If you’re reading this, you’ve either taken the first steps of starting a business or you’re thinking about it. Kudos to you! I know it’s scary, but it will be SO worth it. Especially if it means you are doing something that makes you happy and making an impact on your community.
So, let’s get your ducks in a row. Let’s start with talking about what an entity type even is. It’s basically the legal structure of your business. The structure you choose plays a big part on not only your legal liability (consult an attorney, if needed) and how much you pay in taxes!
Which entity type is best?
Here’s an explanation of each entity type to help you figure out what’s best for your business needs. Keep in mind that you can change your entity type as you grow!
Most new businesses start as a sole proprietor. If you are starting a side hustle, this business structure is the easiest one to form since you don’t have to register or file anything with the state or IRS.
You just report all of your income and expenses on your personal return on your Schedule C. However, keep in mind you have no legal protection here. As you grow, you’ll want to pick another business structure.
Limited Liability Company (LLC)
What’s the main difference between a sole proprietorship and an LLC? Your business assets are separate from your personal assets. You just register the LLC with your state and pay a small fee (unless you’re in California, where you might have to pay higher annual filing fees)
If you are the sole owner of the LLC, you will file the income and expenses just like a sole prop (see above)
All entity types below require filing a separate tax return
If you are going into business with a friend, forming a partnership would be a great option. A partnership is considered a “passthrough entity” which means the tax is not paid by the company. The profits are passed to the owners on a K-1 and reported on your personal return on Schedule E.
This is a passthrough entity just like a partnership. It does not pay taxes on its corporate income; the owners pay taxes on their personal tax returns. If you are expecting to earn high profits (think 60K or more), you could get serious tax savings by picking this option. Learn more here.
Just keep in mind there are added costs to be taxed as an S-Corp. Not only are you filing a separate tax return for the business, but you will also incur fees to process payroll (taxes, returns, etc.) and some more paperwork.
Usually, C Corporations make no sense for small businesses. There is a huge drawback to this entity as well, double taxation. Not only does the corporation pay taxes on any net income, but the shareholders also have to pay tax on any dividends paid out to them. If you do set up a C Corporation, make sure you make that S-election.
Where do you go from here?
The bottom line is your business is unique. Each business entity has pros and cons, so make sure you take the time to find the right one for you.
Choosing the right business entity can potentially save you anywhere from 10% to 40% on your taxes each year, but there are costs to consider, too (formation, ongoing administration, business tax filing requirements, personal liability, control, licenses and permits, etc.)
It’s important to know the benefits and drawbacks of each business entity type. An attorney can advise you on the legal ramifications, consult a CPA for an optimal tax strategy.