This article covers the different options for registering your business with the Secretary of State’s office (in the state that you choose) and the tax implications of that business structure. As stated in the Business Registration Overview article, there are three important considerations when considering business structure: 1) Number of owners and complexity of ownership, 2) liability of the potential venture and assets at risk, and 3) Tax Issues.
Because this article only addresses single owner businesses partnership issues are not discussed. Also, because this article focuses in on legal structure and the related tax implications you may find it helpful to review the Business Registration Overview Article for a more complete description of the registration process. If you have more than one owner in your business refer to the Business Legal Structure with Multiple Owners article.
There are four basic options when choosing your business structure with a single owner: Sole Proprietorship, Limited Liability Company, C-Corporation, and S-Corporation. The following is an overview of the four different options.
1. Sole Proprietorship
Liability - In a Sole Proprietorship the owner has unlimited liability for the activities of the business. In a Sole Proprietorship there is no separation of business and personal assets in the eyes of the law. In other words your personal property is not protected in the event that your company is facing litigation.
Taxation – The owner is taxed on the income that the business produces. Owner’s draws are not a deductible expense for tax purposes. Taxable Income is determined by filling out a Schedule C – Profit and Loss, which is filed with your annual 1040 Individual Tax Return. Taxable income is taxed at a personal tax level three different ways: Federal Income Tax, State Income Tax and Self Employment Tax. You should fill out IRS form 1040-ES Estimated Tax Withholding to determine your estimated quarterly payments to the IRS.
Self Employment Tax is a payment that funds Social Security Insurance and Medicaid. In a normal employment situation you would pay half the amount due and your employer would match the same amount. Since you are self-employed you will have to pay both halves which amounts to 15.3% of your total net income up to $94,200. Income above and beyond that amount is only taxed at 2.9% for Medicare which has no upper limit. Self Employment taxes for each partner are filed at the end of the year using 1040 Schedule SE.
Registration – There is no business registration required for sole proprietorships. If a person starts a business using their own name, has no employees and only sells services the only requirement is that you file your income taxes with the state and federal government.
If you choose to use a name other than your own you will need to file a Trade Name registration or “Doing Business As” certificate with the Secretary's of State office in your state.
2. Limited Liability Company
Liability - A Limited Liability Company (LLC) is the a la carte of business registration. With a single member LLC the owner has limited liability protection for the activities of the business. This means that there is a separation of your business and personal assets and your business is an entity in the eyes of the law. Your personal assets are protected in the event that your company is facing litigation. For most businesses it makes sense to choose the LLC structure over a Sole Proprietorship because of the limited liability protection.
Taxation – Limited Liability Companies are not recognized by the IRS for tax purposes (they are considered a “disregarded entity” ) therefore you can elect how you would like your business to be taxed. By default, a single member LLC is taxed like a sole proprietorship as described above. Companies can also elect to be taxed like a corporation, as described below, by filing IRS form 8832. Finally, if a company elects to be taxed like a corporation they can make a second election to receive Subchapter-S status as described below in section four.
Registration – Registering an LLC requires that you file Articles of Organization with the Secretary of State. Most states provide a sample format that you can follow stating the business name, ownership, length of existence, and other articles of organization. Also, most states require that a company have on file a Registered Agent.
A registered agent is a person or company that will accept correspondence on behalf of the company typically in the event of litigation. If you live in the state you are registered in you can serve as your companies registered agent. If not, a local attorney or a company that provides registered agent services can be retained for a small fee. A registered agent must have a physical address in the state in which the company is registered.
3. C-Corporation
Liability – Like an LLC a single owner C-Corporation is given limited liability protection for the activities of the business. This means that all current and future shareholders personal assets are protected in the event that your company is facing litigation.
It is important to note that some entrepreneurs file as a Corporation because they believe this separation of personal and business entities allows them to borrow money that they will not be personally responsible for in the event the business fails. Because most banks and government program require a personal guarantee for all shareholders with more than 20% ownership you will not escape personal liability for debts.
Taxation – Taxable income is determined by IRS form 1120 and your estimated quarterly payments by IRS form 1120-W. C-Corporations are subject to double taxation. The business is taxed on the net income the business produces on a state and federal level and it is taxed again on the dividends the company pays to its shareholders at a rate of 15%. Owners who work in the business can deduct their salaries as a business expense but this pay is treated as a normal employee paycheck (State, Federal, and both halves of Social Security & Medicare).
Registration – Registration and maintenance of a Corporation is a complex and time consuming process. You will be required to file Articles of Incorporation with the Secretary of State. A board will have to be formed (even if you are the only board member) and an annual report will have to be filed in order to star in good standing with the state you are registered. Most states provide a sample format that you can follow stating the business name, authorization of stock, length of existence, and other articles of organization. Also, most states require that a company have on file a Registered Agent.
4. S-Corporation
An S-Corporation is essentially a C-Corporation that has elected Subchapter-S status by filing IRS form 2553. This tax election allows a corporation to avoid double taxation by way of a dividend pass-through feature for the shareholders of the company. Like a C-Corporation owners can deduct a salary, but all of the taxable income the company produces is automatically paid out to the owners and is not subject to the normal 15% dividend tax. Small Business Corporations file their business taxes using form 1120S. It is important to remember however, S-Corporations are a passthrough entity and therefore do not pay taxes at the corporate level but rather the individual shareholders pay taxes based on their percent ownership.
For many small business owners dividend pass-through allows them to deduct a reasonable salary but saves them the 15% dividend tax that of a regular C-Corp and the 15.3% SE tax on every dollar over and above their salary of a Sole Proprietorship.
Aside from filing a tradename it is advisable for most businesses to enlist the help of a qualified accountant, attorney or incorporation service such as American Incorporators or LegalZoom.com . This will ensure that your business is properly registered and is able to take advantage of all the benefits a limited liability or corporate entity has to offer.
