Every month, around 543,000 new businesses launch in the U.S. They all have to make a choice: which entity type is the best fit for their organization.

A business entity type lets your state’s charter know how your entity is organized for legal purposes, informs your state’s taxation department for state taxes, and informs the Internal Revenue Service (IRS) for federal taxes. The business entity type you select affects if and how you can raise capital, which taxes you pay, and how you admit new partners and/or shareholders into your organization.

Before we get into business entity types, it’s important to understand that the tax classification for an entity could be different from the legal classification. A legal classification refers to how the business entity is organized with the Secretary of State or equivalent (the Department of Consumer and Regulatory Affairs in DC, or the Maryland Department of Assessments and Taxation in MD, for example). 

There are multiple legal classifications available at the state level, such as a Non-Stock Corporation, a Stock Corporation, a Limited Liability Company (LLC), a Limited Partnership (LP), and a Limited Liability Partnership (LLP). A common misconception is that there are default tax implications for each legal entity type, but that’s not true. 

In this article, we’ll guide you through the process of selecting an entity based on the most advantageous treatment for tax purposes. **Note: this information is not meant to inform the process of selecting an entity type when registering with your state. That should be done with an attorney.

The tax classification refers to how the entity is taxed for federal and state income tax purposes. The five tax classifications available at the federal level are:

  • Corporation: files Form 1120
  • Partnership: files Form 1065
  • S Corporation: file Form 1120S
  • Sole Proprietorship: files form 1040, Schedule C
  • Tax-exempt Organization: files form 990-N, 990-EZ, or 990

 

Before we jump into the different tax classifications, make sure you understand these key terms:

Flow/pass-through income refers to business income which, instead of being taxed at the business entity level, flows or passes through to the partners or shareholders of the business. The income is then reported and taxed on their personal tax returns. This type of tax structure is beneficial because it’s not subject to double taxation, which is once at the entity level and twice upon distribution to shareholders and partners. 

Self-employment (SE) tax consists of Social Security and Medicare taxes primarily for individuals who work for themselves. Self-employed individuals pay this tax in addition to personal federal and state income tax. The SE tax rate of 15.3% consists of two parts: 12.4% for Social Security and 2.9% for Medicare. Through the SE tax, the IRS makes a self-employed individual responsible for the employer and employee portion of Social Security and Medicare taxes. Full-time employees who are not self-employed are only subject to 6.2% for Social Security and 1.45% for Medicare. 

The Qualified Business Income Deduction (QBI) was introduced via the 2017 Tax Cuts and Jobs Act (TCJA) and has 2 components. For the purposes of choosing a business entity, we’re only concerned with the first one. This first component provides business owners with a 20% deduction on their pass-through income – if they meet certain requirements.

The requirements are related to both income thresholds and type of business. The standard threshold is an Adjusted Gross Income (AGI) of less than $207,000 for a single filing or $415,000 for married filing jointly. That threshold applies if the business is a Specified Service or Trade Business (SSTB). If it’s not, the business can still receive the QBI deduction in excess of the threshold, dependent on limitations like wages paid, unadjusted basis of qualified property, and the like.

 

A bit more about the QBI deduction:

Before the addition of the QBI deduction, selecting a tax classification was fairly straightforward. Most small businesses with substantial income and no different classes of stock would elect to be taxed as an S corporation, so their profits would not be subject to self-employment tax. The introduction of the QBI deduction makes the entity selection process more complex.

The qualified business income of an S corporation is lowered by the officer’s compensation deduction, thus reducing the QBI deduction that’s available at the personal level for S corporation shareholders. But before electing to be taxed as an S corporation, a business should assess whether the QBI deduction is available for its shareholders and whether the benefit of not having profit subject to SE tax outweighs the benefits of having a lowered QBI deduction. 

To determine if the QBI deduction is available for the shareholders and/or partners of the business, you must evaluate the AGI of the partners and/or shareholders, whether or not the business is an SSTB, if it pays wages, and what the adjusted basis in the qualified property is (if applicable). 

For example, if you’re a single-status taxpayer, a 100% owner of an SSTB, and your AGI exceeds $207,000, then you’re not qualified to take the QBI deduction. That means it makes sense to make an S corporation election. 

Alternatively, if your AGI is $150k (under the phase-out threshold), the savings from receiving the QBI deduction could exceed the savings from not paying SE taxes on the profits of the S corporation. This would depend on how much you pay in reasonable salaries – especially with the extra administrative costs involved with an S corporation.

 

How to make a choice: 

If you have all your projections ready, this QBI Entity Selection Calculator will walk you through the process of selecting the entity type that is most advantageous from a tax perspective. But if not, here are the different business entity types and the most important factors to consider when making your selection for tax purposes.

 

Tax Classification

Corporation

Legal Classification
  • By default, an entity that is organized as a corporation at the state level is taxed as a corporation. 
  • By election, an entity that is organized as an LLC can be taxed as a corporation.

Pros 
  • Owners don’t have any tax implications on their personal tax returns unless they’ve earned dividends or they’re selling their shares. 
  • There are no limitations on the types of stock issued by the corporation. 
  • Corporations have a low entity tax rate of 21% compared to what pass-through entity owners might pay (15.3% SE tax + income tax at the personal level). 
  • Owners are allowed to put aside an option pool of stock for key employees and strategic partners.

