You have another important decision to make other than the product or service you'll offer if you're an individual who wants to start a small business. You must decide which type of legal business structure to use, such as a sole proprietorship, limited liability company or S corporation.
All of these are available to single-owner businesses. They differ based on factors such as the complexity of the business formation process, limits to personal liability, tax treatment and the tax-filing process.
Defining a Sole Proprietorship
There's a good chance you're considered a sole proprietorship if you've operated as a single-person business and haven't completed an official business filing process. This is the easiest business structure to adopt because it's usually automatic. There are no fees involved to start operating. This type of business usually means operating under your legal name, but you can file for a fictitious business name through your state if you'd like.
Operating a sole proprietorship means you'll face more risk and personal liability for business activities than you would with an LLC or an S Corp. You and your business are the same entity. The courts and creditors can come after you personally if you're sued or take out business debts. This can mean losing personal assets such as your house or money in the bank. But you can take out professional liability insurance to reduce some risk.
The Internal Revenue Service requires that you list your business income directly on your personal tax return using the Schedule C form. You must pay self-employment taxes of 15.3 percent (12.4 percent for Social Security and 2.9 percent for Medicare) and your personal income tax rate on business income. You can take personal tax deductions and credits along with claiming business expenses. Other business structures like an S Corp allow you to pay yourself as an employee and distribute the rest of the business income, but you don't get this option with a sole proprietorship.
Exploring Limited Liability Companies
You can form an LLC whether it's just you as part of the company or you have others running the business along with you. Forming this business entity requires investigating your state's process because it includes many steps and there are some fees involved. States set their own rules as to who can form LLCs. The IRS indicates that your state might not let businesses that operate as insurance providers or banks become LLCs. But a variety of members such as other companies and individuals can be included.
As the name implies, this type of business format comes with limited liability to the owners. The LLC itself holds liability for business debts, so you usually don't have to worry about creditors trying to take your personal assets. You're usually not personally liable for other LLC owners' liabilities either. But you can be held personally responsible for bad actions, and some states may allow creditors more flexibility in going after you for business debts if you're the LLC's sole owner.
Your tax filing process is like that of a sole proprietorship. You'll file Schedule C with your tax return and pay personal income taxes and the self-employment tax on business income. You have some separation from the business, but there's no separate tax return for an LLC. You're taxed like a partnership if there are multiple owners and if you don't opt for the S Corp tax status. This means completing and submitting Schedule E with your tax return and paying income tax on your share of the LLC's profits. There's a separate tax return for the LLC, and you must file Schedule K-1 forms with the IRS as well, and issue them to owners.
Read more: What Are Royalties on Schedule E?
Understanding the S Corp Structure
The S Corp is an alternative to other types of corporation types that can lead to double taxation. Business income is passed down to the shareholders/owners as with an LLC, so you don't have to worry about corporate taxes. This business entity differs from an LLC in that you can make non-dividend distributions after all shareholders receive a fair salary.
You can't have more than 100 shareholders and they must be located within the United States. Shareholders can't be corporations or partnerships. There's a thorough filing process and certain businesses such as insurance companies and banks don't qualify for this structure.
You get the personal and liability protection that you wouldn't receive with a sole proprietorship. The S Corp is separate from you as a shareholder, and only the S Corp holds the liability. This type of business entity also survives even if a shareholder passes away or leaves the business. This feature separates it from the other two business formats. Ownership can easily transfer to new people.
Handling the taxes for an S Corp is more complex than with sole proprietorships and LLCs. There are more calculations and paperwork to handle. The S Corp will distribute salaries to each shareholder based on IRS guidelines. Shareholders must pay self-employment and income taxes on that money on their personal returns. Then the S Corp must file its own tax return, Form 1120-S, along with several schedules. Check your state's laws because some tax S Corps as C corps. This would mean losing the benefit of avoiding double taxation.
Sole Proprietorship Tax Advantages & Disadvantages
The biggest advantage of this type of business entity is simplicity when it comes to handling your taxes. You don't have to worry about filing any additional paperwork with the IRS to opt for being taxed as a sole proprietorship. You don't have to request an employer identification number. You can simply use your Social Security number.
Reporting your business income and business expenses on your individual income tax return is as easy as filling out Schedule C. You don't have to worry about completing a separate business tax return like you would with a multiple-member LLC, an S Corp or a partnership. You can benefit from the pass-through deduction that lets you deduct as much as 20 percent of your business's profits from your federal taxable income. You also have access to all relevant personal credits and deductions.
