by Simplice Essou | July 7, 2023
Selecting the type of business entity to register and operate the business under is one of the most important decisions a new business owner will have to make. This decision is crucial and may have implications on your tax bills, on the number of investors allowed, and the personal liability of the owner(s).
Tax treatment, meaning how your business will be taxed, should be of upmost importance for business owners as it can have a direct impact on the business’s cash flows. The choice of entity will determine the tax rules the business will need to follow. Below are the types of entities a new business owner may choose from and their tax implications:
- Sole Proprietorship: A sole proprietorship is not a distinct entity from the owner. The sole proprietorship’s income is subject to a self-employment tax of 15.3% and is also taxed at the proprietor individual tax rate.
- Limited Liability Company (LLC): LLCs are pass-through entities, which means that the LLC does not pay taxes. Rather, the owner (s) pay taxes on their individual tax returns. For the IRS, a single member LLC is a disregarded entity and is taxed as a sole proprietorship. The income or loss is reported on schedule C attached to the owner’s 1040 tax return. The owner pays any tax liability. When there is more than one member, the LLC is taxed as a partnership. It files Form 1065 to report any income or loss from the business and each owner will report its portion of the income or loss on his/her 1040 tax return.
- S Corporation: The S corporation is a pass-through entity, and the owners will report any loss or income on their form 1040. A single member LLC who has elected to be taxed as an S corporation would avoid the self-employment tax. This may result in significant savings for the owner therefore, selecting the right entity type is of upmost importance.
- C corporation: Unless it makes an S corporation election, the C Corporation is a separate tax paying entity. That means that the C Corporation pays taxes on any income and when a part of this income is distributed to investors as dividends, these amounts are reported on the owner’s form 1040 tax return, and taxed. This is known as double taxation.
Number of Owners (Members)
The number of owners can also determine the type of entity the business owner(s) will select. For example, for an S corporation, the number of owners is limited to 100. If owners are seeking to access venture capital the most appropriate form will be the C Corporation as it allows for unlimited number of investors.
Personal liability is an important consideration when it comes to starting a business. Personal liability comes into play when damage or an accident happens in the operation of the business. It could be an injury involving an employee or a client. In this case, the individual business owner could be liable for damages. For a sole proprietorship, the business owner, the business assets, and liabilities are not separate from the owner(s)’s assets and liabilities. Therefore, the owner is liable for the business’s liabilities including claims from lawsuits. In the case of a LLC or Corporation, members cannot be personally liable for the business’s liabilities.
As a new business owner, it is very important to take your time and do the necessary research before selecting a business entity as there are many factors that may affect the business’s cash flow, especially when it comes to taxes. Keep in mind that the number of members within the business and personal liability must also help you determine which business entity is the right fit for your business.