Cons

Corporations are subject to double taxation – once at the entity level and again at the personal level when cash is distributed to shareholders.

Best Fit

A corporation is the ideal entity type for startups. Although C corporations are subject to double taxation, startups typically aren’t profitable. The advantages related to raising capital, offering stock options, and the like far outweigh the disadvantages of double taxation.

 

Tax Classification

Partnership

Legal Classification

By default, when two or more parties manage and operate a business and share its profits, they’re considered a partnership for tax purposes. This includes General Partnerships, Joint Ventures, LLPs, LLCs with multiple members, LPs, and PLLCs.

Pros
  • Partnerships have pass-through taxation, with no double taxation like corporations. 
  • Each partner’s share of profits qualifies for the QBI deduction, other than those subject to QBI limitations.

Cons
  • The owner-operator’s share of business income is subject to self-employment tax.
  • Owner-operator’s pay for services performed can’t be run through payroll or treated as distributions. Instead, it must be paid out as guaranteed payments. 
  • Guaranteed payments are subject to self-employment tax (15.3%). 
  • Guaranteed payments are not considered qualified business income for the purposes of calculating the QBI deduction.
  • The only option for giving employees equity in a partnership would be to share a partner’s membership interest in the company.

Best Fit

Partnerships are the least favorable entity tax classification for owner-operators. However, they are frequently required because most multi-member LLCs, LPs, LLPs, and General Partnerships don’t qualify as S corporations. 

 

Tax Classification

S Corporation

Legal Classification
  • By election (Form 2553), an entity that is organized as a single-member LLC or multiple-member LLC can be taxed as an S Corporation.
  • By election (Form 2553), an entity that is organized as a C Corporation can be taxed as an S Corporation.

Pros
  • S corporations use pass-through taxation, with no double taxation like C corporations.
  • The profits of an S corporation are not subject to self-employment tax (15.3%).
  • The owner’s share of profits from the S corporation qualifies for the QBI deduction unless subject to QBI limitations.

Cons
  • S corporations do not allow multiple classes of stock from a distribution perspective. This means all distributions will be split based on a single ownership percentage.
  • S corporations must pay a “reasonable salary” to the owner for services performed for the business – meaning they must administer payroll even if they have no employees.
  • S corporation shareholders must be U.S. citizens or permanent residents. They can’t exceed 100 shareholders total, and corporations, partnerships, and certain trusts can’t be shareholders.

Best Fit

Any small business corporation or LLC that doesn’t have multiple classes of stock, non-U.S. shareholders, and less than 100 shareholders should consider an S corporation. The QBI entity selection calculator can determine if the savings on SE tax surpasses the reduced QBI deduction as a result of paying a reasonable officer salary.

 

Tax Classification

Sole Proprietorship/Schedule C

Legal Classification
  • By default, when a single person (such as a freelancer, contractor, etc.) operates a business for profit, they’re considered a sole proprietorship for tax purposes.
  • By default, a single-member LLC is considered a “disregarded entity” and treated as a sole proprietor for tax purposes.

Pros
  • Sole proprietorships have pass-through taxation and are therefore not subject to double taxation.
  • There’s no additional tax return filing requirement – the owner simply reports the business income on Schedule C of their personal tax return. 
  • All of the owner’s income (not just share of profits) qualifies for the QBI deduction unless subject to QBI limitations.

Cons
  • A sole proprietor’s total earnings are subject to self-employment tax (15.3%).
  • Schedule C filers have shown a higher probability of getting audited in the past, although this has recently changed.

Best Fit

if the benefit from the increased QBI deduction as a result of filing Schedule C surpasses the self-employment tax savings of an S corporation, then a sole proprietorship makes the most financial sense. However, the extra administration costs for maintaining the S corporation should also be considered.

 

Tax Classification

Tax-exempt Organization

Legal Classification

By application (Form 1023), an entity organized as a C corporation or LLC at the state level can choose to be treated as a tax-exempt or nonprofit organization for tax purposes.

Pro’s
  • Generally, the income of a tax-exempt organization is not subject to tax.
  • The tax-exempt organization can offer tax deductions to individuals or businesses that give charitable contributions.

Con’s
  • The application process to be treated as a nonprofit for tax purposes is very time-consuming. It can also be quite expensive if the organization needs to hire an accountant or attorney to assist. 
  • Tax-exempt organizations must adhere to very strict reporting and governance requirements – otherwise, they could lose their tax-exempt status.
  • The tax-exempt organization’s filing form (990) is open to public inspection.

Best Fit

Any organization that has a mission (i.e., educating the world about global warming) that is not in the business of making a profit, should be taxed as a non-profit or tax-exempt organization.

 

Need Help Choosing a Business Entity Type?

Even with all these details, you might still be unsure what’s the best entity type for your organization. That’s totally understandable – and we’re here to help. If you have questions, contact RY CPAs. Our accounting experts can walk through your organization’s current state and future plans to recommend the optimal business entity type.