The main disadvantage of a sole proprietorship is that you'll have to pay self-employment taxes on your income. This adds up to an extra 7.65 percent because your employer would normally share this cost with you. But you don't have an employer paying their half when you're a sole proprietor. You also don't get the potential benefit of an S Corp where you could just pay self-employment taxes on a salary you're paid and have other money distributed without the extra tax burden.
Read More: What Deductions Are Allowed When You Receive a 1099?
LLC Tax Benefits and Drawbacks
An advantage of an LLC is that the tax filing process is like that of a sole proprietorship by default as long as you're a single-member LLC. All you have to do is list your business's earnings and expenses on Schedule C when you prepare your personal income tax return. You pay the self-employment tax without having to file any additional IRS paperwork for the LLC itself. You can also get the 20-percent IRS deduction for pass-through income.
A downside is that there's more tax complexity when you're forming an LLC with multiple members. The IRS treats such an arrangement as a partnership for tax purposes. This means filing a partnership tax return along with having each owner report their portion of the earnings on their individual tax returns using Schedule E. It also means extra work in creating Schedule K-1 forms to provide to the IRS and all owners.
Both single- and multiple-member LLCs have the benefit of flexibility to complete IRS Form 8832 and become taxed as an S Corp. This comes with the benefit of being able to pay yourself a salary and distribute the rest of the funds without self-employment tax, although this does involve extra paperwork. This can lead to tax savings versus a sole proprietorship. But the IRS requires that salaries be reasonable for the owner's contribution, so don't expect to take a very small one to avoid taxation.
S Corp Tax Advantages and Disadvantages
An S Corp offers the key tax advantage of allowing some of its profit to be used as self-employment tax-free distributions after all shareholders have been paid reasonable salaries. Only income tax would apply to this leftover money, so it can save you the 15.3 percent you'd pay treating the money as a salary. Individual owners just have to report their salaries on Schedule E when they complete their personal tax returns. They can take relevant deductions and credits each year.
Another benefit is the lack of double taxation. The corporation itself isn't taxed on earnings at the corporate income tax rate along with each of its owners also paying their personal tax rates on the money. Income passes through instead so owners will pay the taxes on their shares. The downside is that not every state agrees with this federal classification and yours may double-tax income just as if you were a C Corp. Extra research is needed if you want to gain the benefits of forming this type of business entity.
The tax downsides of an S Corp come down to more complexity. Form 1120S must be filed for the corporation's tax return. Schedule K-1 forms must be distributed to owners and to the IRS. Corporate Direct warns that a business's S Corp status could be revoked in certain situations. This comes with penalties like back taxes and a lengthy waiting period to form as an S Corp again. Tax-free company benefits aren't available to owners who have at least two percent ownership.
Deciding for Your Small Business
Now that you understand the tax differences and benefits of these three business entity types, you can decide which best fits your business. Keep in mind that you can usually easily change your business structure if you're the only owner if your needs do change. But you'll have to come to an agreement and expect some more legal tasks to do so if you end up with more owners.
You can simply operate as a sole proprietorship without doing anything special or spending money on filing fees if you're just starting out and want to keep things as simple as possible. You'll just want to keep the full liability you face with this kind of business entity in mind. It could mean losing your personal property if something goes wrong financially.
An LLC or S Corp can be a good alternative if you'd rather lessen the risk and have the ability to add more owners over time. You just have to complete the formation processes in your state and with the IRS. Opting for the S Corp structure can lead to more complexity but it comes with additional potential tax savings.
It can be worth speaking to a lawyer or accountant to further examine your business startup and discover which of these options would yield better tax advantages.
- IRS: Sole Proprietorships
- IRS: Limited Liability Company (LLC)
- Bplans: How Limited Liability Companies (LLCs) Are Taxed
- Upcounsel: How Does an S Corporation Work: Everything You Need to Know
- IRS: S Corporations
- Intuit Turbotax: LLC Tax Filing Rules
- Corporate Direct: S Corporations: Learn 15 Advantages & Disadvantages
- Entrepreneur: Business Structure Basics
- IRS: 2021 Form 1120-S U.S. Income Tax Return for an S Corporation
- IRS: Qualified Business Income Deduction
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.