We get a lot of questions about what type of business entity I should use for my business because there are lots of different options. You have C corporation, S corporation, partnership, sole proprietorship, LLC which stands for limited liability company. So people are always asking, what’s the best one to use? How should I set this thing up? First, let’s get one thing out of the way. An LLC does not drive any tax impacts. So the other four entities that we mentioned, C corporation, S corporation, partnership, sole proprietorship, those drive how you are taxed. If you are forming an LLC with the state, that’s a good thing to do because it’s limiting your liability, but then, for federal tax purposes, you have to elect either C corporation, S corporation, partnership, or sole proprietorship. So I just want to make that clear that an LLC is not by itself a tax entity. You still have to elect how you want to be taxed.
So with that being said, let’s dive in to the other four type of tax entities. Sole proprietorship is pretty basic. It’s a one person owner. The results get reported on a schedule C of your personal tax return and there’s really nothing else that you need to do. You’re going to need to pay tax on all the earnings of the company and all of those earnings are also going to be subject to self employment taxes. So think social security and Medicare. So there’s no real great benefit to the sole proprietor other than it’s simple. You don’t have to file a whole bunch of extra forms. It’s one more schedule on your personal tax return. And that’s it. So that’s the simple way to go. It’s not the most tax effective way to go, typically. But it’s easy. So if you just want easy, that’s the way to go.
If you have more than one owner, than you are getting into either a partnership or an S corporation or potentially a C corporation. With a partnership, you still have lot of flexibility. You have multiple owners. And what happens is the partnership files a tax return and all of those results flow through to the individual partners on a schedule K-1. Now any general partner, anybody who’s active in the business will still pay self employment taxes in addition to their income tax. So, we’ll talk about S corporations in a second, but there’s no extra tax benefits from being a partnership. It’s simply, you have x number of partners. The business made this much money. That’s going to get split between the different partners based on the operating agreement of the partnership.
Now an S corporation can also have multiple owners, but what’s nice about an S corporation is that you are not subject to self employment tax on the earnings of the business. What you typically have to do is run a payroll, especially if there’s only a couple of people operating the business, each of them must take a payroll that is reasonable compensation and pay the Medicare and social security taxes on that payroll. But then any other money that the business makes is not subject to those taxes. So you get a nice extra tax benefit of forming an S corporation instead of a partnership. The down side though, is that you lose all the flexibility. So an S corporation can only have one type of stock. It has to be split a certain way amongst the owners versus a partnership you can divide up profits versus capital differently, you don’t do, you have a lot of different stuff within the operating agreement. The S corporation’s much more straightforward as far as having one class of stock. Everyone gets a certain percentage that you dictate in the operating agreement but there’s no flexibility there as far as who gets what distributions and who pays what tax. So it’s much more rigid of a structure than the partnership is but you get the tax benefits of not paying self employment taxes on the income that the business makes. So so far, sole proprietor, real simple, one owner, one form on your personal tax return. Partnership can have multiple owners. Again, everything flows through the personal return but you can have some flexibility on the ownership. The S corporation, you get some tax benefits in terms of not being taxed on self employment on the company’s earnings but there’s less rigid tax structure.
The final one is C corporation. And a lot of people, when they talk about companies, just in general, they tend to think of C corporations ’cause they’re use to hearing about stock, especially with the larger public companies, most of those companies are structured as a C corporation. That being said though, for a lot of smaller and medium sized businesses, a C corporation really isn’t the way to go. What happens with a C corporation is you can have a lot of flexibility around having different types of stock, different dividend payouts, different what are called liquidation preferences, we won’t get into all that. You can have different warrants, adoptions, and different debt structures that are tied to these, the stock to the company. So you can do a lot of complex things that are good for larger corporations. But the down side to C corporations is that it’s impossible to get money out of the business without paying some tax. So C corporations are taxed on the earnings of the company but then also, if you’re taking any dividends out of the company, you have to pay tax on that as well. So you get double taxed as a C corporation. So it’s not that C corporations are bad, or that you should avoid them at all cost, but a lot of times they’re just unnecessary, really for smaller and medium sized businesses versus the larger companies need some more complex equity and different ways to raise money. So if you’re a small or medium sized business and you don’t have huge dreams of making this a billion dollar company someday, you can really just set the C corporation off to the side. With the new tax law, the C corporation rates are lower. Maybe that will change over the next several years, we just don’t know. So a lot of people were trying to jump to C corp when they dropped the tax rates, but you still have to realize that you’re also then being taxed on any money that you take out of the business and that’s a pretty big downside.
So if you’re a smaller or medium sized business, we’re gonna be focused much more on partnership versus S corporation because a sole proprietor’s easy. You’re not really getting the tax benefits there. So it’s really a matter of, do you need some flexibility in your equity? In which case, we’d look more towards a partnership. Of if you do not need flexibility in your equity, then we could look more at the S corporation for it’s tax benefits. So I know that was a lot stuffed into one video on different tax structures but I’m hoping to clarify the difference between some of the major structures and also let you know that the LLC, if you’re forming that, is not the end point. That is the starting point that you file with the state, and then you still must elect what you want the tax structure to be from a federal tax perspective, either a C corporation, S corporation, partnership, or sole proprietor. If you have any questions on this, please reach out to me. I am happy to help.