How-to Decipher Between LLC, S-Corp, and Sole Proprietorship Status for Your Business
One of the most frequently asked questions we encounter involves tax status and business structure for small and medium-sized businesses. Whether you’ve picked up a side gig, left your corporate job in favor of consulting, or are looking to launch a hot new product with significant profit potential, selecting the appropriate business structure for your business needs is essential and can lead to tax savings. Walking through a basic example of each type is the simplest way to differentiate between the three options. So we’ve laid out a few fictitious businesses to illustrate the most common business entity setups.
First, let’s get one thing clear that is typical misconception. The three most common business entities for taxation are Sole Proprietor, Partnership, and S Corporation. Many business owners think having a Limited Liability Corporation (LLC) is one way to be taxed. However, a business cannot be TAXED as an LLC. An LLC is a legal entity set up through the state, where the business is doing business, to provide legal protection. If your business is an LLC, you must still choose how you want the business to be taxed.
Limited Liability Corporation (LLC)
A limited liability company (LLC) is a business structure in the US that protects its owners from personal responsibility for its debts or liabilities.
- Name example: Landscapes by Luna, LLC
- Protects Personal Assets: Covered
- Owners are called “Members” and not shareholders
- Cost to Become an LLC: Varies by state – $95 in Indiana
Luna is a hard-working college student who operates a small landscaping business during the summer. She advertises by word-of-mouth and has a handful of local clients who rely on her for lawn mowing, mulching, and weeding services. Filing as an LLC allows Luna to choose how she wants to be taxed as her business grows, and she acquires legal protection of her personal assets as an added bonus. Luna can start her business being taxed as a Sole Proprietor, change to be taxed as a Partnership if she wants to add a partner in a few years and even elect to be taxed as an S Corporation. She never has to change her legal name, get a new Tax ID#, or change her bank account. Her LLC can grow with her business.
If you are considering setting up a business, please consult an attorney on the right legal entity for your situation.
Now that we have cleared up the confusion surrounding LLCs let’s get back to our discussion of the three most commonly used taxing entities.
Sole Proprietorship (Schedule C in your personal tax return)
A Sole Proprietor is the easiest, most commonly established business entity. An individual starts a business, begins collecting money, and can write off any necessary or ordinary expense for the business. Any taxpayer paid directly for services or products and not paid on a W-2 is considered a Schedule C Sole Proprietor.
Kimmy is a stay-at-home mom and wants to make some money on the side. So she starts making deliveries and running errands for other stay-at-home parents and elderly folks. Every time she makes a delivery, she gets paid $50. Kimmy will report that income on her personal return on Schedule C and deduct any expense she incurs for that business.
- Legal Naming Structure:
- Established under her personal name and personal Social Security Number:
- Kimmy Smith doing business as Deliveries by Kimmy
- Or established as an LLC under a business Tax ID#
- Deliveries by Kimmy, LLC
- Established under her personal name and personal Social Security Number:
- Cost to become a Sole Prop: $0
- Owners: Only 1
- Net Profit: Net profits are subject to Federal Tax, State and Local Tax, and Self Employment Tax (15.3%), and the tax is calculated on her personal tax return.
S-corporation (Small Business Corporation)
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The S Corp completes a Form 1120S to report the income and expense, but everything is reported to the owner on a Form K-1 and the owner’s personal tax return.
Sarah is a savvy social media marketer. She left corporate America searching for a better work-life balance, and now operates her freelance writing business.
Sarah elected the S-corp status because it allows business owners like her to lower their self-employment taxes. For Sarah, this means that she pays herself a reasonable salary thru payroll that is subject to the 15.3% social security and medicare tax (also called self-employment tax). However, she can subtract a reasonable salary from her net profit and skip the social security and medicare tax on the amount of her remaining profits.
- Legal Naming Structure:
- Sarah’s Social Media Services, LLC or
- Sarah’s Social Media Services, INC or
- Sarah’s Social Media Services Corporation
- Shareholders: She can have 0 – 100
- Cost to become an S-corp: Varies by state – Annual fees are required
- Net Profits are subject to Federal, State, and Local Tax. Profits from a Corporation are not subject to the 15.3% Self Employment Tax
It is important to note that when you establish your LLC or Corporation legal entity, the S-corp designation is not automatic. After registration, she will need to send Form 2553 to the IRS to indicate she’d like to tax the business as an S-corp.
Partnership
A Partnership is a Sole Proprietorship but with more than one owner. A Partnership files a separate tax return and each partner receives a K-1 reporting their share of the profits. Each partner is responsible for reporting that income on their personal tax return and paying tax at their personal level.
Chaz is a talented pastry chef who just won Cupcake Wars. Cupcakes are flying off the racks and his lifelong dream is taking shape. He has 10 other bakers working for him to take his local cupcakery to a national level. It’s an exciting time, but he needs help bringing his business to scale. With profits pouring in, Chaz wants to be able to keep them within the business. Chaz allows the other 10 bakers to join his business as partners to share in the profits of the business.
- Legal Naming Structure:
- The Chunky Cupcake
- The Chunky Cupcake, LLC
- The Chunky Cupcake LLP
- The Chunky Cupcake Company
- Net Profits are subject to Federal Tax, State and Local Tax, and the 15.3% self employment tax.
- Owners are called Partners, and the number of partners is unlimited.
Every business is unique, just like every business owner. Whether you spend your days mulching, crafting marketing messaging, or decorating cupcakes, our team can help you determine what your financial priorities are and which designation will help you reach your financial goals. Click here to learn more about our business services.
Feel free to contact us if you have any questions or would like to set up a consultation with our business services team. Click here for contact information.
Blog by Kim Storen, EA – Tax Team Lead, Senior Tax Accountant
Learn more about Kim and the rest of the Storen Financial team here.