Why Does It Matter?
When it comes to starting a business, it is crucial to form the right entity. A specific entity can affect many things from tax rates, personal liability, and what it takes to keep up with it. All these including more are important factors to think about when you are forming your entity.
A sole proprietorship is a type of entity which is often used for smaller companies with few employees. This type of entity is easy to form and gives you complete control over your business. While a sole proprietorship is one of the easiest to deal with it also has some major drawbacks.
If you form a sole proprietorship then your entity does not produce a separate business entity, so in other words your business assets and liabilities are not separate from your personal assets or liabilities. This is often a bad thing because you can be held personally liable for the debts and obligations of the business. Another drawback of a sole proprietorship is that you can’t sell stock of your entity and banks are usually hesitant to loan you money. From a taxation perspective, sole proprietorships are simply reported on the tax return of the owner. This is known as a “Schedule C” business. The owner pays income tax and self-employment tax on the net profit on an annual basis.
Another common type of entity is a partnership. There are three different types, General Partnerships, Limited Partnerships (LP), and Limited Liability Partnerships (LLP). In a limited partnership there are two types of partners, general partners also called unlimited and limited partners. General partners are responsible for daily management of the LP and are liable for financial obligations such as debt and litigation against the entity. Limited partners are not responsible for day-to-day activities or for the financial obligations beyond their initial investment. When it comes to an LP at least one partner must have unlimited liability. In California a limited partnership is required to pay the minimum $800 tax. One major advantage of limited partnerships is that they do have legal protections.
Limited liability partnerships are very similar to limited partnerships. The main difference between the two is that in LLP’s all partners have limited liability. This means that no partner is liable for any financial obligations and or problems of any of the other partners. Limited liabilities partnerships are taxed like LP’s as they are required to pay the minimum $800 tax to California.
General Partnerships are like Limited Partnerships and Limited Liability partnerships in some ways but also different. General partnerships are essentially sole proprietorships with two owners. In a general partnership all partners share the profits and the financial liabilities. This essentially gives all partners in a general partnership unlimited liability. A general partnership must also be made up of at least two partners. Unlike limited partnerships and limited liability partnerships, general partnerships are not required to pay the minimum $800 tax to California.
Limited Liability Corporation (LLC)
Limited Liability Corporations, better known as LLCs, are one of the more common types of entities. LLCs are good because they take the best part of corporation and partnership business structures. With an LLC most of the owners’ personal assets like their house, vehicle, and saving accounts are protected. One thing to take into consideration with LLC’s is that members are considered self- employed so they must pay the corresponding self-employment tax contributions towards Medicare and social security. A major benefit of an LLC is that profits are passed through to the individual personal income avoiding the higher corporate tax rates. Depending on the state LLCs sometimes must be reformed. When forming an LLC, it is important to look at the state’s rules on whether an LLC must be dissolved and reformed when members leave or join.
A C corporation, or C Corp, is a legal entity that is separate from its owners. C Corps can make a profit, be taxed, and can be held to legal liability all separate from its owners. In general, corporations are chosen for many reasons but one of the biggest being that they offer the most protection to their owners. On the other hand, they are also more expensive to form and involve much more record keeping, reporting, and operational processes. C Corps are taxed twice, they pay a corporate level tax annually and when they pay dividends their shareholders pay an additional level of tax. When you combine these two levels of tax, they often are in excess of 50%.
S Corporations are another type of corporation that is commonly chosen. These entities are great because they allow taxes to be passed through directly to its shareholders which helps avoid the corporate tax rates. An S Corp is also a very popular entity because it is not subject to the double taxation that the Corp is subject to. To qualify for an S Corp status, you must:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates
- May not be partnerships, corporations, or nonresident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation.
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