Minding Your Business: What You Need to Know About Entity Choice

I grew up in a small town. My mom did our food shopping at Ives. I got my hair permed at Norma’s. My dad got our car inspected at D&H Auto. And on the rare occasion that we ate out, we went to Jones’ Seafood House. You knew who owned the business by the name on the sign. Small businesses were the norm—they were what kept the town going.

Small businesses are still considered the backbone of our country. According to the latest information from the Small Business Association, there are 31.7 million small businesses—independent businesses with fewer than 500 employees—in the U.S.

Those small businesses have made a big impact. Since 2000, they’ve been responsible for 65.1% of new jobs. Small businesses from 2000 to 2019 generated 10.5 million net new jobs. During that same period, large businesses created just over half as many jobs, according to the Small Business Administration.

But even as small businesses have made a bigger footprint in the U.S. economy, their tax pictures have become increasingly complicated. Some of that complexity is due to changes in tax laws or enforcement, like sales tax collections after Wayfair. But some of the confusion could have been avoided by being more thoughtful about choice of entity.

By the numbers, 86.6% of small businesses without employees are sole proprietorships. But once businesses hire employees, that changes dramatically: Only 14% of small businesses with employees are sole proprietorships. More than half of small employer firms are S corporations, while about a quarter are C corporations and others, the SBA says.

The ease of incorporating online—which I’m not necessarily decrying—means that small businesses can easily change entities. That can be welcome for small businesses that are watching every dime. As a small business owner, I totally get it. But the allure of saving money by doing it yourself or using a service or professional to do the initial work and then walking away (sometimes referred to as “one and done”) can—and does—often end in tax compliance issues.

Small businesses and the professionals who support them should work together to ensure that not only does the business make a sensible choice on entity, but that the business understands that choice. If a small business owner cannot properly identify the tax form that they’re responsible for filing each year, something has gone terribly wrong.

Choice of Legal Entity

One of the biggest mistakes that small businesses make is assuming that their legal entity is the same as their tax classification. That can be true, but it’s not always true.

It’s important to understand that choice of entity is initially state-specific. You incorporate or organize at the state level. And not all entity choices are respected or treated the same in every state.

Even if you incorporate in one state—say, Delaware because you’ve heard that it’s tax-advantageous to do so—you may still be subject to filing requirements in other states. For example, most companies that provide goods and services can’t escape tax in the state where they operate simply by incorporating in another state.

Tax Classifications & Elections

Equally important, your choice of legal entity may be different from your tax classification. Incorporation or organization with the Department of State in your state does not constitute a tax election with the IRS. For example, you can incorporate as a C corporation but elect with the 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 even to be disregarded.

Those tax elections may be subject to deadlines. For example, an S election must typically be filed within two months and 15 days after the start of the tax year or at any time during the tax year preceding the tax year it is to take effect. Relief is available for late elections, but depending on the nature of the mistake, it can be expensive or time-consuming to fix.

Tax Forms

Once you’ve determined your tax classification, the tax form you’re responsible for filing at the federal level will follow. Here’s a quick look at some of the most popular:

• Sole Proprietorship. Taxpayers don’t file a separate business tax return for a sole proprietorship. Instead, income and expenses from the business are reported on Form 1040, Schedule C.
• C Corporation. Entities taxed as C corporations file Form 1120. Shareholders also pay tax at their own income tax rates for any dividends or other distributions paid out during the year.
• S Corporation. Entities taxed as S corporations file Form 1120-S. Like a partnership, items of income or loss are reported to shareholders in proportion to their interest, as determined by statute or shareholder agreement.
• Partnership. Entities taxed as partnerships file Form 1065. However, income and losses associated with the partnership pass through to the partners in proportion to their interest, as determined by statute or agreement.
• Limited Liability Company (LLC). Many LLCs are taxed as a partnership—and file Form 1065—because it’s typically more advantageous. However, an LLC can be taxed as a C or S corporation. And a single-member LLC may be treated as a “disregarded entity,” which means that the taxpayer does not file a separate tax form for the business and reports using a Form 1040, Schedule C, just like a sole proprietor.

Entities taxed as partnerships and S corporations are often referred to as “pass-through” entities because items of income or loss flow through the business to the partners, members, or shareholders via a Schedule K-1. Each partner, member, or shareholder is responsible for reporting that information on their respective tax returns.

Tax Filing Deadlines & Requirements

To accommodate tax filing deadlines for individuals, calendar-year federal income tax returns for partnerships and S Corporation are due on March 15. That’s a change from a few years ago when those returns were due on April 15. Corporate returns did just the opposite—they’re due on April 15 (April 18 in 2022), while they used to be due on March 15.

It’s important to understand that the state or local requirements may be very different from federal filing requirements. Even if you don’t owe tax for federal purposes, you may be subject to filing and payment requirements—for example, New Jersey partnerships with more than two partners may be subject to a filing fee for each partner, while Delaware corporations are required to file an annual report and pay a franchise tax, unless exempt.

The Bottom Line

Running a small business can be complicated. And no one expects you to be able to recite tax form instructions from memory—that’s why you hire a professional to do your taxes, right? But that doesn’t mean that you shouldn’t know the basics. At the very least, you should be able to identify:

• your legal entity—how you’re organized;
• your EIN (employer identification number)—if you need one;
• where you’re subject to tax and reporting requirements; and
• how you’re taxed.

If you don’t know the answers to those questions, ask. And keep in mind that your tax professional may not know all of those answers—if, for example, you used a business lawyer or service to incorporate, you may need to provide a copy of your formation documents. Keeping this information together can make life easier during the tax filing season and let you get back to the thing that you’re good at: running your business.

This is a weekly column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.