Every month, around 543,000 new businesses launch in the U.S. They all have to make a choice: which entity type is the best fit for their organization.
A business entity type lets your state’s charter know how your entity is organized for legal purposes, informs your state’s taxation department for state taxes, and informs the Internal Revenue Service (IRS) for federal taxes. The business entity type you select affects if and how you can raise capital, which taxes you pay, and how you admit new partners and/or shareholders into your organization.
Before we get into business entity types, it’s important to understand that the tax classification for an entity could be different from the legal classification. A legal classification refers to how the business entity is organized with the Secretary of State or equivalent (the Department of Consumer and Regulatory Affairs in DC, or the Maryland Department of Assessments and Taxation in MD, for example).
There are multiple legal classifications available at the state level, such as a Non-Stock Corporation, a Stock Corporation, a Limited Liability Company (LLC), a Limited Partnership (LP), and a Limited Liability Partnership (LLP). A common misconception is that there are default tax implications for each legal entity type, but that’s not true.
In this article, we’ll guide you through the process of selecting an entity based on the most advantageous treatment for tax purposes. **Note: this information is not meant to inform the process of selecting an entity type when registering with your state. That should be done with an attorney.
The tax classification refers to how the entity is taxed for federal and state income tax purposes. The five tax classifications available at the federal level are:
- Corporation: files Form 1120
- Partnership: files Form 1065
- S Corporation: file Form 1120S
- Sole Proprietorship: files form 1040, Schedule C
- Tax-exempt Organization: files form 990-N, 990-EZ, or 990
Before we jump into the different tax classifications, make sure you understand these key terms:
Flow/pass-through income refers to business income which, instead of being taxed at the business entity level, flows or passes through to the partners or shareholders of the business. The income is then reported and taxed on their personal tax returns. This type of tax structure is beneficial because it’s not subject to double taxation, which is once at the entity level and twice upon distribution to shareholders and partners.
Self-employment (SE) tax consists of Social Security and Medicare taxes primarily for individuals who work for themselves. Self-employed individuals pay this tax in addition to personal federal and state income tax. The SE tax rate of 15.3% consists of two parts: 12.4% for Social Security and 2.9% for Medicare. Through the SE tax, the IRS makes a self-employed individual responsible for the employer and employee portion of Social Security and Medicare taxes. Full-time employees who are not self-employed are only subject to 6.2% for Social Security and 1.45% for Medicare.
The Qualified Business Income Deduction (QBI) was introduced via the 2017 Tax Cuts and Jobs Act (TCJA) and has 2 components. For the purposes of choosing a business entity, we’re only concerned with the first one. This first component provides business owners with a 20% deduction on their pass-through income – if they meet certain requirements.
The requirements are related to both income thresholds and type of business. The standard threshold is an Adjusted Gross Income (AGI) of less than $207,000 for a single filing or $415,000 for married filing jointly. That threshold applies if the business is a Specified Service or Trade Business (SSTB). If it’s not, the business can still receive the QBI deduction in excess of the threshold, dependent on limitations like wages paid, unadjusted basis of qualified property, and the like.
A bit more about the QBI deduction:
Before the addition of the QBI deduction, selecting a tax classification was fairly straightforward. Most small businesses with substantial income and no different classes of stock would elect to be taxed as an S corporation, so their profits would not be subject to self-employment tax. The introduction of the QBI deduction makes the entity selection process more complex.
The qualified business income of an S corporation is lowered by the officer’s compensation deduction, thus reducing the QBI deduction that’s available at the personal level for S corporation shareholders. But before electing to be taxed as an S corporation, a business should assess whether the QBI deduction is available for its shareholders and whether the benefit of not having profit subject to SE tax outweighs the benefits of having a lowered QBI deduction.
To determine if the QBI deduction is available for the shareholders and/or partners of the business, you must evaluate the AGI of the partners and/or shareholders, whether or not the business is an SSTB, if it pays wages, and what the adjusted basis in the qualified property is (if applicable).
For example, if you’re a single-status taxpayer, a 100% owner of an SSTB, and your AGI exceeds $207,000, then you’re not qualified to take the QBI deduction. That means it makes sense to make an S corporation election.
