Choosing the Right Entity
Here’s the scoop on choosing the right entity for your business or nonprofit and understanding how each is taxed. We’ll cover partnerships, corporations, LLCs, and nonstock (nonprofit) corporations—plus the unincorporated versions where applicable. Let’s dive in!
What You’ll Learn
How partnerships are structured and taxed
How corporations (C and S) work and how they’re taxed
The flexibility of LLCs and their tax options
How nonprofit (nonstock) corporations achieve tax-exempt status
Tax considerations for unincorporated alternatives (sole proprietorships, general partnerships, unincorporated nonprofits)
Actionable tips for choosing and setting up the right structure for your needs
Corporations
C Corporations (C Corps)
A C corporation is a separate legal entity owned by shareholders. It’s governed by articles of incorporation and bylaws.
Double Taxation:
The corporation pays corporate income tax on profits (Form 1120). The current federal corporate tax rate is 21%.
If the corporation distributes dividends, shareholders report that income on Form 1040 and pay individual tax.
Filing Requirements:
C Corps file Form 1120 by April 15 (for calendar-year entities) or the 15th day of the fourth month after year-end.
Estimated tax payments are typically due quarterly (Form 1120-W helps estimate).
Key Considerations:
Liability Protection: Shareholders are generally not personally liable for corporate debts.
Capital Raising: Unlimited classes of stock, multiple shareholders, and easier access to outside capital.
Complexity & Cost: More formalities (board meetings, minutes, corporate resolutions) and higher administrative costs.
S Corporations (S Corps)
An S corp is a corporation that elects to be taxed as a pass-through entity under Subchapter S (IRS Form 2553).
Pass-Through Taxation (No Double Taxation):
Income, deductions, and credits pass through to shareholders (on Schedule K-1, Form 1120-S), and shareholders report them on their Form 1040.
Profits paid as salaries are subject to payroll taxes; the remainder may flow through as dividends (potentially saving on self-employment tax), but compensation must be “reasonable.”
Eligibility Requirements:
Must be a domestic corporation with no more than 100 permitted shareholders (all U.S. citizens or resident aliens).
Can only issue one class of stock.
Filing Requirements:
File Form 1120-S by March 15 (calendar year), with shares of income reported to shareholders on Schedule K-1.
Estimated tax paid via quarterly payments at the shareholder level, if needed.
Key Considerations:
Liability Protection: Same as C Corp.
Limitations: If your business needs multiple classes of stock or foreign shareholders, S Corp status isn’t possible.
Payroll Complexity: Shareholder-employees must take reasonable salaries (subject to payroll taxes).
What You Can Do Next
Incorporate with Your State: File articles of incorporation with state and draft bylaws.
Elect S Corp Status (if desired): File Form 2553 within 2.5 months of your tax year’s start.
Stay Compliant: Hold annual shareholder and director meetings; keep minutes and corporate records.
Limited Liability Companies (LLCs)
What Is an LLC?
An LLC is a hybrid entity that combines liability protection of a corporation with the flexibility of a partnership. It’s formed by filing Articles of Organization (or Certificate of Formation) with your state. Members own the LLC; there’s no “shareholder” terminology.
Default Tax Classification
Single-Member LLC (SMLLC):
Treated as a “disregarded entity” by default: the owner reports all income/loss on Schedule C (if an individual) or the owner’s applicable tax return.
Pays self-employment tax on net income (unless the owner elects otherwise).
Multi-Member LLC:
Treated by default as a partnership: files Form 1065, issues K-1s, and each member reports pass-through income/loss on their own Form 1040 (Schedule E).
Electing Corporate Treatment
C Corp Election: File Form 8832 to be taxed as a C Corp (files Form 1120).
S Corp Election: If eligible, file Form 2553 (turns LLC income into pass-through, but you pay yourself a reasonable salary subject to payroll taxes).
Key Advantages
Liability Protection: Members aren’t personally on the hook for LLC debts.
Flexible Tax Treatment: Choose partnership, S Corp, or C Corp tax classification, whichever makes sense.
Fewer Formalities: Generally fewer meetings/minutes than a corporation.
Key Considerations
Self-Employment Tax: Unless taxed as an S Corp or C Corp, most LLC owners pay SE tax on all net income.
State Fees & Rules: Some states (e.g., California) impose extra fees on LLCs; rules vary by jurisdiction.
Operating Agreement: Even if not required by your state, draft one to clarify management, voting, and buy-sell provisions.
What You Can Do Next
Form Your LLC with the State: File Articles of Organization, draft an Operating Agreement, and obtain an EIN.
Decide Tax Classification: Review projected profits vs. payroll taxes to see if S Corp election makes sense; consult a tax advisor.
Track Compliance: Some states require annual reports/fees—stay on top of deadlines.
Nonstock Corporations (Nonprofits)
What Is a Nonstock Corporation?
A nonstock corporation (often called a nonprofit) is organized for charitable, educational, religious, or similar purposes. It does not issue shares of stock. Boards oversee the organization, and profits must be reinvested in the mission.
Tax-Exempt Status under Section 501(c)(3)
Exemption Criteria:
Must be organized and operated exclusively for exempt purposes (charitable, religious, educational, scientific, literary, etc.).
No part of net earnings may inure to private shareholders or individuals.
Must not engage in substantial lobbying or any political campaign activity.
Application Process:
Form a nonprofit corporation under state law (articles must include required dissolution language).
File IRS Form 1023 (or 1023-EZ if eligible) to request recognition as a 501(c)(3) exempt organization.
Ongoing Compliance:
File annual returns (usually Form 990, Form 990-EZ, or Form 990-N if small).
Maintain records demonstrating charitable activities, and follow limits on political activity.
Benefits of Exemption:
No Federal Income Tax: Exempt organizations don’t pay federal income tax on activities substantially related to their exempt purpose.
Donor Deductibility: Contributions are generally tax-deductible for donors.
Grant Eligibility: Most foundations and government grants require 501(c)(3) status.
Unrelated Business Income Tax (UBIT)
Income from activities unrelated to the exempt purpose may be subject to UBIT (Form 990-T). Examples: a side business not connected to mission, such as sales of merchandise or advertising unrelated to the exempt purpose.
What You Can Do Next
Incorporate Under State Law: Draft articles with the required nonprofit language and file with your Secretary of State.
Apply for Exemption Promptly: Use Form 1023 or 1023-EZ; small organizations often qualify for the streamlined Form 1023-EZ.
Stay Compliant: Keep thorough records, file timely Form 990 series returns, and avoid excessive lobbying/political activity.
Unincorporated Versions
For some entity types, there’s a simpler “unincorporated” counterpart. Here’s what that looks like and how it’s taxed:
Sole Proprietorship
Definition: One person carrying on business for profit without forming a corporation or LLC.
Tax Treatment:
Report all business income/loss on Schedule C (Form 1040).
Pay self-employment tax (Social Security and Medicare) on net profit.
Key Considerations:
Liability: Owner is personally liable for business debts and lawsuits.
Ease of Setup: No formal paperwork (other than local licenses) but consider operating under a DBA (“Doing Business As”).
What You Can Do Next:
File Schedule C with your Form 1040; make quarterly estimated tax payments; buy liability insurance if risk is high.
General Partnership
Definition: Two or more persons carrying on business for profit without forming a corporation or LLC. In most states, any unincorporated business with two or more people defaults to a general partnership if no other entity is formed.
Tax Treatment: Files IRS Form 1065 to report income, deductions, gains, and losses. Partners receive a Schedule K-1 (Form 1065) showing each partner’s share, which they report on their individual Form 1040. Income passes through and is taxed at the partner level.
Self-Employment Tax: General partners pay self-employment tax (Social Security and Medicare) on their distributive share of business income.
Filing Deadlines: Form 1065 is due by March 15 for calendar-year partnerships. Schedule K-1s must be provided to partners by April 15 (or the extended date) so they can file their individual returns.
Key Considerations:
Liability: Each partner is personally liable for partnership debts and obligations.
Formation & Agreement: Even a handshake can form a partnership, but a written Partnership Agreement is strongly recommended to outline capital contributions, profit/loss splits, decision-making processes, and buy-sell provisions.
What You Can Do Next:
Obtain an EIN: Partnerships need a federal Employer Identification Number (EIN) to file Form 1065.
File Form 1065: Report partnership results and issue Schedule K-1s to partners.
Set Aside for Taxes: Budget for self-employment tax and make quarterly estimated tax payments to avoid underpayment penalties.
Draft a Partnership Agreement: Clarify roles, responsibilities, profit-sharing, and exit strategies in writing.
Maintain Records: Track income, expenses, and contributions accurately for tax compliance.
Unincorporated Nonprofit Association
Definition: A group formed by individuals for nonprofit purposes (e.g., a neighborhood association) but not incorporated under state law.
Tax Treatment:
If the group never incorporates and never obtains 501(c)(3) status, it has no official tax-exempt standing—any donations are not tax-deductible.
Unincorporated nonprofit associations can file IRS Form 1023 or 1023-EZ to apply for 501(c)(3) status, but must meet IRS requirements (such as having a governing document and appropriate state law recognition). While incorporation is recommended for liability protection and organizational formality, it is not strictly required to obtain federal tax-exempt status.
Key Considerations:
Liability: Members have personal liability for association debts and obligations.
Credibility & Grants: Without formal incorporation and IRS exemption, fundraising and grant eligibility are limited.
What You Can Do Next:
Incorporate as a nonprofit corporation, adopt bylaws, and apply for 501(c)(3) to unlock tax-deductible fundraising and limited liability.
What You Can Do Next
Draft Basic Documents: Even if you go with a simple sole proprietorship or partnership, have a written agreement.
Obtain an EIN: Most structures (partnerships, LLCs, corporations, nonprofits) require an EIN; Sole proprietors sometimes need one if they have employees or certain retirement plans.
File State Paperwork: Incorporate or form an LLC in your state; register a DBA if you’re a sole proprietor operating under a trade name.
Plan for Quarterly Taxes: If you’re in a pass-through entity (including S Corp or LLC taxed as a disregarded entity/partnership), you’ll likely need to make estimated tax payments.
Stay Compliant:
Partnerships & LLCs (partnership default): Form 1065 and K-1s, plus Schedule SE for self-employment tax.
S Corps: Form 1120-S by March 15, with K-1s; reasonable salary for shareholder-employees.
C Corps: Form 1120 by April 15; possible estimated payments.
Nonprofits: Form 1023/1023-EZ for exemption; Form 990 series each year; stay within lobbying/political limits.
Have Questions?
If you have any questions about what you’ve read, feel free to email us at contact@sotecpa.com. We’re here to help you choose the right structure and navigate the tax rules.
