When beginning a business, you must decide what form of business entity to establish. Certain professions and business types, such as banks and insurance agencies, can dictate which business entity must be established based on state or federal regulations. We'll focus on some familiar entities and discuss their advantages and disadvantage. The most common business forms are the sole proprietorship, partnership, C corporation, limited liability company (LLC), and S corporation. An LLC is a business structure allowed by state statute. Your circumstance regarding liability and legal concerns, as well as tax considerations, must be considered when selecting a business structure.
Sole Proprietor
A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the only member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a S corporation.
Partnership
A partnership is a relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the business's profits and losses.
A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" profits or losses to its partners. Each partner reports their share of the partnership's income or loss on their tax return.
Partners are not employees and shouldn't be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partner.
C Corporation
To form a corporation, prospective shareholders exchange money, property, or both for the
corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. A corporation is a separate taxpaying entity for federal income tax purposes and conducts business, realizes net income or loss, pays taxes, and distributes profits to shareholders.
A corporation's profit is taxed to the corporation when earned and then is taxed to the shareholders when distributed as dividends, and this creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss from the corporation.
S Corporation
S corporations elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their tax returns. They are assessed tax at their individual income tax rates, thus avoiding double taxation on corporate income. S corporations are responsible for tax on some built-in gains and passive income at the entity level.
To qualify for S corporation status, the corporation must meet the following requirements:
Be a domestic corporation
Have only allowable shareholders
May be individuals, certain trusts, and estates and
May not be partnerships, corporations, or non-resident alien shareholders
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic, international sales corporations).
To become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation signed by all the shareholders.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state may use different regulations, and you should check with your state if you are interested in starting a Limited Liability Company.
Owners of an LLC are called members. Most states do not restrict ownership so that members may include individuals, corporations, other LLCs, and foreign entities. There is no maximum number of members. Most states also permit "single-member" LLCs, those having only one owner.
A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state's requirements and the federal tax regulations for further information. There are also special rules for foreign LLCs.
Sole Proprietorship
Advantage
Easy to create and maintain.
Business and owner are legally the same entity.
No fees associated with the creation of the business entity
The owner may deduct a net business loss from personal income taxes.
Disadvantage
The owner is personally liable for any debts, judgments, or other liabilities of the business.
The owner must pay personal income taxes for all net business profits.
C Corporation
Advantage
Owners of the business enjoy limited liability for the business' debts, judgments, and other liabilities
Deductible business expenses include some benefits
Owners and business may be able to pay lower taxes by splitting the business profits among owners
Disadvantage
More expensive to establish than a sole proprietorship or partnership
Complicated paperwork
The corporation must pay its taxes as a separate tax entity
S Corporation
Advantage
Owners of the business enjoy limited liability for the business' debts, judgments, and other liabilities
Owners share the net profits of the business and report their share on personal income taxes
Owners share the net business loss and can offset other income by reporting this loss on personal income taxes
Disadvantage
More expensive to establish than a sole proprietorship or partnership
Paperwork is more complicated than the paperwork required for an LLC, but similar advantages
The ownership interest of the various owners determines their respective incomes from the profits of the business
Owners must own more than 2% of the business' shares to receive some benefits
Limited Liability Company (LLC)
Advantage
Owners of the business enjoy limited liability for the business' debts, judgments, and other liabilities, even if the owners engage in significant control of the business
Allocation of business profits and losses may be different than an ownership interest
Owners can choose how the LLC will be taxed, either as a partnership or a corporation
Disadvantage
More expensive to establish than a sole proprietorship or partnership
Your new business will occupy a large portion of your time and energy. It is critical to establish the entity that fits your long term goals and the specifics of your business plan and model. Remember to check with your accountant and review the impact of each entity option to ensure you understand the tax implications of your decision.
