’ve reached the level of making profits, be sure to file estimated taxes in the frequency required. Also, if you are collecting sales tax, make sure you are making timely payments or hand over that task to your accountant.
There are many different entities to choose from. When most people think of businesses, the first type of entity that comes to mind is a corporation. However, a business can be structured as many different types of entities, including LLCs, sole proprietorships, and partnerships. Each type of entity has its advantage and downside, so choosing the right one for your business is important.
Many factors, such as tax rates, liability protection, and more, come into play when choosing an entity. Your decision will be determined by which entity best suits your needs! If you would like help deciding the correct entity for you or need assistance with any other aspect of starting a business (such as incorporation), check out our service page to inquire about services.