When starting a business there is the choice of entity to use for your business. The basic choices are:
Sole Proprietorship (a one-person entity that requires minimal government filings to form)
Partnership (two or more people or entities operating a business; requires some business filing-usually at the local government level)
Limited Liability Company or Limited Liability Partnership (could be a sole person or two or more people or entities operating a business; requires formal filing usually at the State level)
Corporation, as a “C” or “S” corporation (could be a sole person or two or more people or entities operating a business; requires formal filing usually, also, at the State level)
The below graph shows the general tax aspects and limitation on personal liability of each entity:
|Entity Type||Self employment tax||Income tax||Limited liability|
|Sole Proprietorship||Yes (a)||Personal Rates||No|
|Partnership||Yes (a)||Personal Rates||No|
|Limited Liability Company||(b)||(c)||Yes|
|"C" Corporation||No||Corporate Rates||Yes|
|"S" Corporation||No (d)||Personal Rates||Yes|
(a) Generally, each owner(s) must pay a tax of 15.3% up to the Social Security wage base for any particular year. This is over and above personal income tax rates.
(b) Subject to Self employment tax if the owner(s) fail(s) to make a tax election which then taxes the owner as an individual (if one person owns the LLC) or taxes the owners as a Partnership.
(c) Personal income tax rates, if the owner(s) fail(s) to make a tax election. If one elects to be treated as a "C" corporation then entity is subject to corporate income tax rates.
(d) Internal Revenue Service regulations do require reasonable wages be paid to corporate officers, which subjects these wages, only, to the 15.3% tax.
The above represents a general view of your choices. Some exceptions for the above taxation and some other attributes of the above entities are:
A Sole Proprietorship that conducts rental property activity only will not be subject to the Self employment tax (even presuming it reflects a positive income on such rental activity).
A Partnership can technically form as a Limited Partnership or have Limited Partners. A limited partner will NOT be subject to Self employment tax (but is subject to personal income tax). It is possible to be a limited partner one year but not in other years, which is dependent on how active the partner is in conducting Partnership business.
A Limited Liability Company (LLC) may be owned by one of more persons or entities. If owned by only one entity it is classified as a Disregarded Entity, which means the sole owner reports the income activity on their personal tax returns and thus does not have to file a separate (LLC) return. If there are two or more owners of an LLC then the LLC must file a Partnership return, unless it has made a tax election to file as a Corporation (“C” or “S” are both permitted elections).
A “C” corporation is subject to corporate tax rates but could also lead to double taxation. If this corporation pays its earnings out via dividends then the corporation receives no deduction for paying these dividends but any individual receiving this dividend is taxed on this money, hence the double taxation. Therefore, it is often advisable to compensate owners with reasonable wages because these wages are deductible to the corporation so the wage taxation to the individual owner would not represent double taxation.
An “S” corporation passes through its income to the shareholders. Alternatively, any losses on “S” corporations, generally, can flow through to these owners to reduce their personal taxes. In comparison, a “C” corporation that losses money can only carry the losses to future years of the “C” corporation.