Royal Financial

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Before starting your small business, you’ll need to select an ownership structure for your new venture. This post is to help highlight some key differences and considerations to consider when making your choice. The post isn’t intended to be exhaustive and doesn’t consider the details of your personal income tax attributes and goals. 

1) Sole proprietor/SMLLC

What is it?

A Sole Proprietor is someone who owns an unincorporated business by themselves OR someone who is the sole member of a domestic limited liability company (SMLLC).

How is it taxed?

If you are a sole proprietor or a SMLLC you will file your taxes in combination with your individual tax return. You will file Schedule C “Profit or Loss from Business”. Schedule C will include all income and expenses incurred through the operation of your business. In conjunction with Schedule C you will also be requested to file Schedule SE “Self-Employment Tax” to determine your self employment tax. Sole proprietors are taxed using individual rates & brackets.

Further, because Sole proprietors and SMLLCs are treated as Pass-Through entities they may be able to use the Pass-Through Business Deduction introduced by the Tax Cuts and Jobs Act (TJCA) which allows a 20% deduction of qualified business income.

Legal Considerations?

A distinct difference to point out is the legal implications, with respect to personal asset protection, between a Sole Proprietor and a SMLLC. 

Example 1 – Sole Proprietor: Bill owns a construction company. If the Company is sued and Bill is a sole proprietor, then Bill could potentially lose his house since he is personally liable. 

Example 2 – SMLLC: Bill owns a construction company. If the Company is sued Bill is shielded from personal liability, leaving only assets within the business vulnerable.

Sole Proprietor	Single Member LLC (SMLLC)
Owned by one person.	Owned by one person.
Not registered with the state.	Registered with a state.
Personally liable for business debts.	Not personally liable for business debts.

IRS Considerations?

The IRS has been dealing with smaller budgets compared to previous years (see graph below). As such, they don’t really have the time to deal with filers. When you are a Sole Proprietor or a SMLLC you must file a Schedule C for your business. A couple things to consider when filing your Schedule C to avoid an audit include, but are not limited to, the following:

1. Properly accounting for your 1099-MISCs (Received and Issued)
   1. Let’s say you received a 1099-MISC for $135k for services provided to a client. If you are only showing income of $100k, this can easily be triggered by information systems utilized by the IRS. Remember that the 1099-MISC is not only sent to you, but a copy is also sent to IRS and the state tax agency.
2. Business losses are not unlikely, however if you are showing a lot of revenue and still end up with a net loss for the year (or over multiple years), this may trigger an IRS audit.
   1. Make sure to only report valid expenses and keep detailed records for expenses. Technology has made it easier to track expenses with the various apps available to help record things like mileage and other business receipts.

2) Partnerships

What is it?

A partnership is a business relationship existing between two or more persons. Partnerships can take varying forms which typically depend on their business purpose, management style, and risk allocation. There are generally 3 types accepted across all states 

(1) General Partnership (GP) 

(2) Limited Partnership (LP) and 

(3) Limited Liability Partnership (LLP). 

Note: Be sure to talk to a lawyer or visit LegalZoom to get further details on which forms are accepted in your state. Depending on the product or service a state may require a specific structure.

How is it taxed?

Partnerships are referred to as a Flow Through Entity (FTE) or Pass Through Entity (PTE). This means the business activity of the partnership is provided on an Informational Return Form 1065 US Return of Partnership Income. Included with Form 1065 are Schedule K-1’s which allocate the amount of income between the partners in the partnership. Each partner then includes their Schedule K-1 with the filing of the personal income tax return and tax using the personal rates & brackets provided by the IRS.

Pass-through entities may be able to use the Pass-Through Business Deduction introduced by the Tax Cuts and Jobs Act (TJCA) which allows a 20% deduction of qualified business income. This is subject to various limitations outside the scope of this post.

Legal Considerations?

