Choosing an entity: sole prop, LLC, S corp, C corp

In short

A neighbor of mine once started a lawn care business with a mower and a handshake, and he never thought about what kind of business it was in the eyes of the law. If you are thinking of starting something of your own, you have probably wondered the same thing. The entity you pick sets how the business is taxed, who can come after your house, and how much paperwork lands on your desk. A person who simply starts selling something becomes a sole proprietor by default. A limited liability company, or LLC, can put a wall between business debts and personal property. An S corp and a C corp are tax choices with legal shapes, and both come with more rules and more forms. Your state office and the IRS pages named below spell out the details for where you live.

The whole of it

What it is

I once watched a baker friend sweat over this choice for a full month, and then laugh when she learned the first step was simpler than she feared. An entity is the legal shape of a business. Think of it as the coat the business wears when it meets the world.

A sole proprietorship is the plainest coat. There is no separate business in the law's eyes. The owner and the business are one person. Income flows onto the owner's own tax return, and so do the debts and the lawsuits.

An LLC is a business that a state creates when an owner files papers with that state. The owner is called a member. The law treats the LLC as separate from the member for most debt and lawsuit purposes. For tax, the IRS lets an LLC choose how it wants to be treated.

A C corporation is a separate legal body, and it is also its own taxpayer. It pays tax on its profit, and owners pay tax again when they take profit out as dividends. That is the part people call double taxation.

An S corporation is not really a different kind of company. It is a tax election. A corporation or an LLC can ask the IRS to be taxed as an S corp by filing Form 2553. Profit then passes through to the owners and gets taxed on their own returns, with no tax at the corporate level in most cases.

How it works

If you are holding a business idea and a stack of forms, the first question is who pays the tax and who carries the risk. A sole proprietor reports business income on Schedule C, which attaches to the personal return, Form 1040. The proprietor also pays self employment tax, which covers Social Security and Medicare. The IRS sets that rate at the current figure, which the official source publishes each year percent on net earnings.

An LLC with one owner is taxed like a sole proprietor unless the owner chooses otherwise. An LLC with two or more owners is taxed as a partnership unless the members choose otherwise. In both cases the LLC may instead choose to be taxed as an S corp or a C corp.

An S corp owner who works in the business must be paid a reasonable salary. The business withholds payroll tax on that salary. Profit beyond the salary passes through to the owner and is not hit by self employment tax. That gap is why people look at the S corp. It also adds a payroll system, a separate business tax return, and a closer eye from the IRS on what counts as reasonable pay.

A C corp files its own return, Form 1120, and pays tax at the corporate rate of the current figure, which the official source publishes each year percent set by federal law. The structure is built for businesses that raise money from outside investors or keep large profits inside the company. For a small shop, the second layer of tax is often the catch.

The liability wall is its own matter. A sole proprietor has none. An LLC or corporation offers one, but a court can set it aside if the owner mixes personal and business money or skips the basic rules. Lenders and landlords often ask the owner to sign a personal guarantee anyway. The borrower then has to repay from personal assets if the business cannot.

The numbers, and where to find yours

Every state sets its own filing fee for an LLC or a corporation, and some states charge a yearly fee on top. Those figures change, so the fee for your state is the current figure, which the official source publishes each year, and the secretary of state website for your state shows the current amount. Some states also charge a yearly tax or franchise fee just for holding the entity.

The federal figures come from the IRS. The self employment tax rate, the Social Security wage base, and the corporate rate all sit on the IRS website. The wage base is the current figure, which the official source publishes each year this year. The IRS pages for Schedule C, Form 2553, and Form 1120, along with their instructions, spell out the rules. The Small Business Administration also keeps a plain guide on choosing a business structure at sba.gov.

Check the date on any number you find. Rates and limits move, and a figure from a blog written three years back may be stale. When in doubt, go to the primary source.

A worked example

Let me tell you about Marcus, who runs a one man graphic design shop in a state with a modest filing fee. After expenses, his shop earns $90,000 in a year. He wonders what the choice between a sole proprietorship and an S corp might do to his tax bill. The numbers below are simple figures made up for the example, and they leave out income tax so we can look at one piece.

As a sole proprietor, Marcus owes self employment tax on his net earnings. The IRS applies the rate to 92.35 percent of net earnings, so the first step is $90,000 times 0.9235, which is $83,115. Suppose the rate is 15.3 percent, a plain figure for this example only. Then $83,115 times 0.153 is $12,716. That is his self employment tax.

Now picture Marcus electing S corp status and paying himself a reasonable salary of $60,000. The business and Marcus together pay payroll tax on that salary. At 15.3 percent total, $60,000 times 0.153 is $9,180. The other $30,000 passes through as profit with no payroll tax.

The difference is $12,716 minus $9,180, which is $3,536. That sounds nice. But Marcus now pays for a payroll service, say $600 a year, and an extra tax return from a preparer, say $900. Those two costs add up to $1,500. His gain shrinks to $3,536 minus $1,500, which is $2,036.

Not a fortune. And if the IRS decides $60,000 was too low a salary for his work, the gain shrinks further. The IRS sets the rules for the S corp election, and a business owner in his spot would find those rules on the Form 2553 instructions before anything gets filed.

Where it goes wrong

A friend of mine formed an LLC and then paid her rent and groceries out of the business account. Years later a customer sued, and the lawyer pointed to that mess as proof the LLC was a sham. Courts look hard at that kind of mixing. Business money belongs in the business. Contracts get signed in the business name. The owner holds the yearly meetings and files the yearly reports the state requires.

People also pick an S corp too soon. When profit is small, the extra cost of payroll and returns can eat the savings, as Marcus saw. A salary set too low can bring penalties.

Some owners file the papers and forget the state fees. The state can then dissolve the entity, and the liability wall goes with it. Others forget that a change of entity can trigger a tax bill or a need to retitle assets, licenses, and bank accounts. Insurance matters too. An LLC does not protect against an owner's own mistakes, so many owners carry liability coverage as well.

Questions to answer before you leave this page

How much profit does your business make after expenses, and does the extra cost of payroll and a second tax return still leave a real gain? Does anyone, such as a landlord or a bank, already ask you to sign a personal guarantee that makes the liability wall thinner than it looks? What does your state charge to form an LLC, and what does it charge each year after that? Do you plan to bring in partners or outside investors, which might point toward a different shape than a solo shop needs? And have you read the IRS instructions for Form 2553 and the secretary of state page for your state, so the choice fits your own books?