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Best Entity Structure

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Best Entity Structure

 

A Simple Guide to Save You Time and Money 

One of the most crucial decisions is choosing the proper entity structure. This choice affects how you pay taxes, protect your assets, and even handle paperwork. 

Whether you’re just starting a side hustle, growing an existing business, or thinking about ways to protect what you’ve built, selecting the proper business structure can make your life much easier—and save you money.

You want to read this blog if...

  1. Want to read a simple guide that specifies the main differences in diverse entity structures for your business

  2. Want to know the cons and pros of choosing an entity structure and which is the right one for you?

Let’s look at a real-world example with Jane,

1. Sole Proprietorship

When Jane first started her lemonade stand, she kept things simple. It was just her, selling lemonade on the weekends. She didn’t have to fill out any special paperwork or register her business with an agency. [Note: If the risk of litigation is high from the start, you may want to consider opening an LLC from day one. For example, this is relevant in trade businesses such as electricians, plumbers, and tech companies.

Bookkeeping

Jane could use a simple Excel spreadsheet to track income and expenses, as every penny in the early stages matters. However, subscribing to accounting software like QuickBooks would help her better organize her records as her business grew. Jane can take advantage of the IRS code from the moment she collects her first dollar. 

Tax Deductions/Credits

  • Lemons, Sugar, and Other Supplies:

    Jane deducts the cost of lemons, sugar, cups, napkins, and other supplies she needs to make and serve her lemonade. 

  • Tent and Stand:

    Her lemonade stand and tent cost is fully deductible as a business expense.

  • Marketing and Advertising:

    Jane invested in some flyers and online ads to spread the word about her lemonade stand. These marketing expenses are fully deductible. 

  • Cell Phone:

    Since Jane used her personal cell phone for business calls and text messages, she could deduct a percentage of her phone bill that was directly related to business use. 

  • Home Office Deduction:

    If Jane used a portion of her home (like a small desk) to handle administrative tasks such as bookkeeping or ordering supplies, she could deduct a portion of her rent, utilities, and internet under the home office deduction. 

  • Mileage:

    Jane traveled to different locations to set up her lemonade stand and purchase supplies. She kept track of her business-related mileage, which she could deduct using the standard IRS mileage rate.


For more details on tax deductions and how to maximize savings as a sole proprietor,

Download our Free E-book.


Tax Reporting

  • Sole proprietors report business income and expenses on Schedule C of their individual tax returns (Form 1040). 
  • All profits are subject to income tax and self-employment tax. 

Pros: 

  • No Separate business filings. Everything is reported on your personal return

  • Little paperwork. Just start selling and report earnings

  • Full control over the business.

  • Cell Phone: Since Jane used her personal cell phone for business calls and text messages, she could deduct a percentage of her phone bill that was directly related to business use. 

 

Cons: 

  • Personal liability. If someone gets sick from Jane’s lemonade, she could be sued personally, putting her savings or home at risk. 
  • No tax-saving options beyond personal deductions. Every dollar Jane earns is subject to self-employment taxes. 

When Should You Consider a Sole Proprietorship?

A sole proprietorship is simple and easy to maintain if your business is small, low-risk, and pulling in less than $40K in profit. It’s great for freelancers, side hustlers, and those testing the waters before committing to a more formal structure. 

 

2. LLC (Limited Liability Company)

As Jane’s lemonade business grows, she forms an LLC to protect her assets. This separation of personal and business liabilities helps her feel more secure, especially as she hires a few helpers and takes on larger catering gigs.  

Bookkeeping

  • Since the business has grown, Jane now needs to keep more detailed records. Using QuickBooks or a similar software becomes essential to track income and expenses more effectively. 

