It’s my annual Taxes from A to Z series! If you’re wondering how to figure basis for cryptocurrency or whether you can claim home office expenses during COVID, you won’t want to miss a single letter.
L is for Legal Entity.
A legal entity – for legal and tax purposes – has an existence separate from that of the owners. Your choice of legal entity can affect the number and identity of shareholders and partners, equity structure, control, management, and the kind of funding you might be eligible to receive.
When you’re making a choice about the legal entity, remember two key things:
- Legal entity choice is state-specific. It doesn’t happen at the federal level. You incorporate or organize at the state level. The laws of the individual state matter: not all entity choices are respected or treated the same in every state.
- Your choice of legal entity may be different from your tax entity. Incorporation or organization with the Department of State in your state does not constitute a tax election with the Internal Revenue Service (IRS). For example, you can incorporate as a C corporation but elect with IRS to be taxed as an S corporation. You could also organize as an LLC but opt to be taxed as a partnership, S corporation, C corporation, or be disregarded.
There are several legal entities that you might find appealing, depending on your circumstances. Here are some of the most popular:
Sole Proprietorship. The sole proprietorship is the most simple form of business entity. There is no formal procedure to form a sole proprietorship – no forms to fill out, no agreements to sign, and no documents to file with the state. Since there are few formal accounting requirements, the transferability of personal and business assets in and out of the business is easy. The downside of the lack of formal requirements is that the owner of the sole proprietorship can be personally liable for the business’ debts and obligations. That means that personal assets – like your house – can be treated, for liability purposes, as business assets.
For federal tax purposes, taxpayers do not file a separate tax return for a sole proprietorship. Income and expenses from the business are reported on Form 1040, Schedule C.
General and Limited Partnerships. Partnerships are almost as easy to form as a sole proprietorship: it’s an association of two or more persons to carry on a business for profit. Like a sole proprietorship, in most states there are no formal procedures to form a partnership – no forms to fill out, no agreements to sign, and no documents to file – though it’s certainly desirable from a business and legal perspective. In a general partnership, partners share, jointly and severally, in the liability for business obligations.
- A limited partnership is a bit different because it is typically defined as a partnership formed by one or more general partners and one or more limited partners.
- General partners are treated much like what we think of as “typical” partners: they have joint and several liability for the debts of the partnership and often exercise control over the partnership. In contrast, limited partners may have limited liability (this depends on state law and how much control those limited partners exercise).
For federal tax purposes, while a partnership does file a separate return (a federal form 1065), income and losses associated with the partnership pass through to the individual partners. Items of income or loss retain their character and are reported to each partner in proportion to their interest, as determined either by statute or partnership agreement. Each partner is then responsible for reporting that information on their individual tax returns.
Limited Liability Partnership. A Limited Liability Partnership (“LLP”) is similar to a general partnership, but while a general partnership can exist on an informal basis, an LLP must register with the state. The benefit of registration – a formal acknowledgment of the entity – is that the LLP takes on a form of limited liability similar to that of a corporation. Typically, that means that partners aren’t liable for the bad behavior of the other partners though the level of liability can vary from state to state. There is generally unlimited personal liability for contractual obligations of the partnership, such as promissory notes and mortgages (again, this varies by state).
For federal tax purposes, an LLP is treated as a pass-through entity, similar to a general partnership.
Limited Liability Limited Partnership. No, that’s not a mistake. Some states recognize a Limited Liability Limited Partnership (“LLLP”). If you consider that an LLP is a general partnership with limited liability, think of an LLLP as a limited partnership with limited liability.
For federal tax purposes, an LLLP is treated as a pass-through entity, similar to a general partnership.
Limited Liability Company. The Limited Liability Company (“LLC”) is probably the most popular form of business entity today. It’s a hybrid entity that offers the liability protection of a corporation with the option to be taxed as a partnership or a corporation. An LLC is made up of members, as opposed to shareholders. Individual members are typically protected from liability so long as corporate formalities are observed. That means that you do need to register with the state and pay attention to state laws (like filing annual reports). On the plus side, LLCs have far fewer corporate formalities than other corporations.
For federal tax purposes, an LLC is generally treated as a pass-through entity. While most LLCs are taxed as a partnership because it’s typically more advantageous, there may be situations when corporate tax treatment might be preferred (for example, when the individual members of an LLC are foreign). An LLC can also opt to be taxed as an S corporation (more on that in a bit).
Single Member Limited Liability Company. A Single Member Limited Liability Company (SMLLC) is what it sounds like on the tin: a formally organized LLC with a single member.
The advantage of an SMLLC is that it may be treated as a “disregarded entity” for federal tax purposes. That means that the taxpayer does not file a separate tax form for the business; instead, income and expenses are reported on Form 1040, Schedule C, just like a sole proprietor.
C Corporation. A C corporation is what most people think of when we think of a business. In a typical C corporation, the business is owned by individual shareholders who hold stock certificates or shares (yes, we still call them certificates even though it’s rare that you have a piece of paper evidencing your ownership). The shareholders vote on policy issues, but the decisions on company policy are left to the Board of Directors. The catch? The Board of Directors is typically elected by the shareholders. The day to day work of running the company is performed by the officers of the corporation (think CEOs and COOs). The general appeal of a C corporation is limited liability: individual shareholders are not usually responsible for the company’s debts, obligations, and actions.
For federal tax purposes, a C corporation is a separate taxable entity that figures income or loss each year and pays tax on taxable income using Form 1120. C corporations are taxed at the federal level at a flat 21% (post-TCJA). Shareholders also pay tax at their individual income tax rates for any dividends or other distributions paid out during the year (since tax is already paid on the company’s profits, the term “double taxation” comes from).
S Corporation. An S Corporation is a bit tricky because the term actually refers to a tax election. That means that another entity (a corporation, LLC, or PC) is created at the state level, and an election is made to be taxed as an S corporation. By federal law, S corporations have some restrictions: they must have only one class of stock and have a limited number of domestic (no foreign) shareholders.
S corporations are treated as pass-through entities for purposes of taxation – but not precisely like a partnership. There is a separate tax return called a Form 1120-S, which reflects some differences in how income or losses are treated compared to a partnership. However, like a partnership, most items of income or loss retain most of their character and are reported to shareholders in proportion to their interest, as determined either by statute or Shareholder Agreement.
There may be other corporate entity forms available, but these are the big ones. Remember that these are just the basics: some states may have variations on a theme. I recommend that you consult with a professional before jumping in with both feet.
You can find the rest of the series here:
- A is for ATIN
- B is for BEAT Regs
- C is for Cryptocurrency Reporting
- D is for De Minimis
- E is for Extended Due Dates
- F is for FTE
- G is for GILTI
- H is for Head of Household
- I is for Inflation
- J is for Jeopardy Assessment
- K is for Kiddie Tax
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