One of the most important decisions you’ll ever make is how to legally organize your business. There are several alternatives, and the form you choose will have a big impact on how you’re taxed, whether you’ll be liable for your business’s debts and how the IRS and state auditors will treat you.
What Types of Business Entities Can You Choose?
There are four main business forms:
- sole proprietorship
- limited liability company (LLC), and
If you own your business alone, you need not be concerned about partnerships; this business form requires two or more owners.
There is no “one size fits all” when it comes to choice of entity. Moreover, your initial choice about how to organize your business is not set in stone. You can always switch to another legal form later. It’s common, for example, for small business owners to start out as sole proprietors, then incorporate or form LLCs later when they become better established and make substantial income.
What’s a Sole Proprietorship?
A sole proprietorship is a one-owner business. It is by far the cheapest and easiest legal form for a one-person business. You just start doing business. You’re automatically a sole proprietor if you don’t incorporate, form an LLC or have a partner.
The sole proprietorship is by far the most common business form. Indeed, the latest available IRS statistics show that there are almost 24 million nonfarm sole proprietors in the United States. Most sole proprietors run small operations, but a sole proprietor can hire employees and other contractors, too. Indeed, some one-owner businesses are large operations with many employees.
Sole proprietorship taxes are simple. You and your business are one and the same for tax purposes. You don’t pay taxes or file tax returns separately for your sole proprietorship.
You must report the income you earn or losses you incur on your own personal tax return, IRS Form 1040. If you earn a profit, add the money to any other income you have. That becomes the total that is taxed. If you incur a loss, you can use it to offset income from other sources.
Use the IRS Schedule C, Profit or Loss From Business, to show whether you have a profit or loss from your sole proprietorship. On this form you list all your business income and deductible expenses. If you have more than one sole proprietor business, you must file a separate Schedule C for each.
The big drawback of sole proprietorships is liability. Since the proprietor and the business are one and the same, a sole proprietor is personally liability for all debts and other liabilities. This means that a business creditor-a person or company to whom you owe money for items you use in your business-can go after all your assets, both business and personal.
This may include, for example, your personal bank accounts, your car and even your house. Similarly, a personal creditor-a person or company to whom you owe money for personal items-can go after your business assets, such as business bank accounts and equipment. If you’re a sole proprietor, you’ll also be personally liable for business- related lawsuits.
What is A Partnership?
If you are not the sole owner of your business, you cannot organize as a sole proprietorship. Instead, you automatically become a partner in a partnership unless you incorporate or form a limited liability company. A partnership is a form of shared ownership and management of a business.
The partners contribute money, property, or services to the partnership; in return, they receive a share of the profits it earns, if any. The partners jointly manage the partnership business. A partnership automatically comes into existence whenever two or more people enter into business together to earn a profit and don’t incorporate or form a limited liability company. Although many partners enter into written partnership agreements, no written agreement is required to form a partnership.
A partnership is much the same as a sole proprietorship except that there are two or more owners. Like a sole proprietorship, a partnership is legally inseparable from the owners (the partners). Ordinarily, a partnership does not pay taxes as an entity, although it files an annual tax form. Instead, partnership income and losses are passed through the partnership to the partners and reported on the partners’ individual federal tax returns. Partners must file IRS Schedule E with their returns, showing their partnership income and deductions.
Partnerships are required to file an annual tax form (Form 1065, U.S. Return of Partnership Income) with the IRS. Form 1065 is not used to pay taxes. Instead, it is an “information return” that informs the IRS of the partnership’s income, deductions, profits, losses and tax credits for the year. Form 1065 also includes a separate part called Schedule K-1, in which the partnership lists each partner’s share of the items listed on Form 1065. A separate Schedule K-1 must be provided to each partner. The partners report on their individual tax returns (Form 1040) their share of the partnership’s net profit or loss as shown on Schedule K-1. Ordinary business income or loss is reported on Schedule E, Supplemental Income and Loss.
Like sole proprietors, partners are neither employees nor independent contractors of their partnership; they are self-employed business owners. A partnership does not pay payroll taxes on the partners’ income or withhold income tax. Like sole proprietors, partners must pay income taxes and self-employment taxes (Social Security and Medicare tax) on their shares of the partnership income.
The big drawback of partnerships, and the reason they are not terribly popular, is that they do not provide their owners with limited liability. Partners are personally liable for all partnership debts and lawsuits, just like sole proprietors. This means that you’ll be personally liable for business debts your partners incur, whether or not you know about them.
What is An Limited Liability Company (LLC)? What is a LLC Partnership?