Tax Deductions/Credits

  • Everything from her sole proprietorship applies here: supplies, marketing, home office, and mileage deductions. 
  • Section 179 Deduction: Take advantage of this deduction to immediately deduct qualifying business equipment and software costs. 
  • Additional deductions Jane can consider now include health insurance premiums (if she's paying for her own) and employee wages if she hires additional help. The LLC structure also provides more flexibility in paying herself, allowing her to set aside income for potential tax-advantaged retirement accounts like a SEP IRA. 
Tax Reporting
  • Jane continues to report business income on her personal tax return but now files a Schedule C as a disregarded entity for tax purposes. 

When Should You Consider an LLC Structure?

If your business generates over $40K in profit or involves some level of risk (like a construction contractor or consultant), forming an LLC can provide personal protection without much complexity. It’s ideal for growing businesses that need a more formal structure. 


3. Partnership

Jane wasn’t in this alone for long. Her best friend, Sarah, wanted to join the lemonade empire. Together, they formed a partnership. Jane handled production, while Sarah managed marketing and operations. They split the profits evenly. 

Bookkeeping

With two people sharing the business, investing in a reliable bookkeeping system or hiring a professional to manage profit splits and expenses is essential. Tax Reporting: 

  • Partnerships file Form 1065 and provide each partner with a Schedule K-1 to report their share of profits on their individual returns. 

Tax Deductions/Credits

While many of the same deductions from the LLC still apply (supplies, marketing, etc.), certain personal deductions become more limited in a partnership: 

  • Home Office Deduction: If Jane or Emily work from home for partnership-related tasks, the home office deduction is no longer claimed individually. Instead, the partnership would need to reimburse them for the expenses related to using a home office. 
  • Mileage: Similar to the home office, mileage for business-related travel would need to be reimbursed by the partnership rather than deducted directly by each partner. 
  • Hiring Family Members: If Jane or Emily decide to hire their kids to help with the business, the rules are stricter in a partnership. While hiring children can still offer tax benefits, the wages must be reasonable for the work performed, and the child must be an employee of the partnership, not an individual partner. 

And more tax strategies are limited. This is why having proactive conversations with your tax advisor is critical!  

Tax Reporting

  • Partnerships file Form 1065 and provide each partner with a Schedule K-1 to report their share of profits on their individual returns. 

Pros

  • Shared responsibility and expertise. Jane and Sarah bring different skills to the table, which helps the business grow faster.

  • No business taxes. Like a sole proprietorship, profits pass through to Jane and Sarah’s personal tax returns. 
  • Flexibility in managing the business. They decide how profits are divided based on their roles. 

Cons 

  • Joint liability. If the business goes under or is sued, both Jane and Sarah are personally responsible for the debts. 
  • Disagreements. Partnerships work best when roles and profit-sharing are clearly defined or conflicts can arise.
  • Limited tax strategy options in a partnership.
  • Increased administrative costs such as business tax preparation fees.

When Should You  Consider a Partnership Structure?

A partnership is ideal if you and a partner bring different strengths to the table and want to grow the business together. Just make sure to formalize the partnership with a written agreement to avoid future disputes. It is highly recommended that an attorney set this up correctly. 

4. S-Corp (S Corporation) 

Assuming Jane never entered into a partnership with her best friend Sarah, Jane's lemonade business was thriving. With multiple locations and a steady revenue stream, she wanted to save on taxes. She was profiting more than $60,000 in her business. Her Tax Advisor recommended it was time to switch to an S-Corp; Jane was able to take a salary and avoid paying self-employment taxes on her entire profit. 

Bookkeeping

  • With the increased complexity, Jane hires a bookkeeping firm to categorize income and expenses, handle payroll, and ensure that all business records are kept accurately for IRS compliance. 

Tax Deductions/Credits

  • In addition to everything available in an LLC, an S-Corp offers Jane the chance to save on self-employment taxes, as she's only taxed on her salary. 
  • She can also take deductions for employee benefits, such as health insurance, retirement plan contributions for herself and her employees, and business insurance. Plus, she can deduct reasonable expenses related to running the S-Corp, including bookkeeping and legal fees. 

