Posted by Robert L. Arone
You know your business better than anyone else: whether that be a professional, trade, occupation, dog-walking, catering, or custom-made crocheted goods. But when it comes to giving your business the best legal and tax footing, you may feel a little lost in what choices there are and the benefits and costs of each choice. In this article, I will give a simplified overview of a few business structures available to Massachusetts entrepreneurs and small business owners. Each has its own benefits and drawbacks regarding registration procedure, tax structure, and personal liability. Some choices are better for taxation and some for liabilities and some structures cost more to maintain.
A sole proprietorship is, in many ways, the default legal structure for a Massachusetts business. A sole proprietorship has, as the name would suggest, a single (“sole”) owner (“proprietor”). The procedure for setting up a sole proprietorship in Massachusetts is simple and without too much paperwork.
The proprietor is considered self-employed. There is also no shield from personal liability provided by a sole proprietorship—in case of a lawsuit, all of one’s personal assets are at risk. Income from a sole proprietorship is taxed as individual income and is 100% subject to self-employment taxes. For 2022, this is 15.3% of the first $147,000 of net income and for income above that amount you pay 2.9% to Medicare without limit. The business income is reported on Schedule C of the form 1040.
A partnership involves two or more business owners. Massachusetts recognizes three types of partnerships, each with its own specifications regarding liability and taxes:
- A general partnership (GP): This type of partnership provides no liability protection to the partners. Income from the partnership is distributed between the partners and taxed as a component of their individual income. If the partnership is a business [and not real estate, for example] then 100% of the income allocated to each partner is subject to the Social Security taxes recited for proprietorships. This type of partnership does not require any written agreement but also can have a written operating agreement.
- A limited partnership (LP): There are two types of partners possible within a limited partnership: general partners and limited partners. A general partner assumes unlimited personal liability but has a much greater voice in the running of the business. In contrast, a limited partner is typically liable only for the value of their investment but has a similarly limited role in running the business. This entity must be formed at the Secretary of State’s office and annual costs $500 for the annual report. And while you file a partnership return to the IRS and the DOR, the return has no tax as all income and expenses and special attributes are passed through to the partners to report on their individual returns.
- A limited liability partnership (LLP): In a limited liability partnership, all partners might have equal say in the governance of the business. However, their personal liability due to losses by or legal action against the business or another partner, is limited. Income from a limited liability partnership is shared based upon a variety of allocation choices and is taxed each partner as their individual income. This entity also must be formed at the Secretary of State’s office and annual costs $500 for the annual report. And the tax consequences are the same as for the LP.
Limited Liability Company (LLC)
A limited liability company exists, legally for tax purposes, somewhere between a partnership and a corporation. Like an LLP, an LLC limits the personal liability of members with regards to the business’s debts, obligations, and liabilities. Managing partners’ liability is generally limited to their financial contribution to the business. Like an LLP, in which governance and profits are under a variety of arrangements, LLCs allow flexibility of profit-sharing and governance structures, which will be spelled out in their operating agreements. Unlike an LLP, an LLC may only have one member rather than several. This makes it an attractive incorporation option for an individual business owner who would otherwise have to operate as a sole proprietorship. An LLC can be taxed as a proprietorship, an S-Corporation or a C-Corporation depending upon what election the member makes.
An LLC with multiple partners is presumably taxed as a general partnership but could also be taxed as a partnership or a corporation [either an S-Corp or C-Corp]. If the entity is taxed as a corporation, then it pays both the annual report fee [$520] as well as the minimum corporate income tax amount of $456 while if it’s taxed as a proprietorship or a partnership, there’s only the $520 annual report.
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When considering the best options for setting up your small business in Massachusetts, you can’t afford to go it alone. Contact our office today to discuss your business’s unique needs.