One of the most common questions I receive as a tax professional is “What type of business entity should I choose?” Most new business owners are overwhelmed at this decision and do not fully understand the differences between types of entities. This article will explain rules, filing requirements, and benefits of the main type of business entities: sole proprietorship, LLC, Partnership, S-Corporation, and C-Corporation. Each decision is dependent upon the facts & circumstances of the owner(s), but a thorough understanding of each business type is critical in making the correct entity decision.
The easiest, quickest type of entity to set up is a sole proprietorship. A sole proprietorship is not separate from its owner. This means that the owner of a sole proprietorship has all of the decision-making authority, but they also carry substantial risk. Because this type of entity is not separate from its owner, the owner has personal liability if the company is the subject of a lawsuit. The owner’s personal assets (home, car, personal bank account, etc.) could also be subject to the lawsuit.
Sole proprietorships report the income and deductions of their business on Schedule C of their individual Form 1040 tax return, due April 15. Sole proprietors are also required to pay self-employment tax on their earnings. For sole proprietors, there is not an employer paying a portion of these payroll taxes (Medicare, social security) on their behalf. While a sole proprietorship is simple to establish, the negatives are personal liability and additional employment taxes.
While a sole proprietorship is not separate from its owner, a Limited Liability Company (LLC) is a separate legal entity. The biggest benefit of an LLC is that the members (owners) have limited liability should an issue arise. The members of the LLC are not personally liable should the company be sued, fall into bankruptcy, etc. except to the extent of their initial contribution to the business.
LLCs are very flexible in how they allocate income to partners and in how they report and pay income taxes. For an LLC with multiple members, the default taxation method is to be taxed as a partnership. This means that the LLC will file Form 1065 on or before March 15 for a calendar year taxpayer. Form 1065 will include a Schedule K-1 for each of the members of the LLC. The members will report their share of the LLC’s income & deductions from Schedule K-1 on their individual tax returns. The LLC in this scenario does not pay the tax on the profits of the entity. Rather, the members of the LLC are liable for paying their share of the taxes of the entity. In most situations, members of the LLC are taxed on their proportionate share of the company’s profits for a given year, not on the amount of money distributed to them during the year. These two amounts can be different. For example, let’s say an LLC reports $100,000 of taxable income on Form 1065 for 2019. Let’s also assume Tom is a 25% member of the LLC and received $40,000 of distributions from the company during 2019. Tom would pay tax on $25,000 of profits for 2019 and generally not on the $40,000 he received. As mentioned, LLCs with multiple members are taxed as a partnership by default. Conversely, LLCs with only one member are treated as a “disregarded entity” for tax purposes and taxed as a sole proprietorship. This means that there is not a separately required tax filing for the LLC and the income/deductions of the LLC are reported on the single member’s individual Form 1040 Schedule C.
LLC’s are also allowed to elect to be taxed as either an S-Corporation or a C-Corporation. It is more common for an LLC to elect to be taxed as an S-Corporation than a C-Corporation. See the section that follows regarding the potential benefits of an S-Corporation election.
The benefits of a partnership structure are similar to those of an LLC. In a partnership structure, there are at least two partners that are joint owners of a company. General partnerships are common when the partners are involved in the business operations. Because each partner is involved, they also have additional liability for the debts of the company. A limited partner, on the other hand, is usually not involved in the day to day business and their liability is limited. The taxation of a general partner & a limited partner is the same: the business itself does not pay federal income tax. The income of the partnership will flow through to the partners and the partners will pay their share of the partnership’s tax on their individual tax return. The partnership will file Form 1065 and provide each partner with a Form K-1.
A C-Corporation is a separate legal entity from its shareholders (owners). One way to think about a Corporation is that it is a separate person – it is a standalone entity. Owners of the corporation are called shareholders, and own shares which establish their ownership interest. Corporations have an unlimited life, meaning that when the founder, CEO, or shareholder dies, the business does not dissolve. The Corporation continues. This is because shares can be passed down to heirs, in addition to being purchased and sold.
