Deciding on LLC doesn’t completely decide your Entity.

The Limited Liability Company is a relatively new entity, and is strictly a “state” entity.  The IRS doesn’t recognize LLCs for tax purposes.  So, if you decide on becoming a LLC, you still have to decide (or the IRS will decide for you!) how you want to be taxed.

With the LLC you get ease of set up and limited liability.   There is also less administration for the LLC.  But how are you taxed?  If you are a single member LLC (just you and no one else, not even a spouse) then if you don’t choose differently, the IRS says by default you are a disregarded entity.  This means that you’re taxed just like any other sole proprietor on a schedule C or F (if you’re a farmer).  As a single member LLC you could also choose to be taxed as a corporation or even a corporation that elects S status.  But you can’t be a partnership — takes at least two.  If you have more than one member of the LLC, then by default the IRS taxes the LLC as a partnership.  However, you can choose to be taxed as a corporation or a S corporation.  With the limited liability and ease of set up, this is a pretty good deal.

S Corporations

A S-corporation is a regular corporation that has made an election with the IRS for S status, meaning mostly that the corporation is not taxed and all profit and loss is taxed to the individual shareholders.

The S corporation, like the regular corporation, enjoys limited liability.  There is also the same ease of transfer of interests via “stock” and unlimited life of the corporation.  However, unlike a regular corporation, a S corporation is limited to 100 shareholders and can only have one “class” of shareholders.

Most importantly, the S corporation does not have the double taxation of the regular corporation.  For profit/loss and fringe benefits the S corporation is treated by the IRS much the same as a partnership.  Although the corporation files a separate tax return, form 1120S, it is not taxed.  Profit or loss is reported via a K-1 on the shareholder’s individual return.

The S corporation is a strange bird.  With the structure of a corporation and the flow through of a partnership, the S corporation has rules galore!  The IRS form 1120S should not be attempted by someone not very familiar with the rules for S corporations.  I’m not a S corporation, but they are my favorite entity.

An Old Fashioned Corporation

The regular corporation (or C Corporation as it is sometimes called) has been around for a long, long time.  And of recent, hasn’t been the entity of choice for most businesses.

A corporation is the most costly of the entity choices to set up, and this includes both regular corporations and S-corporations.  Legal services are required and there is considerable red tape to administer them.  Corporation meetings along with minutes documenting all actions are required.  The IRS requires a form 1120 to be filed, and hence one of the biggest strikes against —  double taxation.  The profits of the corporation are taxed at the corporate level and then the dividends that stockholders receive from the corporation are taxed at the individual level.  Definitely a downside!

The corporation does provide limited liability.  And there is ease of transfer via “stock”.  The life of a corporation is not limited by the stockholders.  Another upside is the ability to deduct fringe benefits of the owners.  Aside from non-discrimination rules (you can’t have benefits for the owners and not for other employees), a corporation can deduct health insurance, some life insurance, pension plans, etc.  Is it worth the extra costs and red tape?  Most people think not.  Just FYI, I’m an old fashioned corporation.

When there is more than one — a Partnership?

When there is more than one participant, you can’t be a sole proprietor.  That goes for husband and wife also, except in some special circumstances.  Like a sole proprietorship, a partnership is easy to form and without a lot of red tape.  You do need an agreement, which also makes good business sense!  The biggest downside is that you have unlimited liability not only for your actions, but for the actions of the other partners.

Partnerships are not taxed, but do have their own informational tax return — a form 1065.  The form 1065 reports the income and expenses for the partnership and divides the items among the partners based on the partnership agreement.  Each partner is given a K-1 with his/her share of the income/loss to be reported on various lines of their individual tax return.   The form 1065 can be quite complicated and should be prepared by a qualified tax preparer — another expense.  Partners pay self-employment tax on the income rather than being employees with a W-2.

Fringe benefits are generally not deductible for partners, and the options for fringe benefits and retirement plans are much the same as for sole-proprietors.

A partnership interest can be transferred and continue after the demise of a partner depending on the partnership agreement.  Also, if an LLC is comprised of more than one member, a partnership is the default entity if no other choice is made.  More about this when we get to LLCs.

Sole Proprietorship – Oldie but a Goodie

Sole proprietorship isn’t as popular as in the old days — those days before LLC’s.  But as the LLC newness has worn off, people are taking another look at sole proprietorship.  More about it when we discuss the LLC, but some states (including KY) have established annual reporting requirements and annual fees associated with LLCs, including the single member variety.

The number one advantage to a sole propietorship is the ease and low cost of establishing.  Other than state and local registrations (and an EIN if you have employees), you just start doing business.  Also, it has the lowest administrative costs.  The business income is taxed to the owner on his or her individual tax return on a schedule C or if a farm, a schedule F.  No separate return to prepare.  The business owner is not an employee, and pays self-employment tax as opposed to social security/medicare tax.

The major disadvantage to a sole proprietorship is the unlimited liability (including business and personal assets) for debts and any lawsuits brought against the business.  Some risk can be covered by insurance, but depending on your situation,  you might be wise to discuss with an attorney.

Other disadvantages include, as the same implies, it can ONLY be you.  If you have a partner, then you can not be a sole proprietor.  In addition, It is difficult to transfer interest of a business where the owner is a sole proprietor.  Fringe benefits for the owner are generally not deductible.

For low cost and minimum red tape, it’s the sole proprietorship.