A sole proprietorship is, inarguably, the simplest form of business entity. In essence, it’s not actually a business entity at all, but a direct extension of oneself. A sole proprietorship does not require any set up (besides a DBA or FBN – potentially). Individuals that receive 1099 self-employment income are considered sole proprietors, and there is no distinction between the individual and the business entity.
Tax Form(s): Form 1040 – Schedule C
Pros: A sole proprietorship is the easiest entity to set up, manage, and operate. No additional tax return is required as business income is reported on the personal tax return.
Cons: The individual has unlimited liability for the business’s debts and liabilities. The obligations are considered to be owed by the proprietor and are often reported on the individual’s personal credit report.
Who Should Consider This Entity: Affiliate marketers, multi-level marketers, “mom & pop” shops, independent contractors, self-employed individuals, and businesses with revenues less than $50,000. Most small businesses begin at the sole proprietor level.
A general partnership is very similar to a sole proprietorship, except that two or more partners are involved in the business. In such a case, the partnership must obtain an EIN (Employer Identification Number) from the IRS. The partnership is considered an entity separate from each individual partner, but the partnership income and expenses “flow-through” to the partners’ individual tax returns.
Tax Form(s): Form 1065 – Schedule K-1
Pros: Setting up a general partnership is fairly simple and typically only requires filing an FBN (Fictitious Business Name) and applying for an EIN from the IRS. Partnerships are terminated by simply marking “Final Return” on the partnership’s final tax return. No dissolution is necessary.
Cons: Partnerships require the filing of an additional tax return (Form 1065). Also, accounting for partnerships is generally more complicated than accounting for sole proprietorships. This, along with a need for monetary impartiality, could increase operating costs for the business. While a general partnership is considered a separate entity, the partners have unlimited liability for the business’s debts and liabilities. The obligations are considered to be owed by each individual partner and are often reported on each individual’s personal credit reports.
Who Should Consider This Entity: Small joint ventures with relatively low liability exposure.
Limited Liability Company (LLC)
An LLC’s tax structure is identical to that of a sole proprietorship (for a Single-Member LLC) or a general partnership (for a Multi-Member LLC). Partners or shareholders of an LLC are called “Members.” The difference between the two aforementioned entities and an LLC is the “limited liability” component. In this case, business debts and claims are owed by the LLC – not its members. Keep in mind: this limited liability can be circumvented under certain circumstances.
Tax Form(s): Form 1040 – Schedule C or Form 1065 – Schedule K-1
Pros: LLC’s are considered to be entities completely separate from their members. This means that the LLC’s debts and claims are owed by the LLC itself. In other words, the members are only liable for the amounts invested into the LLC.
Cons: Setting up an LLC in California involves a number of different steps. There are both state and federal documents that need to be filed which can be costly and time consuming. In California, LLCs are subject to a franchise tax, which has a yearly minimum of $800. Although LLCs provide limited liability to their members, this liability can become unlimited in certain circumstances.
Who Should Consider This Entity: Small-to-medium-sized, closely-held companies of all kinds. Business owners with extensive personal assets should choose an LLC over a sole proprietorship or general partnership.
The largest companies in the United States are C-Corporations. Generally, businesses that choose a C-Corporation as their entity structure have millions – if not billions – of dollars in annual revenue. However, some small business owners choose to form C-Corporations for additional liability protection and their “perpetual existence.” C-Corporations are considered an entity in-and-of themselves. Shares of the corporation’s stock can easily be exchanged, sold, and traded and the corporation can continue on, perpetually, even after the death of shareholders, directors, etc.
Tax Form(s): Form 1120
Pros: C-Corporations are entities in-and-of themselves. This means that they have perpetual existence. Ownership of the corporation is easily transferrable at any point in time. Additionally, the corporation’s liabilities and debts are strictly their own. Shareholders are not responsible for the corporation’s debts or liabilities.
Cons: C-Corporations require an extensive amount of work to form and operate. These corporations are also subject to double taxation. Dividends paid by the corporation are not deductible by the corporation, but are included on the shareholder’s tax return. This means that these dividends are taxed twice: once in the net income of the corporation and again in the individual income of the shareholder. For this reason, most small business owners rightfully shy away from the C-Corporation structure. In California, corporations are subject to a franchise tax, which has a yearly minimum of $800.
Who Should Consider This Entity: Large, privately-held businesses and publically-traded companies.
An S-Corporation isn’t technically a legal business entity. Rather, it is an election that can be made – by an LLC or C-Corporation – to be taxed under the provisions of Subchapter S of the Internal Revenue Code (I.R.C.). “S-Corp” status creates a flow-through taxation structure where the corporation’s net income and certain “separately stated” items “flow-through” to the shareholder’s personal tax return. The most appealing aspect of the S-Corp is that net profits are taxed as ordinary income – and are not subject to Self-Employment taxes – on the shareholder’s tax return. The catch is that shareholders are required to pay themselves a “reasonable salary,” which is subject to Self-Employment taxes before any non-salary distributions can be made.
Tax Form(s): Form 1120S – Schedule K-1
Pros: S-Corp status gives business owners the liability protection of a C-Corporation while also enjoying the benefits of flow-through taxation. S-Corp shareholders can potentially save tens of thousands of dollars in taxes every year.
Cons: S-Corporations require an extensive amount of work to form and operate. When S-Corp election isn’t made at the origination of the corporation, there could be built-in gains taxes that apply. Choosing to be taxed as an S-Corp may also involve higher operating costs as the accounting and tax work is more complicated and, likely, more costly. In California, corporations are subject to a franchise tax, which has a yearly minimum of $800.
Who Should Consider This Entity: Small and medium-sized businesses with net income exceeding $100,000 (before shareholder salary). In order for an S-Corp election to benefit the shareholder, there needs to be a significant amount of profits after the reasonable salary is paid to the shareholder. An S-Corp election is popular amongst licensed professionals such as dentists, lawyers, accountants, etc.