If you are thinking of starting your own business you probably are wondering what business structure you should choose to classify your business. There are a few business levels to note but we will focus on the 5 main levels to consider. Based on what business structure you choose, there are different tax rules, risks, protections and fees that must be paid.
This article is an exert from the book entitled Freelance Jumpstart. There is also a free video course that explains this article which can be found by going to the Freelance Jumpstart Video Crash Course Website.
- Sole Proprietorship
- Limited Liability Company
- S Corporations
This means that there is a sole (one) owner of an unincorporated business. The business must be recognized as being connected to one person and their social security number will be used as a means to connect the business name to the individual. When it is time to file taxes a self-employment tax must be paid which is made up of Social Security tax and Medicare tax. The self-employment tax must be paid in addition to paying the income tax on the profit of your business.
This is the easiest type of business to setup, and as long as you have a social security number, you can obtain a DBA (Doing Business As), get a business bank account and you are ready for business. Also the accounting method is normally cash accounting, which is simple addition and subtraction for income and expenses.
Setting up a sole proprietorship means that your business is tied to your social security number and your personal assets, if your business was ever sued and you lost the lawsuit then any personal assets may be at risk.
Also with a sole proprietorship business structure the individual often pays the highest amount of taxes.
Partnerships involve two or more people who have joined together to form a business. Each person that is a part of the partnership contributes money, skill, property and has an expectation to share in the profits and losses of the business.
Partnerships must file taxes on an annual basis and must report their profits, gains, loses and deductions from the business. The partnership organization does not pay income tax. The responsibility of reporting profits and losses falls on each of the partners in the business. Think of a general partnership as the plural version of a sole proprietorship.
- Partnership Income
- Employment Taxes
- Individual Income Tax
- Schedule E (Profit & Loss)
- Self-Employment Taxes
- Estimated tax
The partnership organization itself does not have to pay income tax, each individual in the partnership must report the profit and loss of the business.
If any of the partners of the business is sued or gets in any type of legal proceedings then the business partnership may be seen as an asset and may be at risk.
Limited Liability Company (LLC)
An LLC or Limited Liability Company is a business that has different rules and regulations based upon what state you live in. An LLC can have one single owner or can be owned multiple members. LLCs can even be owned by a parent corporation.
A single member LLC is viewed similar to a sole proprietorship but acts as its own legal entity for tax purposes. The individual owner must obtain employee identification number (EIN) must be obtained if you plan to have employees. The same is true if the LLC elects to be treated as a partnership or corporation. In order to choose how you would like to elect your business to be treated use Form 8832
If you elect to run the business as a single member LLC:
- Form 1040 Schedule C, Profit or Loss from Business (Sole Proprietorship) (PDF)
- Form 1040 Schedule E, Supplemental Income or Loss (PDF)
- Form 1040 Schedule F, Profit or Loss from Farming (PDF)
If you elect to file as a partnership:
If you elect to file as a corporation:
Form 1120, U.S. Corporation Income Tax Return
If you elect fo file as an s-corporation:
Each owner reports their pro-rata share of corporate income, credits and deductions on Schedule K-1 (Form 1120S).
Forms (As an individual):
- Individual Income Tax
- Schedule C (Profit & Loss)
- Schedule E (Supplemental Profit & Loss)
- EIN for employees
- W-9 for employees
Fairly easy to setup in comparison to a corporation
An LLC has the flexibility to file as a corporation, sole proprietorship or partnership if it has more than one owner. A certain level of personal asset protection, this means there is a higher level of protection of your personal assets if you work in a field where you may be sued. If someone were to sue the business (LLC) then they can only pursue assets owned by the LLC and not the LLC owner. If you are thinking of hiring employees you would definitely want to begin with this option and secure an employee identification number (EIN)
Since the LLC is its own entity accurate record keeping is a must, do not mix personal income with the LLCs income.
More than likely your business started smaller and then grew to the point where becoming a corporation would help you establish an IPO. Creating a corporation involves potential shareholders exchanging their assets (money or property) for stock in the corporation. A corporation can be viewed as its own legal entity and can take the same deductions as a sole proprietorship as well as a few special deductions. The corporation is responsible to pay income tax on its earning and when earnings are distributed to shareholders as dividends, they must pay taxes on that income as well, a double taxation.
- Corporation Income Tax
- Corporation Estimated Tax
- Employment Taxes (Quarterly)
- Employment Taxes (Annually)
- Employment Taxes (For Unemployment)
You would still as an individual have to report your income tax if you are an employee or shareholder of the company. So it is like you are filing taxes for 2 people, yourself and then the corporation.
You can issue more than one type of stock and have more shareholders, which normally means the business has access to higher capital.
With a corporation the owner of the business can set their own salary and the wages that are paid to the owner can also be used as a deduction to the business. Normally the taxes paid for a corporation on wages are less than what they would have been if the company is unincorporated. [thank you Ktasha]
If you are a shareholder in the business you cannot deduct any losses for the business. There is a tax on the business and a tax on shareholder earnings, double tax.
S Corporations have similar laws and responsibilities as Corporations except for one main difference, S-Corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The shareholders are then responsible to report this information to the IRS. This is similar to how a partnership requires the partners (members) to report financials to the IRS.
- Income Tax for company
- K-1 Form
- Unemployment Taxes (Annual)
- Unemployment Taxes (Quarterly)
- Shareholder Income Tax (Schedule E), In addition to your own personal income tax
- Estimated Taxes
- EIN for employees
- W-9 for employees
Passing income, losses, credit and deductions through shareholders allows the company to avoid double taxation since the responsibility to report falls on the shareholders of the organization.
If you are a shareholder you are responsible for not only report your own individual income but also the company that you are a shareholder for and this must be done accurately. There cannot be more than 100 shareholders, when stock is issued there can only be one class of stock.
I am not sure if you noticed but as we continued looking through the various business structures the amount of paperwork increased for what had to be reported to the IRS. It is best to start small and as your business grows and you need to protect your assets move up in structure: Sole Prop –> Partnership (if necessary) –> LLC –> Corporation –> S-Corporation
Please note: The contents of this article is summarized and you may read the full information on the IRS website. Your situation may be fact dependent and it is best to seek the advice of licensed professional.
This article is an exert from the book entitled Freelance Jumpstart.
That was a very good article Nathan. Thanks for sharing. From a “Tax
Perspective,” I would like to contribute to your post and mention that
although choosing to start as an Sole Proprietorship is the easiest form
to set up, a person “does pay” the highest amount of taxes. As a Corp,
the business owner will be an Employee to it’s own Corporation, and then
pay him or herself as an Employee and the Taxes the Corp paid on those
Wages are much less than what that same person would be being
unincorporated. “Plus” the wages he/she pays to themselves is a Tax
Deduction to the business. But when people are setting up their
business, it definitely is worth the research to choose what’s best for
that particular person.
You are right and you make a great point. Thank you for taking the time to point that out. I think sole props are good for testing purposes but only for a certain amount of time.
The goal would be to move to something higher so you can maximize your revenue by organizing your business under a better structure. I will change some of the pro & cons mentioned in the article based on your feedback. Thanks. Also I checked out http://smallbusinesstartupconsultant.com/ , some very valuable information can be found there.