Choosing the Right Business Entity
When you decide to start a business, one of the most important decisions you’ll need to make is choosing the right business entity. It’s a decision that impacts many things–from the amount of taxes you pay to how much paperwork you have to deal with and what type of personal liability you face.
Forms of Business
The most common forms of business are Sole Proprietorships, Partnerships, Limited Liability Companies (LLCs), and C Corporations. Federal tax law also recognizes another business form called the S Corporation. While state law controls the formation of your business, federal tax law controls how your business is taxed.
What to Consider
Businesses fall under one of two federal tax systems:
- Taxation of both the entity itself on the income it earns and the owners on dividends or other profit distributions the owners receive from the business. C Corporations fall under this system of federal taxation.
- “Pass-through” taxation. This type of entity (also called a “flow-through” entity) is generally not taxed, but its owners are each taxed (more or less) on their proportionate shares of the entity’s income, even if they have not actually received it. Pass-through entities include:
- Sole Proprietorships
- Partnerships of various types
- Limited Liability Companies (LLCs)
- S Corporations, as distinguished from C Corporations
The first major consideration when choosing a business entity is whether to choose one that has two levels of tax on income or one that is a pass-through entity with only one level directly on the owners.
The second consideration, which has more to do with business considerations rather than tax considerations, is the limitation of liability (protecting your personal assets from claims of business creditors).
Let’s take a general look at each of the options more closely:
Types of Business Entities
The most common (and easiest) form of business organization is the sole proprietorship. Defined as any unincorporated business owned entirely by one individual, a sole proprietor can operate any kind of legal business (full or part-time), as long as it is not a hobby or an investment. In general, the owner is also personally liable for all financial obligations and debts of the business.
Types of businesses that operate as sole proprietorships include retail shops, farmers, large companies with employees, home-based businesses and one-person consulting firms.
As a sole proprietor, your net business income or loss is combined with your other income and deductions and taxed at individual rates on your personal tax return. Because sole proprietors do not have taxes withheld from their business income, you may need to make quarterly estimated tax payments if you expect to make a profit. Also, as a sole proprietor, you must also pay self-employment tax on the net income reported.
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
Broadly, there are two types of partnerships: Ordinary partnerships, called “general partnerships,” and limited partnerships that may limit liability for some partners but not others. Both general and limited partnerships are treated as pass-through entities under federal tax law, but there are some relatively minor differences in tax treatment between general and limited partners.
For example, general partners must pay self-employment tax on their net earnings from self-employment assigned to them from the partnership. Net earnings from self-employment include an individual’s share, distributed or not, of income or loss from any trade or business carried on by a partnership. Limited partners are subject to self-employment tax only on guaranteed payments, such as professional fees for services rendered. However, limited partners may be subject to net investment income tax on their share of the partnership’s profits.
Partners are not employees of the partnership and do not have any income tax withheld at the partnership level. Partnerships report income and expenses from its operation and pass the information to the individual partners (hence, the pass-through designation).
Because taxes are not withheld from any distributions, partners generally need to make quarterly estimated tax payments, if they expect to make a profit. Partners must report their share of partnership income, even if a distribution is not made. Each partner reports his share of the partnership net profit or loss on his or her personal tax return.
Limited Liability Companies (LLC)
A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state is different, so it’s important to check the regulations in the state where you plan to do business. Owners of an LLC are called members, which may include individuals, corporations, partnerships, trusts, other LLCs and foreign entities. Most states also permit “single member” LLCs, i.e. those having only one owner.
Depending on elections made by the LLC and the number of members, the IRS treats an LLC as either a corporation, partnership, or sole proprietorship. A domestic LLC with at least two members is classified as a partnership for federal income tax purposes, unless it elects to be treated as a corporation.
An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it elects to be treated as a corporation.
In forming a corporation, prospective shareholders exchange money, property, or both for the corporation’s capital stock. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.
A corporate structure is more complex than other business structures. When you form a corporation, you create a separate tax-paying entity. The profit of a corporation is taxed to the corporation when earned and then is taxed to the shareholders when distributed as dividends. This creates a double tax.
The corporation does not get a tax deduction when it distributes dividends to shareholders. Earnings distributed to shareholders in the form of dividends are taxed at the rates applicable to their own tax returns. Shareholders cannot deduct any loss of a C Corporation.
If you organize your business as a corporation, generally are not personally liable for the debts of the corporation, although there may be exceptions under state law.
An S Corporation has the same legal structure as a C Corporation; however, its owners have elected to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S Corporations generally have limited liability.
Generally, an S Corporation is exempt from federal income tax other than tax on certain capital gains and passive income. It is treated in the same way as a partnership, in that generally taxes are not paid at the corporate level. S Corporations may be taxed under state or local tax law as C Corporations, or in some other way.
Shareholders must pay tax on their share of corporate income, regardless of whether it is actually distributed. Flow-through of income and losses is reported on their personal tax returns and they are assessed tax at their individual income tax rates, allowing S Corporations to avoid double taxation on the corporate income.
To qualify for S Corporation status, the corporation must meet a number of requirements. Please call our office, if you would like more information about which requirements must be met to form an S Corporation.
When making a decision about which type of business entity to choose each business owner must decide which one best meets his or her needs. There is no one-size-fits-all, and obtaining the advice of a tax professional is critical. If you need assistance figuring out which business entity is best for your business, please don’t hesitate to call us.