Above we highlighted the three main types of partnerships (GP, LP and LLP). The main difference with respect to these three partnerships are related to personal asset protection for business debts, including who is liable for the partnership and to what extent. Below is a brief summary:

General Partnership (GP)	Limited Partnership (LP)	Limited Liability Partnership (LLP)
Pros & Cons	Pros & Cons	Pros & Cons
Easy to form: No state filing required, business is created when operations start.	Limited partners have no active role: The LP(s) only role is funding the business. They are perceived as passive with respect to day-to-day operations.	Professional service: LLPs can only be created by certain types of professional service businesses (Accountants, Attorneys, Doctors, Dentists, etc.)
Lower Costs: No filing fees with states as no filings have been made.	Limited partners are not personally liable: In exchange for giving up participation, the LP is generally not personally liable for business debts.	Limited Personal Liability: The personal assets of the partners in an LLP typically can’t be used to satisfy business debts.
Low Maintenance: Not required to hold annual meetings, issue partnership interest, or keep personal assets separate from business.	No SE tax for LP(s): Because LP(s) are viewed as being not involved in the day-to-day operations they are viewed as Passive. This allows LP(s) to avoid SE tax on their investment (~15.3%).	Malpractice protection: The main crux of an LLP is that it shields one partner from being liable for another partner’s Malpractice/Negligence.
Unlimited Liability: Like Sole Proprietors, partners are personally liable for business debts, including court judgements. In addition, the partners have the ability to sue other partners.	Unlimited Liability for GP only: In an LP there is at least 1 General Partner (GP) and 1 Limited Partner (LP). Only the GP is personally liable for business debts.	State requirements: Some might consider forming a Corporation to shield their personal assets, however, some states require an LLP to be formed instead.
SE tax: All partners are generally subject to SE tax which amounts to ~15.3% of Self Employed Income.	SE tax: GP only is subject to SE tax which amounts to ~15.3% of Self Employed Income.	SE tax: Active members of the partnership would be subject to SE tax (~15.3% of Self Employed income).

IRS Considerations?

There are a few factors that should be considered when filing your Partnership Return with the IRS:

1. New Partnership Audit Rules 
   1. Effective January 2018 the Tax Matters Partner (TMP) has been replaced with a Taxpayer Representative (Tax Rep). The TMP was a member of the partnership who was responsible for representing the business to the IRS in a specific tax year. Partners other than the Tax Rep no longer have the right to participate in a partnership audit or judicial proceeding, nor will they be notified. 
   2. All audit assessments are now at the Partnership level, giving the IRS the ability to perform more audits as they are no longer assessing each individual partner/member of the partnership/LLC.

Note: There are exceptions to the Partnership Audit Rules for partnerships/LLCs that meet specific criteria regarding # of partners & types of partners.

2. Social Security Funding and SE Tax
   1. Some believe U.S. social security funding is having issues. The main driver of funding is the Self Employment Tax which makes up 12.4% of the ~15.3% tax rate.
   2. One of the biggest tax strategies for the wealthy is generating “Passive” income which is not subject to SE tax. It is very possible that the IRS begins to crack down on how the partnership’s are allocating Self Employment income among its partners. As a result, any significant positions should be discussed with a tax professional and documented.

3) Limited Liability Companies (LLC’s)

What is it?

An LLC is a business structure allowed by state statute. Owners of an LLC are referred to as members. Most states do not restrict ownership so members can generally be individuals, estates, trusts, corporations, other LLC’s, foreign entities, and nonprofits. 

Note: Some businesses can’t be LLC’s, such as Banks and Insurance Companies. This depends on which respective state you are operating in.

LLC’s were mainly created to offer businesses the asset protection of a Corporation, but also allow the business to be taxed like a partnership subject to  individual rates and brackets.

How is it taxed?

LLC’s, similar to Partnerships, are referred to as a Flow Through Entity (FTE) or Pass Through Entity (PTE). This means the business activity of the LLC is provided on an Informational Return Form 1065 US Return of Partnership Income with Schedule K-1’s provided to each member. Each member then includes their Schedule K-1 with the filing of the personal/business income tax return and tax using the respective rates & brackets, as applicable.

Pass-through entities  may be able to use the Pass-Through Business Deduction introduced by the Tax Cuts and Jobs Act (TJCA) which allows a 20% deduction of qualified business income. This is subject to various limitations outside the scope of this post.

Legal Considerations?

One of the most important aspects of an LLC is the personal asset protection it provides to the members.

IRS Considerations?

LLCs are treated like partnerships for tax purposes. Please refer to the partnership considerations highlighted above as they will generally apply to LLC’s.

4) S Corporation (S Corp)

What is it?

S Corps are not legal entities recognized by state legislation such as LLCs and Corporations. Instead they are strictly a tax vehicle introduced in 1958 to allow for business to enjoy the asset protection of a Corporation coupled with the ability to be taxed at individual rates and brackets prescribed by the IRS (like an LLC). S Corp elections are made using Form 2553 Election by a Small Business Corporation.