Alternatively, if your AGI is $150k (under the phase-out threshold), the savings from receiving the QBI deduction could exceed the savings from not paying SE taxes on the profits of the S corporation. This would depend on how much you pay in reasonable salaries – especially with the extra administrative costs involved with an S corporation.
How to make a choice:
If you have all your projections ready, this QBI Entity Selection Calculator will walk you through the process of selecting the entity type that is most advantageous from a tax perspective. But if not, here are the different business entity types and the most important factors to consider when making your selection for tax purposes.
Tax Classification | Corporation |
Legal Classification |
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Cons | Corporations are subject to double taxation – once at the entity level and again at the personal level when cash is distributed to shareholders. |
Best Fit | A corporation is the ideal entity type for startups. Although C corporations are subject to double taxation, startups typically aren’t profitable. The advantages related to raising capital, offering stock options, and the like far outweigh the disadvantages of double taxation. |
Tax Classification | Partnership |
Legal Classification | By default, when two or more parties manage and operate a business and share its profits, they’re considered a partnership for tax purposes. This includes General Partnerships, Joint Ventures, LLPs, LLCs with multiple members, LPs, and PLLCs. |
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Cons |
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Best Fit | Partnerships are the least favorable entity tax classification for owner-operators. However, they are frequently required because most multi-member LLCs, LPs, LLPs, and General Partnerships don’t qualify as S corporations. |
Tax Classification | S Corporation |
Legal Classification |
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Best Fit | Any small business corporation or LLC that doesn’t have multiple classes of stock, non-U.S. shareholders, and less than 100 shareholders should consider an S corporation. The QBI entity selection calculator can determine if the savings on SE tax surpasses the reduced QBI deduction as a result of paying a reasonable officer salary. |
Tax Classification | Sole Proprietorship/Schedule C |
Legal Classification |
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Cons |
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Best Fit | if the benefit from the increased QBI deduction as a result of filing Schedule C surpasses the self-employment tax savings of an S corporation, then a sole proprietorship makes the most financial sense. However, the extra administration costs for maintaining the S corporation should also be considered. |
Tax Classification | Tax-exempt Organization |
Legal Classification | By application (Form 1023), an entity organized as a C corporation or LLC at the state level can choose to be treated as a tax-exempt or nonprofit organization for tax purposes. |
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Best Fit | Any organization that has a mission (i.e., educating the world about global warming) that is not in the business of making a profit, should be taxed as a non-profit or tax-exempt organization. |
Need Help Choosing a Business Entity Type?
Even with all these details, you might still be unsure what’s the best entity type for your organization. That’s totally understandable – and we’re here to help. If you have questions, contact RY CPAs. Our accounting experts can walk through your organization’s current state and future plans to recommend the optimal business entity type.
FAQs
Which business entity is best for tax purposes? ›
Many small business owners favor the S corporation structure because of its tax benefits. This type of business entity has the same legal protections as a C corporation. Unlike C corporations, profits distributed to shareholders aren't generally taxed at the corporate level.
What combines the tax advantages of a pass through entity with the limited liability advantages of a corporation? ›The LLC, because it combines the partnership benefits of pass through taxation and operational flexibility with the corporate benefit of limited liability protection, is an attractive business entity.
Why choose an LLC over a corporation? ›You may prefer an LLC if you: want a high degree of management flexibility in running your company. want to allocate profits and losses based upon criteria other than ownership percentage. prefer to avoid the state-mandated requirements imposed on corporations, such as annual meetings.
What is the default taxation method for an LLC with two or more members? ›By default, multi-member LLCs are taxed as general partnerships. As such, a multi-member LLC is a pass-through entity for tax purposes. That means the LLC business entity itself is not taxed, although it must file partnership tax returns with the IRS using Form 1065, which is considered an 'information return. '
What is the best type of business entity? ›Corporations offer the strongest protection to its owners from personal liability, but the cost to form a corporation is higher than other structures. Corporations also require more extensive record-keeping, operational processes, and reporting.
What type of LLC is best for tax purposes? ›The best tax classification for an LLC depends on whether you want your business profits to be taxed at your personal income tax rate, or at the corporate tax rate. If you'd prefer personal tax rates, you can classify it as a disregarded entity or as a partnership. Otherwise, you can classify it as a corporation.
