There are three basic business entities with variations within. The three basic are-
Two notables missing from the list. First, sole proprietors are not an entity nor is the variant “Doing Business As” (DBA). If you wake up and want to sell used copiers, you can, right now, without any formalized structure. It is not smart, but certainly permissible. At times sole proprietors are interchanged with single-member limited liability companies (SMLLC) since the IRS and most states consider a SMLLC to be a disregarded entity for taxation, and both a sole proprietorship and a SMLLC will end up on Schedule C of your Form 1040. However, they are truly different in several underlying ways.
Also note how an S corporation is not listed. It is not an entity. It is a taxation election. The underlying entity has to be one of the above, and usually it is an LLC (either single-member or multi-member) for the ease of formation. Let’s chat about each in turn. Here we go…
As a sole proprietor you might still need a state registration or some licensing for your particular line of work (such as real estate agent, massage therapy, family counseling), but it is easy to do without needing to form an LLC. Additional downsides to sole proprietorships include zero financial liability protection, poor transfer of ownership upon expansion or death, and the ugly self-employment taxes. Income is reported on Schedule C and your Form 1040, a separate business tax return is not necessary.
Single-Member Limited Liability Company (SMLLC)
Multi-Member Limited Liability Company (MMLLC)
We must be technically sound on the nomenclature. People often interchange 401k and IRA, and people often interchange multi-member LLC and partnership. This is incorrect. A MMLLC might be taxed as a partnership, but the underlying entity is a limited liability company.
MMLLCs are similar to sole proprietorships and SMLLCs in terms of self-employment taxes, but enjoy a bit more financial protection through the concept of Charging Orders (more on that later in this chapter as well). Transfer of ownership is the same as a SMLLC since you have a member interest that can be gifted, sold, inherited, etc. However, most MMLLCs will have an Operating Agreement governing the transaction of each members’ interest.
Operating Agreements will also define the sharing of expenses and income. For example, you could be an angel investor at 20% injection but demand 50% of the income. Expanding this concept, a partnership tax return generated from a MMLLC will have three “allocations” for each member; allocation of capital, profits and losses. Commonly profits and losses are tied together. Again, you could have a 20% allocation of capital and a 50% allocation of profits and losses (spoiler alert: S Corp blows this concept up… standby!).
Operating Agreements also become critical when the entity has value- issues like death, divorce, incapacitation and exit strategies must be handled within the agreement, and perhaps a separate Buy-Sell Agreement (usually funded with life insurance- we can help navigate on this). You and your business partner are besties today, but our job at the Watson CPA Group is to not unnecessarily complicate things, but to protect your future. See Chapter 10 for more on Exit Strategies.
In terms of self-employment taxes, the taxation of a MMLLC is very similar to a sole proprietorship or SMLLC as alluded to earlier. Partnerships and those mimicking partnerships (MMLLC) commonly require a separate partnership tax return (with an allowed exception for those living in community property states), Form 1065, which create K-1s for each member or partner. This might be your first brush with the term K-1. A K-1 is similar to a W-2 since it reports income and other items for each member, partner, shareholder, owner or beneficiary, and is coded to tell the IRS how that income should be treated.
A K-1 is generated by an entity since the entity is passing along the tax obligation to the K-1 recipient (hence the concept pass-through entity). There are three basic sources for a K-1, and the source dictates how the income and other items on the K-1 are handled on your personal tax return. Here they are-
All of these are pass-through entities with the exception of a trust, which might or might not a be pass-through depending on the purpose of the trust. A K-1 is usually electronically filed as a part of the tax return that is generating the K-1. So the IRS will be expecting the recipient of the K-1 to report the information on his or her individual tax return.
A K-1 from a Form 1065 Partnership Tax Return and a K-1 from a Form 1120S S Corporation Tax Return are scarily similar. We could hold two K-1s about two feet from your face and you couldn’t tell the difference- heck, we couldn’t either. What makes matters worse, is that they both are reported on Page 2 of your Schedule E, and ultimately on line 17 of your Form 1040.
But here is the crux of the matter, so please pay attention- one is subjected to self-employment taxes and the other is not simply based on which form created it (1065 versus 1120S). There is another subtle difference. Expenses associated with K-1 income from Form 1065 are deducted immediately on Page 2 of Schedule E as Unreimbursed Partnership Expenses (UPE) while shareholders of S corporations do not have a place to deduct shareholder expenses.
Having said that, most shareholders are also employees so they would deduct unreimbursed employee business expenses on Form 2106 and Schedule A. With the recent passage the Tax Cuts and Jobs Act of 2017, Form 2106 expenses are no longer deductible on Schedule A. This is fine from an S Corp owner perspective since these expenses really should be reimbursed by the business and therefore deducted on the business tax return.
Partnerships do not pay Federal tax as an entity- the partners or the members of a MMLLC do as individuals. Note the word Federal. States can do a lot of crazy things, and there is a whole chapter about the 185 reasons not to elect S corporation taxation that touches on state related issues such as franchise taxes and obscene corporate taxes.
