Types of Entities

There are different types of entities a company could have. Here is an episode explaining what they are and the pros and cons of each.

Transcript

Episode #2 -- Type of Entities 

Once you start spending money on a business idea as we discussed in episode #1, you now have to think what kind of business entity you want your company to be depending on what the company will be doing and/or selling.  

There are 4 basic kinds of entities. 

1.    Sole Proprietorship

2.    An LLC (Single Member or Multi Member)

3.    A Corporation – (Either S Corp or C Corp) 

4.    A Non-Profit Organization

There are other lesser-known types of entities, but here we’ll talk about the 4 basic kinds.  

Sole Proprietorship—In most states, the city, county or state government would like you to legally register yourself as a sole proprietorship -- in other words a ‘DBA’ (doing business as...) but some states don’t require registration.  In the state where I live and most of my clients do business, the county wants sole proprietorships to register with a Notary Public in order to make a sole proprietorship legal.  There is no name check – for example, I can be Paul McDonald DBA McDonald’s. McDonald’s might send a cease-and-desist letter, but if I could fight it if I wasn’t a restaurant or in the food business and probably win because I’m not using their logo or colors.  It happens to be my last name. The liability would fall to me personally, since sole proprietorships are not ‘separate’ business entities.  They are the cheapest way to go, but virtually no protection if litigated against. Many bookkeepers, for an example, are Sole Proprietorships especially if they are on a one-person operation because even if bookkeepers make a mistake and put an extra zero where it doesn’t belong, the tax professional who is preparing the tax return should catch it.  Sole Props can have employees, but the owner cannot be an employee of his or her own business.   All the money that the business earns should go into the business bank account and be accounted for, and then the owner can just transfer money out of the business account and into their personal account.  It doesn’t affect taxes, since that withdrawal is considered an Equity “Draw” and not an expense of the company.  The Profit and Loss of the Sole Proprietorship goes on a Schedule C form in your personal taxes.  

LLC (Single member) – A single member LLC is very much like a Sole Proprietorship, except it’s a separate entity --- that is --- it has its own tax ID number assigned to it.  If you are a single member LLC, you cannot use your Social Security number as a tax ID number like you can with a Sole Proprietorship. If you are a sole proprietorship and ‘trade up’ to an LLC, you don’t have to start another set of books like you would if you changed from an LLC to a Corporation.   LLC’s, however, are not recognized in ALL STATES as an entity.  So, if you are in the trucking industry and you travel across several states routinely, if an accident happens in a given state, it could happen in a state that doesn’t recognize an LLC as an entity, hence you would not be insured against any costs to your vehicle or someone else’s even if you have insurance. Most states that do recognize an LLC as a separate entity will charge filing fees once a year and an initial publishing fee to make you an official LLC.  Since you aren’t an employee of your own company, you can invest money in an IRA or a SEP (which is almost like a 401K for self employed people). 

Multi-Member LLC (AKA Partnerships) -- If you have one owner of an LLC, and you have an outside investor, then it’s considered a partnership LLC or a ‘multi member’ LLC. Multi-member LLC’s are treated as a partnership in the tax world, so March 15th is the tax deadline.  Single member LLC and Sole proprietorships are treated as an add-on to your personal tax returns; hence April 15th is your tax deadline.  With a multi-member LLC, each person or entity that is contributing money to the LLC has to have an Equity account for incoming money (Capital) and an Equity account for outgoing money called a ‘Distributions’.  You and your other members must track how much money is invested and how much money is being distributed within the Equity section of the books. Owners or members of a multi-member LLC can’t be on payroll like an employee (the same as a Sole proprietorship), but if either or both of the members actually work at the company, they can be compensated by getting ‘Guaranteed Payments) which would be a company expense that would lower the profit of the company.  The Guaranteed payments would end up being on the K1 form that the members receive and that rolls over to the members personal taxes.  The IRS doesn’t recognize LLCs of any kind as a separate entity for taxes, so the profit of the multi member LLC ‘roll over’ to the members as personal income through a K1 and that is how taxes are paid. If Guaranteed payments aren’t done, then Distributions going through the Equity account can be done and they end up on the K1 as personal income as well. Needless to say, the communication between the person who runs the LLC and the bookkeeper is very important since it’s much more complicated than a single member LLC or a Sole Proprietorship. Multi Member LLC’s use a 1065 form. 

Side note: LLPs are Limited Liability Partnerships.  Two or more owners of the LLC, not just members. Attorneys and doctors might have LLP entities.  

Corporations: 

S Corporation:  An S Corporation’s tax return is also due on March 15th as a separate tax return than the owner’s personal return.  It works in a very similar way as a Multi-member LLC does as the profit of the S Corporation flow to a K1 form, and is taxed with the owners’ personal tax return due on April 15th.  The main difference is if you are an owner or a partner in an S Corporation, you are an employee of your own corporation.  You can get a weekly, bi-weekly or monthly paycheck or you can have payroll done at the end of the calendar year to show that you made a ‘salary’ as you were treated as an employee of your own company.   And of course, you can have other people as employees and pay them accordingly. As an employee of your own company, you can have a 401K just like other employees. The IRS says that you have to pay yourself a ‘reasonable’ salary if your company is making a profit. As with a multi-member LLC, K1’s work the same way as S Corporations.  

