When you start a business, one of the first things you have to do is choose a legal entity. Let’s look at the most common types of legal entities, their tax implications, and how to set one up.
What is a legal entity?
A legal entity is an individual, business, or organization that has legal rights and responsibilities. As a legal entity, your startup can borrow money, pay taxes, and become involved in lawsuits. There are different types of legal entities, and each one comes with different protections and tax burdens.
Types of legal entities
Here are the most common types of legal entities that businesses can register as:
- Sole proprietorship: A sole proprietorship is an unincorporated business run by one person. It’s the easiest and most common way to start a business, but there are risks with this business structure. As a sole proprietor, there’s no legal distinction between you and the business. So if the business fails, creditors can come after your personal assets.
- Partnership: A partnership is a business owned by two people, and there are two main types you can choose from. In a general partnership, the business is divided equally between both partners, and each person is personally liable for the obligations of the partnership. In a limited partnership, one person has majority control of the operations and assumes the majority of the risk.
- Limited liability company (LLC): An LLC offers personal liability protection to partners, owners, or shareholders. LLCs must register with the state, and the filing requirements can vary depending on where you live. An LLC is easier to set up than a corporation and provides owners with personal liability protection, but they also have a bigger tax burden.
- Corporation: A corporation is a legal entity that’s separate from the individuals who own and manage it. A corporation is considered a separate “person” and has the ability to enter business transactions, pay taxes, and file lawsuits. As an owner of a corporation, you’re not personally liable for any legal or financial claims filed against the company.
The right business structure will depend on your long-term business goals and legal risk
How does a legal entity impact taxes?
For most entrepreneurs, taxes play a big role in determining the type of legal entity they set up. For example, sole proprietors are “pass-through businesses,” so they’ll pay taxes on the business earnings at their federal income tax rate.
Single-member LLCs are also considered pass-through businesses, so any income is reported on their personal tax returns. Sole proprietors and LLCs benefit from simpler tax filing requirements, but they also have larger tax burdens. They have to pay a 15.3% self-employment tax — 12.4% for Social Security and 2.9% for Medicare.
In a partnership, the taxable income also flows through to the owners’ individual tax returns, and the amount you pay depends on your partnership structure. For example, if each partner owns 50% of the business, each person will pay taxes on 50% of the taxable income.
Corporations are separate legal entities and must pay taxes on the corporate level, and the federal corporate tax rate is 21%. However, if you elect to be taxed as an S corp, you can avoid double taxation and you’ll cut down your FICA taxes.
How to form a legal entity
Here are the steps you’ll take to form a legal entity:
- Choose your business structure: The right business structure will depend on your long-term business goals and legal risk. Research your options to determine which makes the most sense for your situation.
- Check your state laws: Each state has its own rules and regulations on forming a legal entity. Check your Secretary of State’s website to see what forms and fees you’re responsible for.
- File articles of incorporation: Next, you’ll file your articles of incorporation with the state to give your business legal rights.
- Apply for an EIN: An employer identification number (EIN) is kind of like a Social Security Number for businesses. You’ll apply for an EIN with the IRS, and it allows you to pay taxes and open a business bank account.
This article was originally written by Dan Casarella.
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