Limited Liability Partnerships (LLP) and General Partnerships (GP)
We won’t discuss these much either since they have fallen out of favor lately. Many attorneys are now creating two classes of members within a MMLLC to mimic the different groups that a true partnership would create. So it walks and smells like an LLP but it is actually a MMLLC, without the burden of complication and cumbersome ordering rules. Most of the attorneys we work with don’t create partnerships anymore, including family limited partnerships (FLPs), opting instead for the use of MMLLCs.
Throughout this book we might refer to members as partners. More often than not we are referring to a member of your multi-member LLC. While partner and member are technically different, and that the entity type will ultimately decide member or partner, these words are often interchanged by business owners but we are doing our best to reverse the trend.
C corporations are required in certain situations such as more exotic retirement planning and foreign investors, but typically not the best choice for small businesses. The double taxation issue is the biggest thing- a C corporation will be taxed on its net income before dividends. So, dividends do not reduce taxable income.
Thanks to recent tax law changes, corporations now enjoy a 21% income tax rate. But… not all that glitters is gold. Dividends are then taxable to you up to 23.8% (which is 15% to 20% capital gains plus 3.8% of Medicare surtax potentially). Therefore, your effective tax rate for using a C Corp as your entity choice ranges from 36% to 44.8% where the top individual rate is 37%.
We don’t run into too many business owners who want to make money but never spend it. Sure, you can enjoy a lasting 21% corporate tax rate given the Tax Cuts and Jobs Act of 2017, but to spend it you need to be taxed again at your dividend rate. Read more in our recent blog post-
If you think you are clever and drive corporate profits down to zero with high officer salaries, this too unnecessarily pays more in overall taxes ultimately (payroll taxes being the main culprit). You will discover in Chapter 6 that reasonable salaries must be paid in an S corporation; however, the same is true in a C corporation where too high of a salary is a target for the IRS. Seems odd, but true.
In other words, C corporation plus high salary, Bad. S Corporation plus low salary, Bad. Like Goldilocks, it needs to be just right to the IRS.
C corporations enjoy better financial liability protection however, and have much easier transfer of ownership. Taxes are paid at the corporate level both to the IRS and states (either through an income tax or a business tax) on Form 1120. Notice the subtle difference; 1120 and 1120S.
C corporations are also required for any type of self-directed IRA or 401k, and in some cases where a life insurance policy is being paid for by the corporation (and where the beneficiary is the corporation). For example, if you wanted to open a business with a rolled over IRA it would need to be a C corporation. However, some providers are creating LLCs and funding them with a self-directed IRA. The jury is out on the legality of this, and there are enough attorneys and legal professionals on either side to warrant concern.
If you wanted a life insurance policy on your best sales producer, these are sometimes restricted to C corporations only (essentially, it cannot be a pass-through entity such as a multi-member LLC or partnership, or any entity taxed as an S corporation). C corporations might also be necessary for exotic stock options, vesting schedules, different classes of voting stock (one share equals ten votes, Class A or one share equals one vote, Class B) and initial public offerings. If you have these needs, seek an attorney. A smart one.
How do the recent changes from the Tax Cuts & Jobs Act of 2017 play into this? As stated earlier the highest tax rate is now 21%. With the elimination of several deductions available to individuals, there might be some arbitrage with corporations where their use makes sense. We’ll have to wait until some of the dust settles on this.
Professional Corporations or Limited Liability Company
Recall that Social Security taxes stop at $132,900 (for the 2019 tax year) but Medicare continues into perpetuity. Don’t laugh! That 3.8% Medicare tax times a zillion dollars is a lot of money (spoiler alert: at $2M in net income, your S Corp tax savings is still above $60,000 even with a $400,000 salary). Other payroll taxes such as Unemployment, State Disability Insurance (SDA), etc. actually increase by electing S Corp taxation, but they are minor.
S corporations are pass-through entities and therefore do not pay Federal income taxes, and the shareholders do not pay Social Security nor Medicare taxes on the remaining income from an S Corp (after reasonable shareholder salaries). Having said that, S corporations have various sweet spots in terms of income versus payroll tax savings. In a later chapter, we’ll demonstrate the savings from $30,000 to $2 million, between sole proprietorships, LLCs, partnerships and entities taxed as an S corporation.
S corporations are never formed contrary to popular belief. They are spawned from a limited liability company, partnership or C corporation that elects to be taxed as an S corporation. After the election is made on Form 2553, you are treated as an S corporation for taxation purposes only.
All kidding aside, the equity section in your balance sheet should also have a Capital Stock account and an Additional Paid-In Capital account. Again, while your underlying entity might be an LLC it is being taxed as an S corporation so the balance sheet and tax return should look like a corporation. We can help with the journal entry to populate these accounts correctly so your equity section resembles that of a corporation. This also helps the tracking of basis in your S corporation. A later chapter has some examples.
You are in a weird limbo with electing to be taxed as an S corporation. You need to walk and talk like a corporation, but the underlying entity and what the secretary of state will have on file is going to be an LLC, partnership or C corporation. More on the election, and the behind the scenes stuff in a later chapter plus our thoughts on corporate governance such as Meetings and Minutes.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition