Have you decided to venture out on an entrepreneurial limb? If yes, there is an array of business structures that you can choose from. There are different tax liabilities dependent upon which business structure that you choose. Below, we briefly explore the different entity options.
1. Sole Proprietorship-This type of business is owned by a single individual and is not incorporated. You must file an income tax return with this business [1]. The business owner is liable for the finances of the business. The business can be full time or part time and can include any type of business that the owner wants to start. However, the business cannot be a hobby or investment. An individual must keep adequate records for tax purposes. Individuals will file a form 1040 as their business income will be combined with other income. Sole proprietors are required to pay self-employment tax (Social Security and Medicare) in addition to income tax [1].
2. Partnership-This type of business is one which is owned by two or more individuals who have invested money, time and skills into the business. Partnerships do not have to pay income tax for the partnership, but they do have to file a tax return. They also take responsibility for all profits and losses. A tax return must be files, but the income tax is not paid with this return. . It is a pass through entity where profits and losses are reported on individual partner’s income tax returns. They are not employees and so should not receive a W-2; however, they must furnish copies of a Schedule K-1 by the time Form 1065 needs to be filed. “General Partners must pay self-employments tax on their net earnings from self-employment assigned to them from their partnership. Limited Partners are subject to self-employment tax only on guaranteed payments, such as professional fees for services rendered [2].”
3. Limited Liability Company (LLC)-This type of business structure is similar to a corporation and partnership. It is allowed by state statute. LLC owners are called members. Most states allow single member LLCs. There is no limit to the number of members. For tax purposes, the federal government does not recognize LLCs. The LLC must file taxes as a corporation, partnership or sole proprietorship. If your LLC has 2 or more members, you can choose to be taxed as a corporation or a partnership. If your corporation has one member, it can be taxed as a corporation or a “disregarded entity.”
4. S Corporation-This type of corporation passes income losses deduction and credit all to shareholders for tax purposes. Shareholders report flow through income and losses on their personal tax returns and are taxed at individual rates. This allows S corporations to avoid double taxation on corporate income. They are taxed for some built in gains and passive income. In order to establish an S corporation, there are several qualifications. The Internal Revenue Website states the necessary qualifications below:
- “Be a domestic corporation
- Have only allowable shareholders
- including individuals, certain trust, and estates and
- may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have one class of stock
- Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.[3]”
5. C Corporation-This type of business structure is funded by shareholders who exchange money or property for capital stock. Consequently, business profits are not distributed to the shareholders. Shareholders are generally not personally liable for the debts of the corporation. The profit of a corporation is taxed when earned and then taxed to shareholders when distributed as dividends. This means that it is double taxed. Corporation losses are not deductible [4].
If you are planning on starting your own business, consult with your tax advisor to make sure that the business structure that you choose is best for your needs.
Sources:
Business Structures. http://www.irs.gov/businesses/small/article/0,,id=98359,00.html
[1] Choosing a Business Structure. Sole Proprietorship. IRS. June 2008. Web. Aug. 2011.http://www.irs.gov/newsroom/article/0,,id=183918,00.html
[2] Choosing a Business Structure. Partnership. IRS June 2008. Web. Aug. 2011. http://www.irs.gov/newsroom/article/0,,id=183918,00.html
[3] S Corporations. IRS. Dec. 2010 Web. Aug. 2011. http://www.irs.gov/businesses/small/article/0,,id=98263,00.html
[4] Corporations. IRS. June 2008 Web. Aug. 2011. http://www.irs.gov/newsroom/article/0,,id=183918,00.html
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