Choosing a Business
Structure
ARTICLE
HIGHLIGHTS:
• Choosing a Business Structure
• Sole Proprietorship
• Partnership
• Corporation
• Limited Liability Company
• Disregarded Entity |
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When starting a business, you need to decide what form of
business entity to establish. This is one of the most important
decisions you have to make, since it can affect how much you
pay in taxes, the amount of paperwork your business is required
to do, the personal liability you face, and your ability to
borrow money. Business formation is controlled by the law
of the state where your business is organized.
This article provides a quick look at the differences between
the most common forms of business entities.
The most common forms of businesses are:
• Sole Proprietorships
• Partnerships
• Corporations
• Limited Liability Companies (LLC)
While state law controls the formation of your business,
federal tax law controls how your business is taxed. Federal
tax law recognizes an additional business form, the subchapter
S corporation.
All businesses must file an annual return. The type of form
that is used depends on how the business is organized. Sole
proprietorships and corporations file an income tax return.
Partnerships and S corporations file an information return.
An LLC with at least two members, except for some businesses
that are automatically classified as a corporation, can choose
to be classified for tax purposes as either a corporation
or a partnership. A business with a single member can choose
to be classified as either a corporation or disregarded as
an entity separate from its owner, that is, a “disregarded
entity.” As a disregarded entity, the LLC will not file
a separate return; instead, all the income or loss is reported
by the single member/owner on his or her annual return.
When selecting a type of structure, the business owner should
consider what makes the most sense when it comes to their
individual circumstances.
The type of business entity you decide to establish should
depend on the following factors:
• Liability
• Taxation
• Recordkeeping
Sole Proprietorship - A sole proprietorship
is the most common form of business organization. It is easy
to form and offers complete control to the owner. It is any
unincorporated business owned entirely by one individual.
In general, the owner is also personally liable for all financial
obligations and debts of the business. (State law may also
govern this area depending on the state.)
Sole proprietors can operate any kind of business. It must
be a business, not an investment or hobby. It can be full-time
or part-time work. This includes operating a:
• Shop or retail trade business,
• Large company with employees,
• Home-based business, or
• One-person consulting firm.
Every sole proprietor is required to keep sufficient records
to comply with federal tax requirements regarding business
records.
Generally, sole proprietors file Schedule C or C-EZ, Profit
or Loss from Business, with their Form 1040. Sole proprietor
farmers file Schedule F, Profit or Loss from Farming. Their
net business income or loss is combined with other income
and deductions and taxed at individual rates on their personal
tax return.
Sole proprietors must also pay self-employment tax on the
net income reported on Schedule C or Schedule F. They may
also be allowed to deduct one-half of the self-employment
tax on their 1040. Schedule SE, Self-Employment Tax, should
be used to compute this tax.
Sole proprietors do not have taxes withheld from their business
income, so quarterly estimated tax payments generally have
to be made if a profit is expected to be made. These estimated
payments include both income tax and self-employment taxes
for Social Security and Medicare.
Partnership - 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.
A partnership does not pay any income tax at the partnership
level. Partnerships file Form 1065, U.S. Return of Partnership
Income, to report income and expenses. This is an information
return. The partnership passes the information to the individual
partners on Schedule K-1, Partner’s Share of Income,
Credits, and Deductions. Partnerships are often referred to
as pass-through or flow-through entities for this reason.
Each partner reports his or her share of the partnership
net profit or loss on his or her personal Form 1040 tax return.
Partners must report their share of partnership income even
if a distribution is not made.
Partners are not employees of the partnership, so taxes are
not withheld from any distributions. Like sole proprietors,
partners generally need to make quarterly estimated tax payments
if they expect to make a profit.
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.
Corporation - A corporate structure is more
complex than other business structure. It requires complying
with more regulations and tax requirements. It may require
more tax preparation services than the sole proprietorship
or the partnership.
Corporations are formed under the laws of each state and
are subject to corporate income tax at the federal and generally
at the state level. In addition, any earnings distributed
to shareholders in the form of dividends are taxed at individual
tax rates on their personal tax returns.
The corporation is an entity that handles the responsibilities
of the business. Like a person, the corporation can be taxed
and held legally liable for its actions. If you organize your
business as a corporation, you are generally not personally
liable for the debts of the corporation. (Exceptions may exist
under state law.)
When a corporation is formed, a separate tax-paying entity
is created. Unlike sole proprietors and partnerships, income
earned by a corporation is taxed at the corporate level using
corporate tax rates. Regular corporations are called C corporations
because Subchapter C of Chapter 1 of the Internal Revenue
Code is where general tax rules are found affecting corporations
and their shareholders.
A corporation files Form 1120 or 1120-A, U.S. Corporation
Income Tax Return. If a shareholder is an employee, he or
she pays income tax on his or her wages, the corporation and
the employee each pay one-half of the Social Security and
Medicare taxes, and the corporation can deduct its half. A
corporate shareholder pays only income tax for any dividends
received, which may be subject to a dividends-received deduction.
Subchapter S Corporation - The subchapter
S corporation is a variation of the standard corporation.
The S corporation allows income or losses to be passed through
to individual tax returns, similar to a partnership. The rules
for subchapter S corporations are found in Subchapter S of
Chapter 1 of the Internal Revenue Code.
An S corporation has the same corporate structure as a standard
corporation. It is a legal entity, chartered under state law,
and is separate from its shareholders and officers. There
is generally limited liability for corporate shareholders.
The difference is that the corporation files an election on
Form 2553, Election by a Small Business Corporation, to be
treated differently for federal tax purposes.
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.
An S corporation files Form 1120S, U.S. Corporation Income
Tax Return for an S Corporation. The income flows through
to be reported on the shareholders’ individual returns.
Schedule K-1, Shareholder’s Share of Income, Credits
and Deductions, is completed with Form 1120S for each shareholder.
The Schedule K-1 tells shareholders their allocable share
of corporate income and deductions. Shareholders must pay
tax on their share of corporate income, regardless of whether
it is actually distributed.
Limited Liability Company - A limited liability
company (LLC) is a relatively new business structure allowed
by state statute.
LLCs are popular because, similar to a corporation, owners
generally have limited personal liability for the debts and
actions of the LLC. Other features of LLCs are more like a
partnership, providing management flexibility and the benefit
of pass-through taxation.
Owners of an LLC are called members. Since most states do
not restrict ownership, members may include individuals, corporations,
other LLCs and foreign entities. 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. Keep in mind that there are
special rules for foreign LLCs of which you need to be aware
of.
If you are considering starting up a business, we can help
you select a business structure that best suits your needs.
Please call our office for an appointment.
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