Making Sure You Are the Correct Business Entity

by Gabriel Piña

I had a call the other day from a potential tax client asking about my services for Tax Preparation. As I went through my services list, I noticed the person calling had an out of state area code. “Where is the company located and where are you located?” I asked.

“The business,” he said, “is in Wyoming,” and then he went on to mention that he was located in California.

My next question: “What type of entity is your business?”

His response, “I’m an LLC.” 

“Okay that is great,” I replied, “but the IRS doesn’t recognize LLC as a ‘Tax’ entity…”

 “WHAT????” He uttered as I noticed his jaw dropping, even though the telephone.

Here is what I went on to explain:

“Well, you see there are only these tax forms...

  • 1120 – ‘C Corporation’
  • 1120S – ‘S Corporation’
  • 1065 – ‘Partnership’
  • Schedule C (which is part of the 1040) – ‘Sole Proprietor’

‘LLC’ is a State designation to help protect you from legal protection of your personal assets.  The IRS will default your LLC to either a ‘Partnership’ or ‘Sole Proprietor’.   

Here is a quick explanation of each tax entity:

‘C Corporation’ is its only entity, and the Corporation pays tax based on the ‘Net Profit’ of the business. In 2020 the tax rates for the C Corporation were 21%.

‘S Corporations’ are a pass-through Corporation.  The owners are given a K-1 depending on your percentage of the company, the net profit or loss will be added to your personal taxes.  All your other income, as well as the company’s net profit or loss will determine what your tax rate will be. This is the only entity that will allow the owners to receive a paycheck. 

The ‘Partnership’ is similar to the ‘S Corporation.’  The owners are given a K-1 depending on your percentage of the company, the net profit or loss will be added to your personal taxes.  Your other income will determine what your tax rate will be. You must include your distributions as income and pay self-employment tax as well as income tax.  This entity you cannot draw a paycheck from. 

The ‘Sole Proprietor,’ which is filed on your personal tax return using Schedule C, you will have to pay self-employment tax as well as income tax on the Net Income of the business.”

This was the quick explanation of each tax entity I gave over the phone to help my customer in California understand tax entities. To determine which one is best for you, talk to your Accountant so they can understand your business, what your projected Net Profit will be for the next year, and look over your last year tax return.

Call and schedule an appointment with your Accountant and maximize them to your benefit. That is why you are paying them, after all.

If you do not have an Accountant or if your Accountant does not offer this service, you can schedule a consultation with us: https://go.thryv.com/site/pinabiz
@Gabe_The_CigarAccountant