Forming your entity
Assuming you’ve already selected a name for your business, forming your business is the next step.
You have many options when it comes to structuring your business entity which are dependent on a number of factors. One option is not to form an entity at all, rather, you just file a DBA (doing business as). This is generally not advisable for several legal reasons including liability protection.
When forming a legal entity with your state, the most common options are (1) Limited Liability Company or LLC, (2) Corporation or (3) Limited Partnership. Professional organizations (such as doctors, lawyers, etc.) have additional common options.
It is important to discuss what entity is right for your business with a business attorney.
Tax implications of forming your business entity
One of the most important factors about creating a business entity is the tax implications. Let’s breakdown the entity formations and their tax impacts (as of 2024):
Limited Liability Corporation (LLC) – Overall, an LLC is your typical go-to in almost any state. The cost depends on the state, but it’s affordable and a great way to start your business quickly. As well, it’s easier to maintain from a compliance standpoint.
So what’s the big deal about LLCs from a tax standpoint? In addition to generally being less expensive to form than most other entity types, the LLC is a very flexible business entity for tax purposes.
Forming a Single Member LLC and the tax implications
A single member LLC can be taxed in multiple ways at the election of the owner, including (1) as a disregarded entity that does not need to file a federal income tax return and reports its revenue and expenses directly on Schedule C of the owner’s individual income tax return, Form 1040.
The net profit reported on Schedule C is taxed by the owner at their individual income tax rates.
In addition, single member LLCs are subject to a self-employment tax rate of 15.3%.
The owner can also elect to treat their single member LLC as an S-Corporation, which is considered a flow through entity and will file its own S-Corporation federal income tax return and report the net income or loss to the owner on Schedule K-1, which the owner will report and be taxed on their personal income tax return.
Or, the owner of a single member LLC can elect to treat their LLC as a C-Corporation for federal income tax purposes. A C-Corporation files its own tax return and the net income is taxed to and paid by the LLC itself and does not flow to the individual’s personal income tax return.
Multi-member LLCs and tax implications
A Multi-Member LLC can be taxed as either (1) a Partnership, which is a pass-through entity that files its own partnership income tax return and net income or loss is reported to the owners on Schedule K-1.
Owners can also elect to treat their multi-member LLC as an S-Corporation, which is considered a flow through entity and will file its own S-Corporation federal income tax return and report the net income or loss to the owners on Schedule K-1, which the owners will report and be taxed on their personal income tax return.
As well, an owner of a single member LLC can also elect to treat their LLC as a C-Corporation for federal income tax purposes.
What is the difference between having your LLC taxed as an S-Corporation or as a partnership since both are flow-through entities?
The S-Corporation is a more complex tax structure but the main advantage of it is that it allows the owner(s) to pay themselves reasonable compensation as an employee, subject to 15.3% payroll taxes (up to the SS threshold).
After paying the owner(s) reasonable compensation the remaining net profit will not be subject to employment or self-employment taxes. This can be beneficial in scenarios where the S-Corporation has significant net income after paying reasonable compensation to the owner(s).
In comparison, an LLC taxed as a disregarded entity or partnership for federal income tax purposes cannot W2 its owner(s) and the owner(s) will be subject self-employment tax on 100% of the net income.
Just because we are talking about percentages, don’t let it fool you. Under the right circumstances the difference can be 10s of thousands of dollars saved.
However, while it might seem like an S-Corporation is the clear winner, we see many LLCs that made the election to be taxed as an S-Corporation either prematurely or never should have made it at all.
There are many factors to consider in whether to make an S-Corporation election or not, including but not limited to, the expected net income of the business and what owner reasonable compensation needs to be.
This is something an experienced tax professional can help you model out and make the right decision.
Did you know?
There is a rebuttable presumption that an LLC that does not show a NET Profit 1 out of 3 years, can be considered a hobby by the IRS, and the IRS can disallow current year and previous year losses on an audit. It is always alright to show a loss on your books/taxes, but it can become problematic if it happens three years in a row without good reason.
If you need help with forming an entity, reach out to Blaze Business Concepts! info@blazebusinessconcepts.com.