Although entities are created equally they are not taxed the same.
Let’s take a look at some terminology.
I often ask clients and potential clients what sort of tax entity they have and the universal answer is almost always “I have an LLC.”
This is one of the toughest concepts to get across to new founders. An LLC can be many things. If it is US owned and has one owner it can be a Sole Proprietorship, an S Corporation or a C Corporation. If it is owned by more than one US person it can be a Partnership, an S Corporation or a C Corporation.
The IRS has a special term for a Sole Proprietorship as they call it something that sounds awful, “a Disregarded Entity.”
With foreign ownership the S Corporation option is taken away.
Why is this tax structure important? Simply because the entity selected will determine who and how any profits are taxed.
When do I decide what election to choose? This is normally done at the time you organize your business under state law and apply for your EIN. There are provisions for late elections.
A simplified recap of each is as follows:
Sole Proprietorship
The reason the IRS calls this a Disregarded Entity is because it does not get taxed but rather you are personally the taxable entity. You report the profit or loss on your personal return and pay the tax there.
It is important to note that earnings from the business are taxed on your personal return in two places. You will pay an Income Tax on the net profit you may have and then you will also pay a Self Employment Tax that is added on to your regular tax. The tax rate on Self employment income is over 15%. So although you may or may not have an income tax, depending on your other personal deductions, you will always have a Self Employment tax.
Partnership
This is similar to the Sole Proprietorship in that you and you partners will pay a personal income tax on the net income of the business. Although it does file its own return and in most cases the net income derived there is also subject to employment tax.
S Corporation
It is similar to a Partnership in that you pick up your portion of the net income on your personal return. Any wages you pay out would flow to you on a W-2 as income and would be deductible on the company return. However, the net profit after the wage distribution is not subject to self employment tax. A quick run through the numbers can demonstrate how much of an impact this will create.
C Corporation
This is probably the most common tax structure when Venture Capital investors are part of the picture. This entity stands alone from its shareholders and pays it own tax at 21%. Any wages paid to the founders are deductible as wages and must be reported on the founders personal income tax return. There is a possibility of dividend distribution which can be the worst of both worlds as they are taxed at the personal level but not deductible to the corporation.
Planning
Because of this double taxation factor you can see where a great deal of planning is needed with any of the entities you select. Most founders are busy working out their product, their funding and almost everything else when the long term tax structure should be determined.
So when I hear someone say “ I am an LLC”, there is usually some work ahead correcting what has been done and formulating a plan for the future.
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