What is the greatest advantage of the limited liability company form of ownership? ›The main advantage to an LLC is in the name: limited liability protection. Owners' personal assets can be protected from business debts and lawsuits against the business when an owner uses an LLC to do business. An LLC can have one owner (known as a “member”) or many members.
What is the main advantage of a limited liability company versus a partnership? ›In general, an LLC offers better liability protection and more tax flexibility than a partnership. But the type of business you're in, the management structure, and your state's laws may tip the scales toward partnership.
Which of the following is an advantage of being taxed as a pass-through entity? ›One of the main tax benefits of electing a pass-through business structure is avoiding double taxation. Business earnings are only taxed once, on the owner or shareholder's personal tax return. Ready to start your business? Plans start at $0 + filing fees.
Is an LLC or S Corp better for taxes? ›Taxes on S corporations are lower than on non-S corp. LLCs. As an LLC owner, you'll incur steep self employment taxes on all net earnings from your business, whereas an S corporation classification would allow you to only pay those taxes on the salary you take from your company.
Why is C Corp better than LLC? ›
LLC: Advantages. In the C-corp structure, company profits can remain in the company rather than being paid out to shareholders. A C-corp can also easily issue shares of stock to raise money to expand the business.
Is an LLC better than an S Corp? ›Both LLCs and S corps offer limited liability protection for owners, but LLCs may provide more flexibility in terms of personal asset protection—especially if the business has multiple owners.
Which is better for taxes single-member LLC or multi member LLC? ›A single-member LLC is easier for tax purposes because no federal tax return is required, unless the business decides to be treated as a corporation for tax purposes. The income is reported on the member's tax return. A multiple member LLC must file tax return, and give the members K-1 forms to file with their returns.
How do LLCs avoid paying taxes twice? ›Unlike C corporations, LLCs and sole proprietors are legally considered pass-through entities. The structure means their earnings go directly to their owners, who pay their taxes through their personal income tax. Another way you can avoid double taxation is by adopting the S corporation structure.
How do people use LLC to reduce their taxes? ›As an LLC owner you're able to reduce taxes by:
Claiming business tax deductions. Using self directed retirement accounts. Deducting health insurance premiums. Reducing taxable income with your LLC's losses.
If you want sole or primary control of the business and its activities, a sole proprietorship or an LLC might be the best choice. You can negotiate such control in a partnership agreement as well. A corporation is constructed to have a board of directors that makes the major decisions that guide the company.
What is the most common entity? ›Limited Liability Companies - This is the most common form of business entity in the United States.
Which business entity has the greatest liability? ›Unlimited liability-this is by far the greatest disadvantage to the proprietorship. Even though proprietors may invest only part of their capital in the business, they remain personally liable to the full extent of their assets for the liabilities of the business.
What is the most tax efficient way to pay yourself LLC? ›For most businesses however, the best way to minimize your tax liability is to pay yourself as an employee with a designated salary. This allows you to only pay self-employment taxes on the salary you gave yourself — rather than the entire business' income.
What type of LLC is most common? ›The most common type of LLC is a domestic LLC. A domestic LLC is formed and operates in the same state. A domestic LLC may also register to do business in a different state, where it would be considered a foreign LLC.
Which TurboTax should I use if I have an LLC? ›
If your LLC is a single-member, your company will be treated as a sole proprietorship, and you can use TurboTax Home & Business. If you have a multi-member LLC, it is best to choose TurboTax Business. TurboTax offers plenty of features for the price.
What are 3 disadvantages of an LLC? ›- Cost: An LLC usually costs more to form and maintain than a sole proprietorship or general partnership. States charge an initial formation fee. ...
- Transferable ownership. Ownership in an LLC is often harder to transfer than with a corporation.
- Separate legal identity. ...
- Limited liability. ...
- Perpetual existence. ...
- Flexible management structure. ...
- Free transferability of financial interests. ...
- Pass-through taxation.
An LLC has distinct advantages in the areas of legal protection and liability. While there are filing fees for setting up an LLC, that cost can be well worth it when compared to the thousands of dollars you could be liable for as a sole proprietor. On the other hand, it costs no money to start a sole proprietorship.
