What Kind of Business Entity Should You Form?

Business owners have a variety of choices as to how they want to structure their businesses.  They can be sole proprietorships, corporations, LLCs in their home states, or LLCs in places like Delaware or Wyoming (unless of course, you live there, haha). 

The purpose of Bold Tax Law Firm is to provide entrepreneurs and businesses with a solid outline of knowledge that helps direct further research and make the decision as to the most favorable entity choice. It is necessary to understand all implications to choose the most efficient legal and tax framework for your work among various options.

Sole Proprietorship, LLC, or a Corporaton?

Liability protection and entity type

It’s about reducing personal liability against both taxes and potential losses/claims against your business. This way, you get protection on both sides: if you do really well, and sell millions of dollars of goods and services, you will be best positioned to keep as much of the profits as possible; but, if things don’t go so well…and a customer/client/vendor sues you and your company for negligence or some legal tort, you will have a shield of protection against you personally, where your company takes the hit, not you. 

Therefore, structuring a business as an LLC or a Corporation is always more advantageous than a sole proprietorship first of all regarding the personal liability. LLC structuring usually protects the personal assets of the owners from claims. In other words, your assets (like homes, vehicles, and bank accounts) are covered in the event of a lawsuit and cannot be used to pay off the debts or liabilities incurred by the LLC or Corporation owned by you.

For many business owners, a primary goal is to protect their assets from claims against their business, and Corporations traditionally fulfilled this objective best. On the other hand, U.S. tax law favored operating many businesses as “pass-through” entities, such as LLCs, to avoid the double-tax dilemma faced by traditional Corporations. In conventional Corporations, earnings were first taxed at corporate rates. The remainder was subject to tax at individual rates when those earnings were distributed to the owners through dividends.

This tension between tax and nontax objectives led to the development of specific “hybrid” types of entities, such as S corporations ( to be exact: LLC with S-corp status), limited partnerships, and limited liability companies, which sought to combine the advantages of personal liability protection with a single layer of tax.

Tax regulations

LLC is not a separate tax entity like a corporation; instead, the IRS calls it a “pass-through entity,” like a partnership or sole proprietorship. All of the profits and losses of the LLC “pass-through” the business to the LLC owners (called members), who report this information on their tax returns. The LLC itself does not pay federal income taxes, although some states impose an annual fee on LLCs.

  • Single-member LLC will be taxed as a sole proprietorship on individual tax rates and pay self-employment taxes on all income (regarding liability protection, it will still protect its owner).

 

  • Multimember LLC will be taxed as a partnership (each partner on applicable individual tax rates) + paying self-employment taxes on all income according to their shares (regarding liability protection, it will still protect its owners).

 

  • LLC with S-Corp status can help you save money on self-employment taxes (you will pay self-employment taxes only on the reasonable salary, which you’ll pay yourself from the LLC’s income, but not on the real income of the LLC).

However, it’s necessary to  take into account S-Corp’s administrative responsibilities as well:

  • running payroll and filing quarterly payroll returns (federal and state),
  • keeping accurate books and a balance sheet, and
  • filing a corporate tax return

20% deduction and how to calculate it

The tax law permits certain non-corporate owners (i.e., individuals, trusts, or estates) of certain LLCs (functioning like partnerships, S corporations, and sole proprietorships regarding taxation) to claim a 20% deduction against qualified individuals’ business income. That allows pass-through businesses to deduct up to 20% of their net income, making them taxed on only 80 cents of each dollar they earn. This reduces the top marginal tax rate on pass-through business entities from a new maximum tax rate of 37% down to a reduced rate of 37% x 80% = 29.6%

Qualified business income (QBI) is the revenue the business is generating, less the applicable expenses.  

The deduction, however, is limited to the LESSER OF:

  • 20% of qualified business income, or
  • 50% of the total W-2 wages paid by the business. This “50% of W-2 wage limitation,” however, does not apply if the total TAXABLE INCOME of the business owner is less than $315,000 for the year (if married, $157,500 if single). 

However, the law places limits on who can take the break. For instance, entrepreneurs with “service businesses” — including doctors and lawyers — may not be able to grab the deduction if their income is too high.

Qualified business income does not include:

o   Certain service-related income paid by an S corporation or a partnership. Specifically, the qualified business income does not include an amount paid to the taxpayer by an S corporation as reasonable compensation (salary).

o   A payment by a partnership to a partner in exchange for services (regardless of whether that payment is characterized as a guaranteed payment or one made to a partner acting outside his or her partner capacity).

o    certain investment-related gain, deduction, or loss.

Entity choice

The table below provides the opportunity to compare different options of the entity choice, taking into account the tax law implications.