Choice of Entity Structure for your Farm Business

When starting a new business, there are many challenges and considerations. While entity selection and structure may not be at the forefront for an entrepreneur, making an informed decision early can allow the focus to remain on the business operations and enable a smooth initial tax filing. Let’s examine some key structural considerations and tax implications.

Owning and Operating a Business by Yourself

Sole ownership of a business can come without much additional formality. By default, these businesses will be considered sole-proprietorships and not require a legal entity or additional tax filings. Sole proprietors report all their business income and expense within their individual tax return on an appropriate Schedule C, F, or E.

Often a sole proprietor seeks to differentiate their business from themselves, at least in terms of a name or brand. Obtaining a “Doing Business As” (DBA) is an efficient way to do this. DBAs are typically managed and administered at the local level. From a tax perspective, the DBA is used in addition to the individual’s information within their individual tax return.

Some sole proprietors will still want to separate themselves from the business with a legal entity. A business with one owner can consider forming a Single-Member LLC if their state permits. These entities are disregarded federally and for tax purposes. This means that while you may enjoy limited liability by separating the business from yourself, the tax reporting mirrors that of a sole proprietor without any formal entity structure. Corporations also allow for ownership by a single individual. Once formed under state law, a corporation may make a tax election to be treated as an S-Corporation rather than the default C-Corporation. The tax differences in these corporation classifications are the same if there is one owner or multiple and is explored further in the next section.

Owning and Operating a Business with Others

When more than one person shares in the income, expense and risk of a business, an entity structure is required to be considered. From a tax perspective, even without a legal structure, a separate return for the joint activity may be required. When it comes to the legal process of forming an entity, most joint businesses will be either a corporation or a partnership. All the various other entity types discussed are actually just tax classification branching off these two legal structures.

Corporations

A corporation is an entity separate of its individual owners; by default, a corporation is treated as a C-Corporation for tax purposes. These entities file their own tax return (Form 1120) and pay their own tax on business profits. Individual owners, or shareholders, of a C-Corporation will only include W2 wages received from the corporation or dividends received from corporate earnings in their own individual tax return. While wages paid to an owner are deductible to the corporation, the dividends are not. This creates the element of “double taxation” associated with C-Corps.

By election, a corporation can be taxed as an S-Corporation. This creates a pass-through taxation model in which the S-Corporation merely aggregates the items of income and expense, reports them, and then distributes them to the shareholders to compute their own tax liability. Thus, the S-Corporation does offer a single layer of taxation at the individual level. An S-Corporation has more rigidity than other flow-through entities with inflexible profit/loss allocations and limitations on number and type of partners.

Partnerships

Partnerships are separate entities of their individual owners and require having more than one owner. Once formed under state law, an entity classification is made with the IRS to classify them into one of many tax structures: General Partnership, Limited Liability Company, etc. While there are some unique distinctions within these tax entity classifications, we will focus on the overarching similarities.

Partnerships will file their own tax return (Form 1065) in which the income and expense of the business is aggregated to then be reported to each individual partner on a Schedule K-1. The K-1 is then used to compute the individual level tax on their share of the business activities. Partnerships offer flexibility in the allocation of profits and loss enabling changes to the actual capital ownership of the business overtime. With a single layer of taxation, the partners in a partnership are reporting the entire taxable income of the operation without regard to actual cash distributions that they received during the year. While a partner in most cases cannot receive a W2 wage from their partnership, any cash paid to them can be considered a guaranteed payment or draw which are reported on the Schedule K-1.

Making Your Choice

The basic framework of entity structure and classification initially may be driven by the income tax classification that is inherent within each entity type. However, businesses should take a holistic approach when making these decisions to ensure they set themselves up for their needs currently, as well as having flexibility into the future. Beginning the conversation early with your legal counsel, tax and financial advisors, and business consultants is a great way to set your new or growing business up for success!