In the first stages of starting a small business, many prospective business owners rarely think about their business structure and how it will affect their financial and operational requirements. However, understanding the similarities and differences between each entity can answer many of the “sole proprietorship vs LLC vs S Corp” questions asked by most business owners.
To help you choose the correct tax entity structure for your business, we are going to list the various types of business entity types, along with their characteristics, so you can make an informed decision about your new business structure.
Why It’s Critical To Choose The Correct Entity Structure For Your Business
Taking time to research and understand the best structure for your business is one of the first and most important decisions you’ll make as a new business owner.
Your choice of business structure affects the level of protection for your personal assets, as well as your personal liability.
In addition to protecting your personal assets, there are numerous considerations related to taxes and administrative needs.
Sole proprietorships are the easiest business structure to set up because they do not require any legal documents like bylaws or articles of organization. However, your state or city may require you to pay for licenses or permits.
There are also no annual filings besides the owner’s personal tax returns.
As the name implies, sole proprietorships cannot have more than one owner. This is because the owner and the company are legally considered to be the same entity.
Sole proprietorships are a popular business structure choice for new business owners because they enjoy the following tax benefits:
- Business taxes are filed as the owner’s personal taxes.
- The business receives a pass-through tax.
- The owner can deduct business expenses from their personal tax return.
- Sole proprietorship owners are not required to pay payroll taxes.
- Sole prop owners do not have to withhold income tax.
However, sole proprietorships also come with the following disadvantages:
- Owners must pay self-employment taxes.
- Owners can be held personally liable for business debts and
Partnerships can be formed with two or more partners, but it’s worth noting that partnerships with more than 10 members can be quite difficult to manage.
There are two types of partnerships, general partnerships and limited partnerships.
General partnerships are the most common type of partnership, in which each partner contributes to the management and operation of the business. In a general partnership, each partner has equal authority in business decision and legal matters. Partners also have an equal level of liability and responsibilities, unless they sign a partnership agreement that states otherwise.
In limited partnerships, one or more partners are not directly involved in managing the business and are known as a “silent partner”. Silent partners often serve as investors with their funds being the extent to which they contribute to the business’ operation. Silent partners do not have any decision-making power and must get approval from a general parter.
Limited Liability Company (LLC)
Limited Liability Companies (LLCs) are a popular choice among sole proprietorships because they can be used to run almost any kind of business, are relatively cheap and easy to set up, and protect personal assets from business debts or lawsuits.
In addition to personal asset protection, LLCs also provide owners with pass-though taxation which lets owners report profits and losses on for the business on their personal tax return. Profits are taxed on the owner’s individual tax rates.
Growing companies often elect to become an S Corporation, rather than a C Corporation, because of the many benefits provided for S Corps. Here are the top advantages:
- Limited liability for shareholders, employees, and officers
- Pass-through taxation for owners, meaning owners report profit and loss on their personal tax return
- No double taxation – each owner’s income is only taxed once, not twice.
- Continuity, meaning that the company can exist even if the owners leave or die
- Taxes are filed once a year, rather than every quarter like C Corps.
Top Questions About Sole Proprietorship vs LLC vs S Corp
When you’re trying to start a business or even after you’ve run your business for a while, you may start to wonder if you’ve made the best business structure or tax entity decision for your business.
We get a lot of questions at our firm about the pros and cons of sole props, LLCs, and S Corps so we decided to round up the most common ones. Hopefully they’ll help you as you make your decision!
Is it better to be a sole proprietorship or S Corp?
This article is only intended to inform you about the most common business entity structures. If you have any questions regarding this article or your specific situation, don’t hesitate to call MBS Accountancy and our knowledgeable tax law experts and accountants will help you find your answers!
What is the difference between a single-member LLC and an S Corp?
An S-corp is a tax entity designation, not a business structure like a single-member LLC. A single-member LLC cannot be designated as an S-corp because the IRS defines single-member LLCs as sole proprietorships.
Is an S Corp better than an LLC?
Whether it’s better to have an S Corp or an LLC will depend on your situation and needs. A significant advantage of S Corps over LLCs is that S Corp owners are considered employees, not self-employed, so they only pay regular taxes on their salary.
What are the benefits of an LLC vs sole proprietorship?
One of the biggest benefits of having an LLC instead of a sole proprietorship is that personal liability for LLC members is limited to their investment in the LLC. This means that LLC members are not liable for debts incurred by the LLC.
Do S corp owners have to take a salary?
Yes, the IRS requires all S Corp shareholder-employees to receive a fair or “reasonable” salary, which is calculated based on the following factors:
- The wages paid for those in similar positions
- Your training and experience for your position
- The time and effort you put into operating your business
- How much you pay your non-shareholder employees
- Any compensation agreements
It’s unwise to avoid a reasonable salary and just take a distribution since the IRS frowns upon this.
In general, S Corp owners can elect to take a reasonable compensation plus distribution, just a reasonable compensation, or no compensation at all.
What certificates are required for an LLC and an S-corp?
To file as an S Corp, you must complete and file Form 2553, file articles of incorporation in your state, and make sure you meet the guidelines outlined in the Subchapter S requirements.
The requirements for LLCs depend on your state and may require you to notify the public.
Learn more and achieve accounting success!
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