How is it taxed?

S Corps, like partnerships/LLC’s, are referred to as a Flow Through Entity (FTE) or Pass Through Entity (PTE). In contrast, S Corp file Form 1120-S U.S. Income Tax Return for an S Corp with Schedule K-1s provided to each member/shareholder.

At this point, you may be thinking that this sounds a lot like an LLC. So, why not just be an LLC? I think it is very important that we touch one four key tax differences between an LLC and an S Corps:

Note: there are a couple of others, such as how states treat the entity and basis calculations.

1. Allocation of Profits and Losses: One thing that wasn’t touched on when discussing LLCs, LP’s and partnerships is the flexibility on how profits and losses may be allocated to members/partners. For instance, LLC’s do NOT have to allocate profits and losses based on ownership %s. 

Example 1: Investment LLC has 4 partners, one being a manager and the other three being passive (non-managers). For the sake of this example let’s say they all own 25%.  In year 1 the business had profits of $100k. The LLC could have chosen, within their signed operating agreement, that the three non-managers would recoup their investment before the manager gets any share of profits. So the allocations of the $100k would be spread amongst the three non-managing members.

Example 2: Assuming the same facts above, except that Investment LLC elected to be taxed as an S Corp.  The $100k in profits MUST be allocated to the 4 owners in proportion to the ownership ($25k each).

2. Eligible Owners: Briefly touched on above, S Corps can only have members who are domestic & qualifying individuals, certain trusts, and estates. Further, S Corps can’t have no more than 100 owners. As a result of the foregoing, if you are planning on raising equity or having foreign operations, an S Corp may not be your best option.

3. Reasonable Compensation (and SE tax): This is a key difference and essentially the crux of why the S-Corp was enacted in 1958. The idea for many when choosing an s-corp was to save some money on self-employment tax (~15.3% tax on your first 132k in 2019). The best way to explain this is using an example.

Example 1 – LLC:  Zane and his 3 partners decide to open up a restaurant. Zane has experience and will be managing the business. Zane will pay himself $50k which is reasonable compensation for a manager at a new restaurant. Year 1 the company makes $200k in profit after all expenses including Zane’s compensation. As a result, Zane will have to pay self-employment tax (~15.3%) on $100k. The $100k is derived from the $50k the company pays him and the $50k of Zane’s share of business profit. As a result, Zane’s total SE tax expense is $15,300.

Example 2 – S Corp: Using the same facts as above, the SE tax amount changes due to being formed as an S Corp. If the company was formed as an S Corp Zane would pay tax on $50k. Zane’s distribution from the company, under the S Corp regime, wouldn’t be subject to SE tax. As a result, Zane’s total SE tax expense is $7,650.

Difference is $7,650. Imagine this over 10 years and being placed in a 401(k), college fund, or back in the business. 

4. One class of stock: S Corps may only have one class of stock. Historically the “class” of stock has been associated with priority allocations and distributions of income. In other words S Corps can still have voting and non-voting stock, however allocations of income and distributions must be proportionate with the partner(s) share in the S Corp. 

Legal Considerations?

A couple things to consider here in addition to personal asset protection. 

1. State registration: In order to elect S Corp status, the business has to be registered as an LLC or a Corporation. 

Note: If S Corp elections are deemed invalid when made or the requirements necessary to maintain the S Corp election have not been met, IRS may treat the taxpayer as if an election was never made and have other structuring implications outside the scope of this post.

2. Ownership structure limitations: S Corps have ownership limits such as (A) Can not have more than 100 shareholders (B) Owners must be resident natural persons, estates, permitted trusts exempt organizations and (C) may only issue one class of stock with respect to allocations of profit and loss, IRS still allows S Corps to have voting vs non-voting just not preferred shares where income allocations of one shareholder can take priority over another.

Conclusion

The fact you are asking the question on whether to form and taxed as an S Corp or LLC is a great start as you are aware of the many avenues. As this post isn’t meant to be exhaustive you should still consider talking to your accountant or legal advisor.

Disclaimer: The information provided herein is intended solely for informational purposes and no person(s) or other third-party may rely upon it as financial, tax, or legal advice or use it for any other purposes. As a result, Royal Financial, and any affiliates, assume no responsibility whatsoever to readers, or any other persons for that matter, as a result of the information contained herein.