When you are forming your new business, there are many choices for an entity to use: a sole proprietorship, C-Corporation, S-Corporation, Limited Liability Company, Partnership, Family Partnership, Limited Partnership, to name a few. The choice you make has both tax impacts and legal impacts.
The first consideration is always whether your new business has some potential for liability. If so, and you are the sole owner, you will not want to be a sole proprietor. A sole proprietor type of business will not protect your non-business assets from liability in the event that someone or some company decides to sue you. A better option is to use a single member limited liability company. This is a company formed by the Secretary of State usually in the state that your company will be located in. It is considered a legal entity which protects your assets that are non-business assets from liability, but can be disregarded for tax purposes. What this means is that you would use a Schedule C on your individual U.S. 1040 to report your earnings from the entity, which simplifies your taxes. All of the income is taxed to you individually at whatever your rate of tax is.
If you are not the only one involved in the business, you can also use a limited liability company (LLC). Again, this provides you and the other members of the business protection of your personal assets from liability of the LLC. It would be taxed as a partnership, which would pass through to each partner their percentage of the profit or loss of the business. Special allocations of income and expenses are allowed, based upon an economic reality test. A standard partnership (a non-LLC) would be taxed the same way, but does not offer any protection from liability. Before the existence of an LLC, a popular form of business was a limited partnership, where the ownership of the limited partnership was in part by a general partner who was totally liable for any debts or lawsuits and limited partnership interests who were only responsible for debts to the extent of their investment.
Many people choose to use an S-Corporation. This is a corporation for legal purposes and provides you with a limitation of liability. The corporation becomes an S-Corporation with a properly and timely filed election to be an S-Corporation. From a tax standpoint, all pass through income and deductions must pass prorate according to the shareholder’s ownership. There is only one class of stock allowed, although you may be able to have one class of stock with several series. There are no special allocations allowed.
Some S-Corporation shareholders attempt to minimize payroll taxes by paying themselves minimal salaries and taking their profits out as corporate dividends rather than salaries. With a self-employment tax of 15.3%, there can sometimes be an incentive to try to minimize this tax. If your salary amount is deemed to be unreasonable by the IRS, they can challenge and recharacterize part of your dividends to salary, resulting in back payroll taxes. This has been the focus of an IRS challenge for years and continues to be so.
One thing that S-Corporation shareholders may forget is that minimizing the salaries of the owners may reduce payroll taxes, but it also minimizes the owners’ opportunity to contribute to a qualified retirement plan, which contribution is based on the amount of salary that the owner has.
As you can tell, there are a number of considerations in determining the proper type of entity to fit your new business. Consider consulting with your attorney and CPA to pick the proper entity for you.