One of the first decisions you have to make as a new small business owner is choosing the type of legal entity to operate under. While seemingly minor, this decision will have a significant, long-standing impact on both the liability protection and tax implications for both the business, and yourself as the owner. It is pivotal to closely consider both the legal and the tax piece in this process – many businesses don’t consider either, some only consider one, but the best businesses have a keen eye on both.
With that, let’s take a look at one of the main entity structures available to business owners and how it measures up from a liability and tax perspective:
Sole Proprietorship
This is the simplest entity structure and one that doesn’t take much setup at all. Essentially, if you start operating a business, and you’re the only owner and operator of that business, it is a sole proprietorship.
- Liability Protection – essentially none. Since there is no separate legal entity, the owner owns all the assets of the business and assumes all of the debts. Personal assets can be at risk as well in the case of a legal issue since there is no entity structure in place to shield and separate the personal assets from the business ones.
- Tax Treatment – sole proprietorships are treated as a “flow through” entity where all profits and losses of the business simply flow, or pass, through to the owner, who picks up these items on their individual tax return and pays tax at the individual level only. Owners get to take advantage of the section 199A Qualified Business Income Deduction to reduce taxable income; however, they get hit with two different IRS-level taxes – income tax and payroll tax. Often, that could result in a federal tax rate of 25-30%+, plus state taxes as well.
- Good for simplicity and easy set up. Bad for liability protection. Neutral for tax planning.