I have been having quite a few conversations lately with people interested in starting a company and trying to decide which entity to choose. It is probably the number one question I receive as a tax professional. What is more surprising is the number of people venturing out on their own amidst a global pandemic. I attribute this to all of the hours we are probably spending at home and finding things that bring us joy and wanting to learn how to center our wage-earning power around those things. It is inspiring, and implants a resemblance of hope back into what feels like a fiscal catastrophe.
Often, this new-found entrepreneurial desire is accompanied by fear, specifically concerning tax and compliance. And rightfully so, taxing authorities have built a culture of fear around compliance: ‘pay or else we will come for your firstborn.’ So naturally, you start with one of the most critical questions: what kind of entity do I set up? This question is so difficult to answer because it depends on what you are currently selling and what you plan to do with your business in the future. There is no exact formula, so making an adequate decision is primarily based on the information you have acquired and how it applies to your unique situation.
And since I love quick, digestible information, here is a summary of benefits, downsides, and how to set up the four main entity types.
aka Sole Prop
1) Benefits: All income and expenses are reported on a Schedule C that goes with form 1040, so you do not have to worry about much. If you are new to the small business game and want to test your idea to see if people will buy what you are trying to sell, then a Sole Prop will work fine. Plus, it is easy to set up and comply with tax rules (see #3). Most independent contractors and side hustlers take this route.
2) Downsides: Not so much of a good fit if you are growing more significant than a traditional micro-small business, because you personally hold all the liability. Meaning your personal assets can be seized to satisfy a debt. And this headache becomes more realistic the larger you grow. Also, it is not a good fit if you are thinking of taking on investors.
3) How to set up: This is the simplest entity to set up. A DBA, a business bank account, and a business license is usually all that is needed. A DBA is a notice to your local county that you will be operating a business (aka Doing Business As) in that county/city. This DBA is generally required when setting up a business bank account. You will also need to register with your local jurisdiction to cover your business license requirements and sales tax (with the state) if you are selling taxable goods.
or LPs or LLPs
1) Benefits: Like a Sole Prop, the owners recognize all income and expenses on their individual tax returns using a K-1. The only difference is the shared responsibility with two or more parties.
2) Downsides: The tax responsibility is all on the owners. While there is some legal protection with Limited Partnerships (LPs) and Limited Liability Partnerships (LLPs), tax liability remains with the partners. Yes, the IRS can come for your personal coins if the business is not compliant. Also, it is not a suitable investment entity.
3) How to set up: I highly recommend having a partnership agreement between all partners. This agreement is more of a legal document rather than a tax document, but it helps to delineate how much of the company each person will own and how much of the loss they will be able to claim on their tax forms. Also, I have seen several companies fall apart behind expectations and no clarity. Other than that, you will want to make sure the business is complying with state registration requirements, business licenses, and sales tax registration, if applicable.
Limited Liability Company
aka LLC (single and multi-member)
1) Benefits: LLCs are fun if you understand how they are taxed. You have three options: 1) single member, which can file on a schedule C; 2) multi-member, which can file with a 1065; or 3) multi (or single)-member filing as a corporation. Fun fact, the IRS doesn’t recognize an LLC as a taxable entity hence why you have to choose one of the three options. Keep in mind that if you want to be an LLC filing as a corporation (C or S) you have to elect that option using form 8832 or 2553. You might be thinking, ‘what is the difference between the three options?’, and it basically comes down to how you want to be taxed.
2) Downsides: I like LLCs and don’t have too many disadvantages except that they are not the best option for investments. Also, the forms can get confusing if you are not careful.
3) How to set up: There are levels to this process. At the federal level, you’ll have to complete election documents if you want to be taxed as a corporation. At the state level, you’ll have to complete state registration documents and sales tax registration docs if applicable. At the local level, you’ll have to complete business license documents. If you have inventory, generally valued at more than $100k, you will have business personal property tax to consider. I know this is a lot, but don’t panic; you can do this.
aka C-Corp or S-Corp
1) Benefits: There is no personal liability; a corporation is responsible for itself and can file bankruptcy on its own. As an owner, its strongly advised that you set up payroll to pay yourself instead of taking personal draws, or a balance of the two options. Establishing payroll takes the headache and guesswork out of filing personal taxes as the business owner. With a corporate entity structure, investment becomes much simpler because you can simply sell shares of the company to interested parties. And the percentage of shares you own equals the portion of the company you own.
2) Downsides: This structure is usually the most expensive setup and often requires third party assistance. Let me suggest Clerky or IncFile to assist with form filling. Another downside is double taxation, this happens because the business pays income tax for itself, and the shareholders pay income tax on distributions, hence double taxing. It is also more complex to set up.
3) How to set up: Pick a name. Pick a state where you want to incorporate. File Articles of Incorporation. Appoint a registered agent. Prep corporate bylaws. Appoint a board of directors. Issue stock (file 83-b). File annual state registration. Register for sales tax if applicable and local tax registration.
If your head is spinning, then good, that means you have been paying attention. Also, keep in mind ComplYant is here to help you sort through all of this, so visit the website for more information.
Shiloh Johnson, CPA, MsT works with small business owners and early entrepreneurs to make sure they understand relevant tax rules and requirements. She founded ComplYant in 2019 as a call to action for changing the way we think about tax. Her motto “We all have to do it, why not do it better.” Shiloh holds an undergraduate degree in Accounting and a Masters of Taxation and is also a member of several professional organizations, including the Institute for Professionals in Taxation, American Institute of CPAs, Institute for Professionals in Taxation, and the National Association of Black Accountants.