C Corporations:  C corps are a completely separate entity from someone’s personal financial life unlike S Corporations. With an S Corporation, you can take out a home equity loan, for an example, through the Corporation, and pay it back through the corporation, without using the money for the corporation. But C Corps – are different.  C Corps are treated as a totally different entity.  They aren’t connected to an individual in any way directly.  The Board of Directors makes decisions for the C Corp. policies, and individual stockholders (if it's a publicly traded company), can vote on certain things that the Board of Directors want to do.  Not that different bookkeeping wise between an S Corp and a C Corp, but a C Corporation’s tax return can be much more tedious and time consuming for an accountant or any tax preparer.  Also, think liability.  If the company manufactures space heaters, for an example, then you might want to consider a C Corp. so that any liability that might occur by a badly manufactured unit or any kind of a lawsuit cannot leak through to you or the Board members personal bank accounts.  There’s a lot more that we can talk about with C Corps and S Corps, but I’ll let you continue that conversation with your CPA or tax preparer.   

Non-Profit Organizations:  Usually non-profits are S Corporations, some are C Corporations, but none that I know of are LLC’s.  A non-profit organization is a designation that the IRS gives for the reason that the entity exists.  The entity serves a purpose.  From Wikipidia: A nonprofit organization is a business that has been granted tax-exempt status by the Internal Revenue Service (IRS) because it furthers a social cause and provides a public benefit. Closed captioning is one example, or a device to transcribe telephone conversations for the hard of hearing into something that they can read in real time is another. Collecting donations and giving money to museums from the donations accepted is another example.  A non-profit, if selling items, can collect sales tax from customers (since selling an item isn’t a donation), and non-profits are allowed to make a profit if that profit is used for operating costs for the next year.  Non-profit entities have to file annually in May of every year, and since they don’t pay taxes, they have to explain, not just in numbers, but in writing paragraphs about how they receive money and how they spend money. There’s a lot of explaining to do! The recent ‘famous’ case that hit the entertainment news in the last year is the Locast story.  I’ll do an episode just on that case, but Locast was a streaming service that re-transmitted the over the air free TV channels on the internet through an app. They were shut down because they were not following the rules and laws of a non-profit entity. 

These are the 4 big buckets of entities to think about when you form your own company.  

Here’s the kicker though:  If you have a single member LLC, the IRS allows you to file your taxes as an S Corporation using all the rules of the S Corporation tax filings as per the IRS. I have a few clients who are doing that.  Generally (but not always), your tax liability might go up if you have a single member LLC but choose to file as an S Corp.  There are no payroll fees if you don’t have employees in a single member LLC, but if you are filing as an S Corp, it could be (if you are receiving a paycheck every week), around $100 a month payroll fee.  The S Corp pays payroll tax, you, as an individual, have payroll taxes withheld from your own paycheck, and then as part of your personal tax return, you would have money that you have made being an employee, and the profit of the S Corp. being converted into a K1 which is taxable as well as personal income. However, you could ‘overtax’ yourself as an employee to help pay the tax on the income that the net profit of the S Corp. makes.  A lot more work bookkeeping, more payroll fees, more accounting fees with your CPA or tax professional, only to sometimes find that it’s the same amount of tax that you pay to your state and to the IRS. 

And I know that’s a mouthful -- but if you want to look more into that, it should be a conversation with your tax professional. 

And now – our client story for this week: 

Actually, I don’t have just one client story, but so many that I can’t count them all. Suffice to say that I have had new clients with single member LLC’s call me on March 10th asking me if the books are ready for tax filing.  I tell them that their date is April 15, not March 15th. They tell me that they are filing as an S Corp.  I tell them that I see no payroll for them in the books --- so how can you file as an S Corp.  The client is making a profit and no payroll is taken, but they are filing as an S Corporation. The client tells me that this is the way they have been doing it for 2 or 3 years. I suggest a new accountant! Keep in mind that a corporate tax return costs more to prepare.  More hours, more forms, more reporting. Some accountants and accounting services charge by the form, others charge by the hour. Either way, the accounting costs go up if you file a corporate return as compared to an LLC.  Sometimes, clients have a psychological reason to file as an S Corp.  They may have been working as an employee for many years and they are used to getting a weekly paycheck. So, they form an LLC, file as an S Corporation and even though they might be paying more taxes than they have to, they don’t mind, since they are getting a paycheck every week. There are tax professionals who suggest to clients to create an S Corp. from the very beginning but having no real reason to do that for the client. The client accepts that suggestion from the tax professional, only to find out later that they really should have been a single member LLC and not a corporation. I have had a few clients in that position.  I went through a number of S Corporations being ‘converted’ into LLC’s. We had to file with the IRS forms that would enable the S Corporation to be dissolved. Once that happened, the assets of the S Corporation can belong to the LLC that is created, and a new set of books need to be created. 

One final word – or a bunch of words --- It’s an interesting tax system that we have.  The tax return is filed and signed by a tax preparer, but if audited, the individual who has paid for the professional to file taxes is liable for anything that the IRS finds that’s wrong with the tax return. At the same time, business owners are not tax professionals. Tax professionals are responsible for fraud at their end. If the tax professional is stealing money through the books or through bank accounts, that’s one thing, but a routine audit, the tax professional isn’t fined for producing an inaccurate tax return, the client is.  The moral?  Think of your bookkeeper and tax preparer as a surgeon.  If you need surgery and you have a little time to figure it out, I’m sure you’ll interview surgeons, get all the information from them such as how many of the specific surgery that you need have, they done and what is their success rate? Did they graduate in the top 10 of their class? Please do that with your accounting professionals.  You will get a cleaner tax return, probably a lower tax liability to the IRS and your state, and you’ll be able to sleep better at night knowing that you have a real honest to goodness pro on your side. 

Please send comments to Bookkeepermensch@gmail.com or Numerex@numerexonline.com  and look out for the next episode!