Welcome to Selfmade Finance School, our new money series with Block Advisors to help small business owners with their tax, bookkeeping, and payroll needs year-round. This week, we explore five different types of business entities you can consider for your small biz.
There are millions of things to consider when starting your own business. Some of them are very exciting and glamorous — "what cool name should we give our business?", "what fun logo should we choose?". Some decisions we make are not as glamorous but just as important! Here, I will focus on the not-so-fun decisions you need to make when establishing your business.
What Kind of Entity Should We Be?
Many new business owners often struggle with how to establish their business. First, I suggest talking to a tax professional or an attorney before you make this decision. All businesses operate differently and when you are trying to make this decision, you need to consider what type of business you are running, how many people are involved, and what your personal tax situation looks like. Here are some examples of entities to consider:
Sole Proprietor: If you operate a business on your own and the business is unincorporated, you are most likely a sole proprietor. Sole proprietors need to complete an individual tax return using Schedule C that will serve as a profit and loss (P&L) statement. This will include all your business income and your expenses. You would file the Schedule C with your personal 1040 by April 15 each year. On top of regular income tax, a sole proprietor will pay self-employment taxes, at the same rate as the employee and employer share of Social Security and Medicare taxes. The advantage of this business entity is simplicity; no need to create a separate legal entity or file a separate tax return.
"You can stop and start a sole proprietorship at any time, so this is a good way to get your feet wet while you explore whether your business will be successful," says Marcie Rahn, Master Tax Advisor and Enrolled Agent at Block Advisors.
Partnerships: Partnerships have two or more people working together in a trade or business. Each person contributes money, property, labor or skill and expects to share in the profits and losses. A partnership must file an annual information return using Form 1065 which is due March 15. A Partnership doesn't pay tax at the business entity level, but instead passes the profits and losses on to the partners. Each partner then reports their share and pays the taxes on their individual returns. The tax consequences will vary based on each partner's personal income situation.
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Photo by You X Ventures on Unsplash
C Corporation: A C-Corp is an entity that is formed under state, federal, or foreign corporation laws. A C-Corp has shareholders that elect directors and the directors manage the corporation. The officers and managers hired by those directors carry out the day-to-day work of the business. C-Corps must pay taxes on any profits earned. C-Corps will use Form 1120 and file by April 15. Shareholders will also pay taxes on any distributed dividends when they file their individual tax return, so corporate income has an element of double-taxation. However, a C-Corp is truly distinct from its owners and employees and can have an unlimited life.
S Corporation: An S-Corp is a corporation that makes a Subchapter S election. It must be a domestic business with no more than 100 shareholders. You can even be a single-member S-corp. This entity has only one class of stock. S-Corps will file Form 1120S to report any profits. It should be filed by March 15. It is not taxed like a C-Corp, but like partnerships, income and losses are passed on to shareholders who will report the tax consequences on their individual tax return. If you work for your S-corp, you'll pay yourself a reasonable wage for your services, which are subject to Social Security and Medicare taxes, but additional business profits are taxed as ordinary income. "There are situations where self-employed individuals can use an S-Corp to save on self-employment taxes, so you may want to explore these options as your business grows," says Rahn.
Limited Liability Company: An LLC is a legal entity that may be treated a few different ways. While an LLC provides legal protections for a business, it does not have a specific tax form like the other business entities. Instead, the IRS looks beyond the LLC designation to see how many members the LLC has and whether it has made any elections to file taxes as a specific type of business. A default rule treats a single-member LLC like a sole proprietor for tax purposes.
If the LLC has two or more members, a default rule treats it as a partnership for tax purposes. The LLC could also elect to be treated as a C- or S-Corp, and file taxes like those entities. A common misconception is that all sole proprietors must form an LLC, but this is not true. Although LLC status carries no tax benefits, the legal protections can be important for businesses of all shapes and sizes.
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Photo by You X Ventures on Unsplash
Choose Your Calendar Year
This is a weird one, but you should think about it. Most business use a calendar year (January 1 to December 31), which is easy and aligns with the dates of your personal tax returns and tax documents. However, a fiscal year might be better for your business. For example, if you're in an industry that is highly seasonal, you may want to wrap up your year after your season ends. A fiscal year can be any 12 consecutive months that ends on the last day of the month other than Dec 31st. Another option is a 52-to-53-week tax year. This is a fiscal tax year that varies from 52 to 53 weeks but does not have to end on the last day of a month.
You May Need an EIN
EIN stands for Employer Identification Number. Although it is only required if your business is incorporating, operating as a partnership, or and has employees, it's a good idea for every business. You'll be providing your tax ID number to contractors and vendors frequently, and it's better to have an EIN than to give out your personal Social Security Number! An EIN is very easy to request on the IRS web site.
You should always consult a tax professional or an attorney before incorporating or changing your business structure, and don't forget that you can always change the way your business is set up on your journey. We recommend working with a Block Advisors small business certified tax pro because they can help you with your small business taxes and more – for small businesses just like yours.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regards to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results. Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. O'Keeffe Financial Partners and any other entity listed herein is not affiliated with Kestra IS or Kestra AS Investor Disclosures: https://bit.ly/KF-Disclosures
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