Best Business Practices

For tax purposes, a business entity is then treated as one of the following:

• Disregarded Entity.
• C-Corporation (Corporation).
• S-Corporation (S-Corp).
• Partnership.

The tax classification of a business entity is important because the tax rules that apply to a disregarded entity, C-Corporation, S-Corp and partnership are quite different, as discussed below.

Disregarded Entities 

A business entity that is treated as a “disregarded entity” for tax purposes is any business entity with a single owner. The entity itself is generally ignored for tax purposes. The owner of the disregarded entity is considered to own the assets (and is subject to the liabilities) of the disregarded entity for tax purposes and reports the entity’s income and expenses on its own income tax return. In other words, a disregarded entity is treated like a sole proprietorship, or a branch or division of the individual owner.

For example, a single-member LLC that is treated as a disregarded entity for tax purposes, and does not file a US federal income tax return and rather. Rather the owner of a single member LLC reports the LLC’s income and expenses directly on the owner’s individual income tax return.

Under the default classification rules, a single-member LLC is treated as a disregarded entity for tax purposes, unless the owner has filed an S-Corp tax election.

C-Corporation

All corporations other than S-Corporations are C-Corporations. C-corporations generally are subject to two levels of tax on their income (also known as double taxation). Income tax is paid at the entity level when earned and again the stockholder level when distributed.

An eligible C-Corporation generally can avoid double taxation by electing on formation to be treated as an S-corporation if it meets the Internal Revenue Code (IRC) requirements for an S-Corporation election (see IRC §§ 1361 and 1362). If a C-corporation makes an S-Corporation election after formation, there are potential adverse tax consequences. A C-Corporation (without an S-corp election), is not likely to be the best entity form for an independent sales representative due to the double taxation issue and red tape inherent to managing and operating a C-Corporation

S-Corporation

An S-corporation is a “pass-through” entity for tax purposes, which means it generally does not pay an entity level tax (thus avoiding the double taxation discussed above). Instead, the S-Corporation’s profits and losses generally pass-through to its stockholders (or owners) who include their respective share of those items on their income tax returns (whether or not distributed). Importantly an S-Corporation is a tax election and not an entity by itself. Both a C-corporation and a limited liability company may be an S-Corporation.

There are significant limitations on the availability of the S-Corporation election. For example, an S-Corporation can have only one class of stock, no more than 100 stockholders, and with certain limited exceptions, only US individuals (citizens or residents) can be stockholders (see IRC § 1361). An eligible US entity must also make a timely S-Corporation election on IRS Form 2553, no more than two months and 15 days after the beginning of the tax year the election is to take effect (see IRC § 1362).

For independent sales representatives, a single-member LLC meeting the requirements for the S-corporation election can elect S-corporation tax status on formation. Electing an S-Corp as a single member LLC may have important tax savings for a self-employed individual, though requires some additional administration, as explained below.

S-Corp owners are required to pay themselves a “reasonable salary” as an employee. S-Corp owners must also pay tax on business profits. Being paid as an employee means that the single owner’s wages are subject to FICA tax withholdings (namely Social Security, and Medicare), AND the company must pay the employer payroll taxes. When the single owner employee is paid a salary via payroll, taxes are taken directly out of their payment. The employee payroll taxes and wages then become a tax-deduction for the company (which lowers profits, and therefore taxes). S-Corp profits then are not taxed as self-employment income, which saves 15.3% self-employment tax on profits. Instead, the single owner only pays payroll taxes on the salary they earn from the S-Corp.

Importantly, the lower an individual’s net income, the less beneficial an S-Corp will be. There is no “magic number” or threshold which indicates it’s time to set up an S-Corp, but if an individual does not make at least $40,000 in net profits annually, they probably won’t derive much benefit from switching to or starting an S-Corp. S-Corps may also cost additional money or time in administration due to the necessity of running payroll.

Partnership

Like an S-Corporation, a business entity taxed as a partnership is a pass-through entity for tax purposes, which means it does not pay an entity level tax. Instead, the partnership’s profits and losses are computed and allocated among the partners annually and pass-through to the partners who include their respective share of those items on their income tax returns (whether or not distributed).

Unlike an S-Corporation, a partnership does not have any restrictions on the number (other than the requirement that a partnership have two or more owners), type or residency of its owners. Therefore, a business entity that desires pass-through taxation often chooses partnership tax status.

Although both S-Corporations and partnerships are both pass-through entities for tax purposes, the tax rules that apply to S-Corporations and partnerships are somewhat different.

A partnership would  also not be appropriate for an individual independent sales representative as it requires more than one partner.