So, you want to start a business but there are all these different terms being thrown around about how you should structure it. It can get a bit overwhelming! We are here to help you understand what these different business structures mean and what may be best for you and your business.
Sole proprietorships and partnerships are similar business structures. However, if you have more than one owner, your business is considered a partnership. As a sole proprietorship, when you file your personal tax return there is an additional form called a Schedule C where you include the businesses income and expenses. A partnership files a separate return called Form 1065. Partners in a partnership receive Form K-1, which needs to be reported with each partner’s personal tax return. Any profit or loss from the business then flows through to each partner’s personal tax return.
You are not able to pay yourself through a W-2 but you are able to take draws or distributions from the business without it being considered additional taxable income. Since you are not paid with a W-2, you are not having Social Security or Medicare taxes withheld; therefore, you have to pay self-employment tax on your personal return. That amount is calculated based on the profit of the business. The main downside to this business structure is that the business owner(s) are potentially personally liable for any claims against the business. You may be able to better protect your personal assets by registering your business in its home state as a Limited Liability Company (LLC). Be sure to consult with an attorney when evaluating the liability aspects of a business structure.
Limited Liability Company (LLC)
By registering as an LLC, liability is generally limited to the business’ assets. Again, we recommend consulting with an attorney to evaluate protection of your personal assets under varying business structures. Note that becoming a LLC does not change how your business files its taxes. You must pay a $125 registration fee when registering to become an LLC in New Jersey and you must file an annual report each year that has a $75 fee.
S-corporations are similar to sole proprietorships and partnerships in the sense that your income from the business flows through to your personal return and you can take draws or distributions from the business without it being considered additional income. The rules for taking distributions are stricter for S-corporations, as each shareholder must take distributions proportionately to his/her ownership percentage. For example: If shareholder A is a 60% percent owner and shareholder B is a 40% owner and they take a $10,000 distribution from the business, shareholder A receives $6,000 and shareholder B receives $4,000.
Another benefit of this organizational structure is that owners can pay themselves on a W2. To do this, owners must be paid a reasonable salary. The benefit to that is it reduces the businesses income but you would be receiving W-2 wages and withholdings that include Social Security and Medicare taxes. For example: If the business has a $100,000 profit as a partnership but you become an S-corporation and you have two partners that now take $50,000 salaries, the business income would be zero and the partners would not have to pay self-employment taxes with their personal tax returns. You are still paying half of your self-employment taxes through your withholdings, while the business deducts the other half on its S-corporation tax return. Talk to us about determining the amount of a “reasonable salary” for your particular business.
Becoming an S-corporation requires a one-time tax election that you make when setting it up. Partnerships and LLC’s can make elections to be taxed as S-corporations, while retaining their legal structures. Partnerships and LLC’s have the opportunity to make this election annually. S-corporations file their own tax returns, using Form 1120S for federal purposes.
C-corporations are different from the other organizational structures mentioned above. The main difference is that they themselves incur tax on their profits, so the income does not flow through to the owners’ personal returns. C-corporation owners are compensated by receiving salaries from the business. The business may also pay dividends to its owners. Note that dividend recipients pay tax on that income.
This type of structure is usually not recommended for small businesses due to the double taxation, in that dividends or distributions from LLC’s and partnerships don’t create taxable events. They also do not work well with real estate because of the tax treatment on the sale of assets. The C-corporation setup is better suited for larger businesses that manufacture and sell products, and have large numbers of employees. In addition, C-corporations can have unlimited shareholders and multiple classes of stock, unlike S-corporations, which have a single class of stock and maximum of 100 shareholders.
If you are interested in starting a business or need help filing an election, Eiger, Lang & Company, CPA LLC is here and ready to help