Updated: Jan 6
Starting a small business has so many facets. Legal, accounting, and tax implications are key in choosing the correct entity type. Below is a general description of each entity type to help you understand the unique differences and requirements. Please consult with an attorney or licensed financial adviser to determine which entity type will be the right fit for your small business.
Description: A sole proprietorship is an unincorporated business owned by a single individual.
Structure & Liability: A sole proprietor's business assets are not legally separate from the sole proprietor's personal assets, which means the business owner is personally liable for any business debts, lawsuits, and creditor obligations.
Formation: Sole proprietorship formation might require an Employment Identification Number (EIN), business license or seller's permit.
Taxes: Business net income is subject to income tax at the individual's tax rate as well as the self-employment tax.
Example: Freelance photographers, artists and other creatives are often sole proprietors.
Description: A Partnership is an unincorporated business with more than one owner. (Please note, a Limited Liability Company with more than one member can be classified as a Partnership. This is detailed under the Limited Liability summary below).
Structure & Liability: Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business. Each partner's business assets are not legally separate from their personal assets, which means they are personally liable for any business debts, lawsuits, and creditor obligations.
Formation: Partnership formation might require an Employment Identification Number (EIN), business license or seller's permit.
Taxes: Partnerships are considered flow-through entities. Business income is reported on Form K-1 of Form 1065. The K-1 income "flows through" to Form 1040 to be taxed at each partner's individual tax rate. Business income is also subject to self-employment tax. State fees may also apply.
Example: Consulting services and small revenue businesses often organize as partnerships.
Limited Liability Partnership
Description: A limited liability partnership (LLC) is an incorporated business entity that has two classes of partners - general partners and limited partners.
Structure & Liability: An LLP is required to have a General or Managing Partner that is liable for all of business activity. The remaining partners are "silent" and are only liable for their individual activity.
Formation: Complete applicable state forms and create a Partnership Agreement. Partnership formation will require an Employment Identification Number (EIN) and possibly a business license or seller's permit.
Taxes: Partnerships are considered flow-through entities. Business income is reported on Form K-1 of Form 1065. The K-1 income "flows through" to Form 1040 to be taxed at each partner's individual tax rates. State fees may also apply.
Example: Law practices and other licensed professional practices will sometimes be organized as Limited Liability Partnerships.
Limited Liability Company
Description: A Limited Liability Company (LLC) is a business structure allowed by state statute that allows limited liability protection to each member.
Structure & Liability: Owners of an LLC are called members. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner. LLCs with more than one owner, Mutli-Member LLCs, are treated as Partnerships for tax purposes. In the case of lawsuits, liabilities, and creditors, each member is only liable for the amount they have invested in the LLC.
Formation: Entity formation varies by state. Many states require or highly recommend an Operating Agreement upon formation. Some businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.
Taxes.: Multi-Member LLCs are considered flow-through entities. Business income is reported on Form K-1 of Form 1065. The K-1 income "flows through" to Form 1040 to be taxed at each partner's individual tax rate. Business income is also subject to self-employment tax. State fees may also apply. For single member LLCs, business income is directly reported on Form 1040 and is subject to income and self-employment tax.
Example: Real estate properties are often held in LLCs.
Description: A corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
Structure & Liability: Corporate officers can perform services and run the entity. Shareholders receive business interest in the entity. Annual shareholder meetings, corporate minutes, and shareholder votes are required with an S-Corporation. Shareholders, officers and owners are not personally liable for corporate debts and liabilities.
Formation: S-Corporations begin as standard corporations. Within 75 days of incorporation, Form 2553 must be filed to declare the entity elects to be taxed as an S-Corporation. Note, if the 75 days window has passed, retroactive election is possible. To qualify as an S-Corporation, the business must:
Be domestic corporation
Have only allowable shareholders
May be individuals, certain trusts, and estates and
May not be partnerships, corporations or non-resident alien shareholders
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Income Tax Forms: Form 1120-S and applicable state forms.
Taxes: Owners/officers are required to take a reasonable salary that is subject to FICA tax and income tax. Shareholder profits flow through via Form K-1. These profits may be subject to income tax, but they are not subject to self-employment tax. Shareholder losses are subject to certain limitations that require the computation of stock and debt basis. The tax treatment of distributions is determined by the accumulated adjustment account (AAA).
Example: Some accountants and attorneys recommend that any business with net income greater than $30,000 or $50,000 consider the S-Corp election to benefit from the avoidance of self-employment tax.
Description: A nonprofit organization is a corporation that is exempt from taxes under IRS code sections 501(c), 501(d) or 401(a). The IRS refers to these types of entities as "tax-exempt." These organizations qualify for tax exemption because most of them provide some type of public or charitable benefit. Nonprofit organizations include all types of industries including education, cemeteries, veteran organizations, and more. The most common type of tax-exempt organization is the public charity described under IRS Code Section 501(c)(3). Donors that give to these types of organizations are eligible to receive a tax deduction on the personal tax return.
Structure & Liability: Public charities are governed by a Board of Directors. The Executive Director, Chief Financial Officer and other members of management are subject to the decisions of the Board. In addition, no single person owns a public charity's assets. These assets belong to the public and must be transferred to a charitable purpose upon dissolution. Public charities are also required to receive a minimum amount of revenue from the general public every year to maintain their 501(c)(3) status.
Formation: Nonprofit formation usually requires one to create an EIN, file Articles of Incorporation with state, complete IRS Forms 1023 or 1024 and corresponding state forms, and register with applicable states for charitable solicitation.
Income Tax Forms: Form 990 series (note tax-exempt returns are available for public disclosure).
Taxes: Unrelated Business Income is subject to tax at the corporate rate. Private Foundations pay an annual excise tax on net investment income.
Please keep in mind that each state has unique taxes and legal requirements for all of the entities listed above. Please review the applicable state requirements before forming your business entity. For more information on the different types of business entities, please contact The Little CPA.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.