A Quick Introduction
to Business Entities
Thinking of starting a new business? Here is some
information you should know before you get started....
The basic types of business (entities) are (1) Sole Proprietorship (2) Partnership (3) Limited Liability Company - LLC (4) C-Corporation and (5) S-Corporation. The following is far from comprehensive (consult a tax attorney is you really need all the details) but it should help you make an informed decision about how to set up your business.
My personal opinion - overall - simpler is better (and easier). Only elect one of the more complicated entity types if it offers you a clear advantage given your individual situation. So - here we go....
1) Sole Proprietorship. One owner. Your SSN is your EIN (Employer Identification Number). The business does not file its own tax return, all income and expenses go on your personal (Form 1040) tax return schedule "C". This is the ONLY entity type that can deduct home office expenses (if you have a space set aside exclusively for business purposes - no personal use at all - and meet clients and/or conduct business activities in that space. You can get a DBA ("Doing Business As") application from your county and "name" your business and use that name for bank accounts, advertising, and other legal purposes if you WISH but it is not REQUIRED. You can legally conduct all business under your name. You can put money into the (business) bank account and take it out anytime you want without any restrictions. You can even use a personal bank account (under your name) as the business bank account. You are personally liable for all actions related to the business.
2) Partnership. More than one owner. You will need to apply for an EIN on the IRS web site. You do not need a state EIN. The business files its own tax return, all income and expenses go on a Form 1065. The income can be divided up between the partners in any manner you see fit. Each partner will get a form K-1 (generated by the partnership tax return) that list their share of the income and they pay taxes on this amount. It is required (when you apply for the EIN) to give the business a name. All bank accounts and legal documents MUST be in the name of the business. You can put money into the (business) bank account and take it out anytime you want without any restrictions. You are personally liable for all actions related to the business.
The next 3 types of entities are corporations. They offer the advantage of legal liability protection - if the business becomes liable for a debt that it cannot pay, the creditors can only get a judgment against the assets of the business. They cannot go after ANY of your personal assets (car, house, money, personal property, etc). However - there are disadvantages to these entity types as well. All CA corporations are subject to the FTB minimum corporate tax of $800 per year even if they do not operate or make a profit.
3) LLC ( Limited Liability Company). If only one owner, is treated almost exactly like a sole proprietorship. If more than one, is treated like a partnership. The owner(s) can also elect to be taxed as a corporation (if they wish to) - that is an election you can make when you set up the LLC. You will need to apply for a state EIN and also apply for a federal EIN. LLC's are subject to a minimum tax of $800 per year PLUS additional fees ($900 to $2500) if the LLC has a lot of income. The same rules for entity types 1 and 2 (see above) apply, but you MUST have a business name and conduct all business affairs using the business name and EIN's. A single-member LLC is usually a disregarded entity for tax purposes. This means that the LLC exists to provide the legal liability protection, but that is all it does.
4) C-Corporation. Any number of owners. You will need to apply for an EIN on the IRS web site and the FTB (state) web site. The business files its own tax return, all income and expenses go on a Form 1120-C. The business pays tax on its own income at its own tax rates. AND - California has a C-Corp tax rate of 8.84% with an $800 minimum - so if you have profit of over $ 9,050 you will pay additional state income tax. If the business makes a profit, the owners MUST take a "reasonable" salary like any other employee - meaning you will need to hire a payroll service and pay yourself actual wages. Example - if the business made $50K, you would need to take the money as compensation (say $40K in wages) - the business would deduct the $40K as a salary expense and pay tax on $10K of income remaining in the C-Corp. You would get a W-2 showing $40K in income and pay taxes in it. Total taxable income would be $50K between your tax return and the corporate tax return. You CANNOT simply withdraw money when you want - if you do, you get taxed TWICE. Such draws are classified as "dividends". They are taxable to the recipient (you) and non-deductible to the corporation.
5) S-Corporation. A much more common corporation type than the C-Corp. You will need to apply for an EIN on the IRS web site and the FTB (state) web site. The business files its own tax return, all income and expenses go on a Form 1120-S. It is taxed much like a partnership - whatever income the business makes is distributed to the owners on a form K-1 and taxes are paid at the individual tax rate of that shareholder. BUT - CA has an S-Corp tax rate of 1.5% with an $800 minimum - so if you have profit of over $ 53,300, you will pay additional state income tax. It has the same salary requirements as a C-Corp - you must take wages commensurate with the value of your work for the corporation if you have a profit. If you simply withdraw funds from the S-Corp and do not take a salary (and therefore avoid payroll taxes) and the EDD or FTB find out, it will be a very expensive lesson for you.
Should I set up a Corporation?
In my opinion, it depends on the nature of work you plan on doing. Ask yourself - can you make a mistake that might result in a HUGE legal liability? If I am a doctor I could make a $10,000,000 mistake, so I would definitely set up a corporation. If I am doing retail sales, computer coding (or income tax preparation), I don't see that happening - so I would not. If I am a landlord, my property probably already has an insurance policy with a $1,000,000 liability limit, so I would not need any addition legal protection. So think about the nature of your work, what kind of expense your biggest mistake could generate, and decide accordingly. Corporations are NOT cheap - the CA minimum corp tax plus tax prep fees for the corporate tax return will be well over $1,000 every year. Make sure you are getting value for your money if you elect to set up a corporation.
Here is what is the SAME between all
of the different kinds of business entities.
A) Licenses do NOT matter. The IRS and FTB do not care about licensing, they only care about income, expenses, and the taxes on your net income. Your city or county MAY require you to get a license if your business is subject to certain regulations (like tax preparers) but other businesses (like housekeeping) would not require any kind of licensing.
B) You will be taxed on your net income (total income less expenses). It does NOT matter if you take it out of the business bank account or leave it in there. It's like interest - if the bank paid you $35 in interest on your savings account last year, you will be taxed on that $35, even if you did not withdraw it. You will be taxed when it is received (paid to you), not when you take it out of the account.
C) Any kind of expense that is "reasonable and necessary" for the operation of the business is a deduction. Any expense (except for home office which is for sole proprietorships only) that is a valid deduction is allowable for ALL entity types. There is no type of business that has deductions not permitted to others. If such an entity existed, we would all elect that one!