The business entity type you choose for your company has a serious impact on taxation and legal status, and it shouldn’t be taken lightly. The best way to illustrate the different types of business entities is to tell the story of John, a small business owner who traversed each entity type on his way to becoming a large manufacturing firm. His story illustrates that there is no one type of business that is better than another, but each has its place in the growth of a company.
Like many business owners, John began his firm out of his garage. He started small, manufacturing and selling his product by word of mouth. Over time, he found that his product was wildly successful! John was thrilled, until it came time to pay his taxes. As he looked into the myriad of entity types and taxation methods, he realized it was time to get serious.
The Sole Proprietorship
John realized that what he had started was a sole proprietorship. As the sole owner, he “was” the business. Legally, there was no separation between the two. His first tax year, he reported his business income on his personal tax return and paid taxes as he would on any other wages. He also found that he had to pay self-employment tax, which the government charged to recoup the federal taxes that normally would be taken out of an employee’s paycheck.
John’s success grew early in his second year. He wanted to expand, so he decided to join forces with his friend, Bill.
Bill offered John $10,000 in cash to invest in the business in return for a 50% partnership with John. John agreed, and a partnership was formed. While they later formalized this agreement with a partnership contract, at first it was based on just a handshake, which was still legally binding. At the end of the second year, John and Bill split the income on their personal tax returns and paid their tax liability much like John had in the first year.
Upon discussion, John and Bill realized that as they sold more product, they held liability if something went wrong. As such, they decided to form a Limited Liability Company, or LLC.
The Limited Liability Company (LLC)
Bill and John filed formal paperwork with the state’s corporation division to form the LLC. Bill and John listed themselves as the two founding members of the LLC, and after some brief paperwork, the entity was formed. They found that they had multiple options for entity type and taxation. While their business type would technically be an LLC, they had the option of being treated like an S- or C-corporation for tax purposes. If they elected to be treated as a standard LLC, they would treat their yearly tax returns much like they had before. If they decided to be treated as a formal corporation, they would fall under those tax rules while retaining the LLC structure.
In their fourth year of operations, once Bill and John had their own manufacturing site and business continued to improve, they were approached by a third partner, Emily. Emily offered to invest $200,000 in the business in return for 20%. As Bill and John discussed it, they realized that it was time to move on to a more formal business entity.
Bill and John filed the appropriate paperwork to transition to an S-Corporation. They decided to keep it simple and issue 100 shares of stock. Twenty shares would go to Emily, and the remaining 80 would be split between Bill and John.
The owners’ main incentive to form an S-Corporation was the preferential tax treatment. As an LLC, Bill and John had retained their pass-through status, so they reported income as they had in the past. Now as an S Corp, they had to pay the three owners in two different ways: salary and distributions. Bill and John decided to draw a salary of $150,000 per year and receive distributions at the end of the year based on performance. Emily, a passive partner, expected only distributions of $50,000 per year. Bill and John paid employment taxes on their salary and reported it as regular wage income. Their distributions received were not subject to employment taxes like FICA, and they reported it on their tax returns in the same manner as their salary. At the end of the year, they paid their normal income tax rate on their total income and received credit for the withholdings against their $150,000 in salary. Emily, as a passive owner, paid taxes on her distributions the same as Bill and John, with the exception that if the company had taken a loss, she would not be able to deduct the full amount in most cases.
In the 10th year of operations, the company had expanded to several locations, and the owners decided to dilute their ownership in return for sales of their stock. They decided the best way to handle this change was to convert into a C-corporation.
After converting their stock and making the appropriate financial statement adjustments, the owners found that the C-corporation transition only required a letter to the IRS requesting the new entity type for tax purposes. Beyond that, the main change was that the qualified dividends received instead of distributions were treated preferentially for tax purposes. Instead of paying their ordinary tax rate, they paid a lower rate between 0 and 15%. The drawback was that now all income was taxed at the corporate level once, and again on their personal tax returns. Despite warnings of “double-taxation” at this level of operations, the tax treatment was actually preferable to the owners, especially later as they took a more passive role in the business.
A Familiar Story
Bill, John & Emily’s story is fictional, but many business owners have followed the same path. Forming your business usually starts as simply as beginning operations. Later, protecting yourself and your business through proper entity organization becomes vital. More than likely, you are somewhere along the path that the owners above followed; if so, contact a your tax advisor to discuss whether your business type is best for your company. You have nothing to lose by researching your options, and your firm’s future to gain.