What Entity Choice is Right for Me?
Are you thinking about starting a business and not sure what entity is the right choice for you? If you’ve ever gone on to the secretary of state’s website to create a new entity, the choices can be a bit overwhelming. Let’s go through some of the basic advantages and disadvantages of each of the most common entity choices.
Sole Proprietorship – The perfect entity choice for a side hustle looking to just make a little pocket change. Sole proprietorships are extremely easy to set up as there is no setup, you just start working, and all income and expenses are reported on your individual tax return. The downside of sole proprietorships includes being personally liable for everything involved with the business, self-employment tax on net income and running everything in your own name.
Partnership – Very similar to the sole proprietorship, but now you’re working with one or more people. It is still relatively easy to set up, but filing with the secretary of state and obtaining an EIN from the IRS becomes mandatory. Partnerships also require their own tax return and still being held personally liable for anything the company gets into. Think of a partnership like you do a sole proprietorship, but with more paperwork and more people. The partnership does not pay income taxes itself, as the taxable income ”flows through” to the partners.
LLC (Limited Liability Company) – A common misconception among the general population is exactly how an LLC is taxed. I have had people tell me, “I have an LLC, I can’t file in on my individual return.” The truth is, an LLC can be taxed the same way as a sole proprietorship, partnership, S-corporation, or a corporation, pending the right election. The biggest advantage of an LLC is creating an entity away from the individual, that prevents the individual from being held totally liable for the company. There are certain circumstances like commingling personal and business assets, gross negligence or unethical behavior, where the individual could be held liable, but generally it keeps the individual’s assets safe. Outside of truly small side income streams, an LLC is almost always going to be a better route than a sole proprietorship or a partnership because of the extra liability protection, while still being just as flexible. Filing with the secretary of state and getting an EIN is necessary, but if you are the sole owner, the LLC can file taxes exactly like a sole proprietorship on the individual return.
Corporation – Worried about raising capital in an industry where huge up-front costs could be a barrier to entry? A corporation (c-corp) might be the best option for this route, since c-corps can offer multiple types of stocks and has no limit to shareholders. Another advantage for c-corps is the corporate tax rate maxes out at 21%, while the individual tax rates go all the way up to 37%. While this is an advantage up front, it can turn into a disadvantage if the shareholders (owners) want to pull the profits out of the company, as they will then be taxed on the profits again on the individual side. This double taxation is one of the biggest downfalls of c-corps and something to consider if you believe you will want to pull profits out of the company.
S-Corporation – Election time has come, and no I’m not talking about Washington DC. An S election can be made for an LLC or a c-corp and effectively gives you a bit of both worlds, regardless of the original entity type. An s-corp allows the flow through of profits to the shareholders, while avoiding the self-employment tax that comes with a partnership and sole proprietorship. The active members do have to pay themselves a salary for their work, like the c-corp, but the withdrawals of excess profits is generally not taxed again. The s-corp also has a few limitations when it comes to stockholders that the c-corp does not have, like a 100 person limit and another company cannot be a shareholder. Converting to an s-corp could have other side effects, depending on your situation, but if the situation is right, could result in some considerable tax savings.
Every tax situation is unique and a CPA should be contacted before making the decision, if you are not sure which entity is best for you.