While not all corporations are publicly traded, essentially all publicly traded companies are C-Corporations. Because corporations are separate "people," they have multiple ways to raise capital. The two most common ways are to issue stock or take out a loan. Because the Corporation is a separate person, the Corporation itself can be the signer on the debt. The shareholders of a corporation are protected from personal liability for the company’s financials and actions. While there are many benefits of forming a Corporation, it can be costly and cumbersome. Corporations must make annual filings and follow strict regulations.
Another negative to C-Corporations is that they are subject to double taxation. C-Corporations make a separate tax filing for the corporation on Form 1120, due April 15 for calendar-year entities. Because the Corporation is a separate person, the C-Corporation is liable for paying taxes on their income each year. Unlike the other entity types, the owners of the business are not responsible for taxes on annual earnings. However, for a Corporation to pay shareholders, the C-Corporation must issue dividends. These dividends are not tax-deductible by the Corporation. Additionally, the shareholders will pay tax on the dividends they receive. This creates double taxation on C-Corporation earnings: the C-Corporation pays tax on income, then pays dividends which they can’t deduct for tax, and then the shareholders pay tax on the dividends they receive.
S-Corporations are a stand-alone business entity which functions very similarly to a C-Corporation. S-Corporations are a tax entity, not a legal entity. Taxpayers make elections to treat their existing legal entity as an S-Corporation for tax purposes. An S-Corporation issues stock to shareholders and has a board of directors and officers. It also offers the same protection to members of the S-Corporation. They are not personally liable for the S-Corporation’s actions. Unlike C-Corporations, S-Corps can only have up to 100 shareholders and one class of stock. Additionally, foreign shareholders are not allowed to own stock of an S-Corporation. While S-Corporations differ from C-Corporations in many ways, they are taxed very similarly to partnerships & LLC’s. S-Corporations file Form 1120S with the IRS. Form 1120S includes a Schedule K-1 for each shareholder. The S-Corp does not pay tax, which is another major difference between an S-Corp and a C-Corp. Rather, the shareholders of the S-Corporation pick up their portion of the S-Corp’s income on their Schedule K-1 and pay the tax on their individual tax return, just like a partnership or LLC.
A unique aspect of an S-Corporation is that an LLC can elect to be taxed as an S-Corporation. What this means is that rather than filing Form 1065 as a partnership, the LLC can file Form 2553 with the IRS to elect to be taxed as an S-Corp (and file Form 1120-S instead). Why would an LLC make this election? The main benefit of an S-Corporation is that employee-owners can save on self-employment taxes. Normal LLC members have to pay a 15.3% self-employment tax (which covers Medicare & Social Security) on their full share of the partnership’s net income. By converting an LLC to an S-Corp and paying an employee-owner a reasonable salary, the S-Corp can deduct the employer portion of Medicare & Social Security taxes. The excess money earned by the S-Corp attributable to the employee-owner is not subject to self-employment taxes. Because of this the self-employment tax benefits, S-Corp’s are very common tax structures for companies whose owners are also employees of the company.
The Best Structure
In determining the best structure for your farming business, each taxpayer needs to answer a few questions:
- How much liability do you want to have?
- How big does this business expect to be?
- What are your sources of funding?
- Do you want to have to pay taxes personally?
- How much money are you willing to spend to establish the business entity/
- How many partners/members do you expect to have?
Each situation is uniquely different, which makes it impossible to definitively say which entity is the “best.” We commonly see entities who have a member(s) involved in the business operations day to day set up as an LLC but taxed as an S-Corp to save on self-employment taxes. It’s also very common for larger farming operations to be established as a C-Corporation to have multiple funding options and limited shareholder liability. A C-Corporation can also present numerous different potential exit strategies and disposition options. Taxpayers who are starting a farming business should consult with their attorney and/or CPA to ensure they are choosing the business entity type that best suits his or her needs.
This article should not be construed as, and should not be relied upon as legal or tax advice.
Tyler Davis works for SVN: Saunders Ralston Dantzler real estate and also owns his own CPA Firm, Tyler Davis CPA where he provides tax preparation, consulting, and provision services. SVN: Saunders Ralston Dantzler is a leading agricultural land brokerage based in Lakeland, FL. Tyler can be contacted at firstname.lastname@example.org