Deciding which form of entity your business will take has serious implications on tax responsibility; therefore, you must choose wisely after carefully considering all the options.
The type of business you set up – i.e. a sole proprietorship, a partnership, a corporation, or a limited liability company — determines not only the income tax form you will need to file, but also the basic type of income tax you will be assessed: income, self-employment, employers, or excise taxes.
What type of business will you be?
Following are your choices:
Sole Proprietorships – A business run by one individual by him- or herself. All of the assets are yours; however, all of the liabilities are yours as well.
Partnerships –Two or more persons who run a business. Each contributes money, property, labor or skill, and each shares in the profits and losses.
Partnerships must file an annual information return to report income, deductions, gains, losses, etc., from its business operations, but it does not pay income tax. Instead, the income tax is “passed through” to its partners via each partner’s share of the partnership’s income or loss on his or her own personal tax return.
Corporations – In a corporation, prospective shareholders exchange capital, property, or both, for the corporation’s capital stock. Generally speaking, a corporation takes the same deductions as a sole proprietorship on its taxable income, but can also take special corporate deductions. For federal income tax purposes, a C corporation is a separate taxpaying entity. A corporate form of business realizes net income or loss, and pays appropriate taxes and profit distributions to shareholders.
A corporation’s profit is taxed when earned to the corporation, and then is taxed again as shareholders’ dividends, creating what’s known as a “double tax.” On the other hand, liability is generally limited to the corporation itself, a legally fictitious “person,” and not to the shareholders, employees, or management team.
S Corporations – S corporations are those that choose to pass corporate income, losses, deductions and credit through to shareholders who, in turn, report the flow-through of income and losses on their personal tax returns. Consequently, they are then assessed tax at individual income tax rates, thereby avoiding the double taxation on corporate income.
To qualify for an S corporation designation, the following requirements must be met:
- Be a domestic corporation;
- Have only allowable shareholders such as individuals, certain trusts and estates, and NOT including partnerships, corporations, or non-resident aliens;
- No more than 100 shareholders;
- One class of stock only; and
- May not be certain financial institutions, insurance companies, or domestic international sales corporations.
The corporation must submit Form 2553 Election by a Small Business Corporation (PDF), signed by all shareholders, in order to become an S corporation.
Limited Liability Company (LLC) – A Limited Liability Company (LLC) is a state-specific statutory business structure. Similar to a corporation, LLC owners have limited personal liability for the debts and actions of the LLC. Other benefits include management flexibility and the benefit of pass-through taxation. Owners are called members, and may generally include individuals, corporations, other LLCs, and foreign entities. There is no maximum number of members, and most states even permit “single member” LLCs. Those that cannot be a LLC include banks and insurance companies. An LLC as must file as a corporation, partnership or sole proprietorship for federal income tax purposes.
For more information on these different types of taxes, please see the IRS’ Guide to Business Taxes Web-page.
Additionally, most states assess state taxes on businesses predicated upon business formation. See this State Tax Guide for state-specific requirements.
This article is for informational purposes only and is not intended to be construed as legal advice. If you need help setting up a business or legal advice, you are urged to contact a licensed attorney.
For more info:
State-specific helpful links for businesses
IRS Publication 542 – Corporations
IRS Publication 334 – Tax Guide for Small Business
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