Tax Reporting

  • Jane now files an 1120S (S-Corp Return), and her salary and business distributions are reported on her personal tax return. She’ll also need to issue herself a W-2 for her salary. Additionally, the S-Corp will issue a K-1 for the remaining profits/losses. 

Pros

  • Tax savings. Jane now only pays self-employment taxes on her salary, not on all of her profits. 
  • Avoids double taxation. Profits pass through to her personal return, avoiding corporate-level taxes.
  • Personal asset protection remains in place. 

Cons

  • Salary requirements. Jane has to pay herself a “reasonable” salary, and the IRS keeps a close eye on this. A tax professional is highly recommended to assist us.
  • More paperwork. She needs to keep records, hold annual meetings, and file additional paperwork to maintain the S-Corp status. 
  • Jane must formally run payroll and stay on top of it. She utilized a payroll provider, which was another cost of doing business. 

  • Increased administrative costs such as payroll fees, business tax preparation fees, etc.

When should you consider an S-Corp structure?

An S-Corp is ideal for businesses making over $60K in profit, where owners want to save on self-employment taxes. It’s perfect for owners who are ready to formalize operations, hire employees, and scale up. But keep in mind that you’ll need to handle payroll and corporate formalities. 

5. C-Corp (C Corporation)

Jane's lemonade empire had grown so large that she decided to raise funds from investors and offer stock to her employees. She also contemplated selling the business when the right opportunity arose. To achieve this, she restructured her business into a C-Corp, enabling her to issue stock and appeal to more serious investors. 

Bookkeeping

  • At this stage, Jane works with a professional accounting firm to manage the C-Corp’s financials, ensuring payroll, inventory, and expenses are all categorized and managed properly. 

Tax Deductions/Credits

  • On top of deductions for supplies, marketing, and payroll, a C-Corp can deduct employee benefits like health insurance, retirement plan contributions, and fringe benefits like company cars.
  • A C-Corp can also take advantage of certain tax credits, like the Research and Development (R&D) tax credit if Jane is innovating her lemonade recipe or production process. 
  • Jane may be able to sell the business with the right tax strategy in place and minimize her tax burden by now being a C-Corp and following proper compliance steps. 

Tax Reporting 

  • The business now files a Form 1120 (C-Corp Return) and pays corporate income tax on its profits. Jane is taxed separately on any dividends she receives from the business. 

Pros

  • Ability to raise capital. Jane can now issue stock and bring in more investors to fuel her business growth.
  • Lower corporate tax rates. For large, profitable businesses, the corporate tax rate can be lower than individual tax rates.
  • Employee benefits. C-Corps can offer stock options and better benefits to attract top talent. 
  • Minimize capital gains tax if she sells the business. 

Cons: 

  • Double taxation. Jane’s business profits are taxed at the corporate level, and then she’s taxed personally on any dividends. 
  • Complex regulations. C-Corps have strict rules, require a board of directors, and involve lots of paperwork. 
  • Increased administrative costs such as payroll fees, business tax preparation fees, etc. 

When Should You Consider a C-Corp Structure?

A C-Corp is perfect for large businesses planning to grow significantly, raise investor capital, or go public. It’s also the best choice if you want to offer stock options to employees. However, the double taxation and complex compliance requirements make it less ideal for small businesses.

Here’s a summary recap to help you decide:

SPARK WALLPAPERSGRAPHS (1)

 

By recognizing the advantages and disadvantages of each business structure, you can make an informed decision that aligns with your goals, risk tolerance, and financial aspirations. Every business is unique, so select the structure that best suits your vision for growth and success. 

 

 

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Disclaimer

The information provided is for general purposes and does not constitute tax, legal, or financial advice. Tax situations vary, and we recommend consulting with a qualified tax professional or attorney before taking any action. Spark Tax Services LLC is not responsible for any errors or the outcomes from using this information, and tax laws may change.

 

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