What are the advantages of an LLC over an LP? ›With an LLC, all of the members generally obtain limited personal liability. The members may also participate in the management of the business and keep their limitation of liability. In an LP, only limited partners enjoy limited personal liability.
Why is it an advantage to have limited liability? ›Limited liability is important for companies, as it helps them raise money. With limited liability, investors only risk losing the money they have invested in shares. As a result, shareholders are more likely to invest in a company if they know they will not lose their personal assets.
Is it better to be a partnership or limited company? ›Some advantages of partnership over private limited company include ease of establishment and lower costs. A partnership consists of two or more individuals who own a business together and share all its profits and losses, as well as the right to manage and make decisions on behalf of the business.
What type of account is tax-advantaged? ›The term tax-advantaged refers to any type of investment, financial account, or savings plan that is either exempt from taxation, tax-deferred, or that offers other types of tax benefits. Examples of tax-advantaged investments are municipal bonds, partnerships, UITs, and annuities.
What is the most efficient tax structure? ›The most efficient tax system possible is one that few low-income people would want. That superefficient tax is a head tax, by which all individuals are taxed the same amount, regardless of income or any other individual characteristics.
Which of the following is a disadvantage or limitation of limited liability companies LLCs )? ›The main disadvantages of limited liability companies are the fees and taxes associated with the business structure. However, as LLCs are governed differently by each state, regulations also become a disadvantage.
Why would I want my LLC taxed as an S corp? ›
As we mentioned, one of the advantages of an LLC filing as S Corp is that you can pay profits out to owners as distributions. These distributions aren't subject to employment taxes, like Social Security or unemployment insurance tax. Only the owner's employee wages are subject to payroll taxes.
Do you pay more taxes as an S corp? ›Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.
Why is an S corp better for taxes? ›The tax benefit for S corporations is that business income, as well as many tax deductions, credits, and losses, are passed through to the owners, rather than being taxed at the corporate level.
What is the downside to C-Corp? ›- Double taxation. It's inevitable as revenue is taxed at the company level and again as shareholder dividends.
- Expensive to start. There are a lot of fees that come with filing the Articles of Incorporation. ...
- Regulations and formalities. ...
- No deduction of corporate losses.
Corporations offer more flexibility when it comes to their excess profits. Whereas all income in an LLC flows through to the members, an S corporation is allowed to pass income and losses to its shareholders, who report taxes on an individual tax return at ordinary levels.
Which is better C-Corp or S corp for LLC? ›Single layer of taxation: The main advantage of the S corp over the C corp is that an S corp does not pay a corporate-level income tax. So any distribution of income to the shareholders is only taxed at the individual level.
Should I treat my LLC as an S corp? ›An LLC taxed as an S corp offers the benefits of a corporation while also providing flexibility on income treatment. If you want to operate on the most bare-bones, tax-stingy structure possible, an LLC taxed as an S corp may be right for you.
Should I be an S corp or single member LLC? ›Ultimately, there are many factors that will drive your choice between an LLC vs. S-corp, but profitability should be one of the key factors. If your business has income left over after you pay yourself a reasonable salary, then you should consider electing S-corp tax status.
What is reasonable salary for S corp? ›The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.
What are the disadvantages of a single-member LLC? ›| Pros | Cons |
|---|---|
| Ability to bring on new members | Must submit compliance forms to prove you're following the rules and stay in good standing |
| Flexible federal income tax filing (choose to file as a sole prop or corporation) | Must maintain corporate veil—piercing it puts your assets at risk |
How should a multi-member LLC be taxed? ›
Generally, members of LLCs filing Partnership Returns pay self-employment tax on their share of partnership earnings. If the LLC is a corporation, normal corporate tax rules will apply to the LLC and it should file a Form 1120, U.S. Corporation Income Tax Return.
What is the disadvantage of multi-member LLC? ›The biggest drawback of a multi-member LLC is that in some instances, members can be held responsible for other members' decision-making and actions when doing business. Members can be held liable if they: Misuse company funds, including the bank account.