The limited liability company, or LLC, is the newest type of business form in the United States. The LLC is a unique hybrid: a cross between a partnership (or proprietorship) and corporation. LLCs have become very popular because they provide the flexibility, informality and tax attributes of a partnership or sole proprietorship, and the limited liability of a corporation.
To form an LLC, one or more people must file articles of organization with their state’s business filing office. Although not required by all states, it is highly desirable to adopt a written LLC operating agreement laying out how the LLC will be governed. If you don’t prepare an operating agreement, the default provisions of your state’s LLC laws will apply. Operating an LLC is simpler than when you form a corporation. It is not necessary to have officers and directors, board or shareholder meetings, or the other administrative burdens that come with having a corporation.
LLCs with only one member are “disregarded entities” for tax purposes. This means that they are treated like a sole proprietorship. The member reports profits, losses, and deductions on Schedule C-just like a sole proprietor. An LLC with two or more members is treated like a partnership for tax purposes unless the members elect to be taxed like a C corporation (which is rare). An LLC with two or more members must prepare and file the same tax form used by a partnership-IRS Form 1065, U.S. Return of Partnership Income-showing the allocation of profits, losses, credits and deductions passed through to the members. The LLC must also prepare and distribute to each member a Schedule K-1 form showing the member’s allocations.
LLCs are a clear favorite over partnerships because they offer the same tax benefits but also provide limited liability. They are also a serious alternative to corporations, because they are simpler but offer the same limited liability as corporations and have some tax advantages.
A corporation is formed by filing articles of incorporation with the state Secretary of State (or similar official) and paying the required fees. Unlike a sole proprietorship, a corporation has a legal existence distinct from its owners and is considered its own legal “person.” That means it can hold title to property, sue and be sued, have bank accounts, borrow money, hire employees and do anything else in the business world that a human being can do. Forming a corporation provides its owners (the shareholders) with “limited liability.” This means that the shareholders are not personally liable for corporate debts or lawsuits.
In theory, every corporation consists of three groups of people: those who direct the overall business, called “directors;” those who run the day-to-day business affairs, called “officers” and those who just invest in the business, called “shareholders.” However, in the case of a small business corporation, these three groups often boil down to the same person: A single person can direct and run the corporation and own all the corporate stock. So, if you want to incorporate your one-person business, you don’t have to go out and recruit a board of directors or officers.
Owners of small businesses that incorporate ordinarily work as employees of the corporation, in addition to fulfilling their other corporate roles. This differs from sole proprietors, partners or LLC members who are not employees of their businesses for tax, unemployment insurance, workers’ compensation or other legal purposes.
Creating and operating a corporation takes more money, time and trouble than being a sole proprietor, partner in a partnership or LLC member. But the corporate form continues to be chosen by many small businesses. LLCs don’t have stock, while corporations do. The ability to offer investors or key employees stock ownership is a great advantage of the corporation. It’s possible to give investors or employees a membership interest in an llC, but the process is awkward and likely less attractive to them.
When it comes to taxes, there are two types of corporations:
- C corporations, sometimes called regular corporations, and
- S corporations, also called small business corporations.
What Are The Tax Implications Of A Corporation?
When you form a corporation, it automatically becomes a C corporation for federal tax purposes. A C corporation is the only business form that is not a pass-through entity for tax purposes. Instead, a C corporation is taxed separately from its owners. C corporations must pay income taxes on their net income and file their own tax returns with the IRS. They also have their own income tax rates (which are lower than individual rates at some income levels). Because a C corporation is a separate tax-paying entity, it may provide its employees with tax-free fringe benefits, then deduct the entire cost of the benefits from the corporation’s income as a business expense. No other form of business entity can do this.
You always have the option of having your corporation taxed as an S corporation instead of a C corporation by filing an election with the IRS. An S corporation is taxed like a sole proprietorship or partnership. Unlike a C corporation, it is not a separate taxpaying entity. Instead, corporate income or losses are passed through directly to the shareholders: you and anyone else who owns your business along with you. The shareholders must divide the taxable profit according to their shares of stock ownership and report that income on their individual tax returns. An S corporation normally pays no taxes, but must file an information return with the IRS showing how much the business earned or lost and indicating each shareholder’s portion of the corporate income or loss.
Each type of corporation has benefits and drawbacks. S corporations are the most popular type of corporation for one-person businesses, primarily because they can result in reduced Social Security and Medicare taxes. C corporations can be better for successful businesses with substantial profits. However, a C corporation is not a good choice if you expect your business to lose money in its first few years of operation, because you can’t deduct such losses from any other income you have, such as salary income.
You can start out as an S corporation and switch to a C corporation later, or vice versa.
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MileIQ’s blog does not constitute professional tax advice. You should contact your own tax professional to discuss your situation.