Can IRS go after LLC members? ›For state purposes, an LLC is a business separate from its owner in which the owner is protected from the LLC's acts and debts, such as bankruptcy and lawsuits. For federal tax purposes, an LLC is disregarded as separate from its owner, therefore is liable for taxes.
Can IRS go after my LLC for personal taxes? ›While the IRS can't levy your business account for your personal back taxes, the IRS can freeze and seize your company's assets to satisfy your tax debt if your business has a sizable tax liability. In most cases, for the IRS to implement a levy, your business must have: A substantial amount in back taxes.
What are the tax disadvantages of an LLC? ›A major disadvantage of an LLC is that owners may pay more taxes. When setting up as a pass-through to owners, they are subject to self-employment tax. Self-employment tax ends up higher compared to being taxed as an employee.
How do I write off my car with an LLC? ›The IRS considers all commuting expenses non-deductible. Can an LLC write off a vehicle purchase? Yes. A limited liability company (LLC) may write off 100% of a vehicle's cost using a Section 179 deduction.
How do small businesses avoid paying taxes? ›- Hire Family Members. ...
- Account for Business Losses. ...
- Track Your Travel Expenses. ...
- Consider All Expenses Such as Rent and Utilities. ...
- Hire a Reputable CPA. ...
- Deduct Assets to Charity. ...
- Track Every Receipt With Software. ...
- Fully Utilize Your Retirement Plan Contributions.
In terms of tax implications, sole proprietorships are considered a “pass-through entity.” Also known as a “flow-through entity” or “fiscally transparent entity,” this means that the business itself pays no taxes.
Which is better for taxes LLC or S corp? ›Taxes on S corporations are lower than on non-S corp. LLCs. As an LLC owner, you'll incur steep self employment taxes on all net earnings from your business, whereas an S corporation classification would allow you to only pay those taxes on the salary you take from your company.
Is LLC better than sole proprietorship for taxes? ›Starting an LLC may help a new business establish credibility more so than if the business is operated as a sole proprietorship. Taxes. LLCs typically do not pay taxes at the business entity level. Any business income or loss is passed-through to the owners and reported on personal income tax returns.
What is the simplest business entity for tax purposes? ›
Sole Proprietorship
It is the simplest form of business organization. Proprietorships have no existence apart from the owners. The liabilities associated with the business are the personal liabilities of the owner, and the business terminates upon the proprietor's death.
- Pay for health insurance.
- Save for retirement.
- Claim the qualified business income deduction.
- Using your car for business purposes.
- Depreciation expense.
- Home office deduction.
- Financing costs for the business.
- Employ a Family Member.
- Start a Retirement Plan.
- Save Money for Healthcare Needs.
- Change Your Business Structure.
- Deduct Travel Expenses.
- The Bottom Line.
Single layer of taxation: The main advantage of the S corp over the C corp is that an S corp does not pay a corporate-level income tax. So any distribution of income to the shareholders is only taxed at the individual level.
Why should LLC be taxed as S corp? ›Having your LLC taxed as an S corp includes these upsides: The business pays your salary and its payroll taxes. This may save you money on taxes because, as with a regular LLC, you would pay self-employment taxes on the business's gross income. Additional earnings are distributed to shareholders as dividends.
Is it better to be a single member LLC or S corp? ›If you form an LLC without electing S Corp taxation, you could have a higher tax bill. The IRS taxes an LLC as a sole proprietorship by default, which includes self-employment tax on all of your business's profits. Electing S Corp status for your LLC could reduce the amount of income subject to self-employment tax.
How much can you write off as a sole proprietor? ›Qualified Business Income Deduction
In tax years 2018 through 2025, certain sole proprietors can take deductions equal to 20% of their business income, with adjustments.
The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. A Limited Liability Company (LLC) is a business structure allowed by state statute. Legal and tax considerations enter into selecting a business structure.
Why are LLCs taxed twice? ›This means that profits are first taxed with the corporation. Then, if the corporation decides to take that profit and distribute dividends to shareholders, the dividends are taxed again (this time, on each shareholder's personal tax statement).
What are the 5 entity types? ›U.S. state governments recognize many different legal entity types, but most small businesses incorporate under one of five entity types: sole proprietorship, partnership, C corporation, S corporation, or limited liability company (LLC).