When you decide to start
a business, one of the most important decisions you'll need to make is choosing
a business entity. It's a decision that impacts many things--from the amount of
taxes you pay to how much paperwork you have to deal with and what type of
personal liability you face, and with the passage of the Tax Cuts and Jobs Act
of 2017, it's more important than ever to choose the business entity that
benefits your business.
Forms of Business
The most common forms of
business are Sole Proprietorships, Partnerships, Limited Liability Companies
(LLCs), and Corporations (C-Corporations). Federal tax law also recognizes
another business form called the S-Corporation. While state law controls the
formation of your business, federal tax law controls how your business is
taxed.
What to Consider
Businesses fall under
one of two federal tax systems:
1. Taxation of both the
entity itself on the income it earns and the owners on dividends or other
profit participation the owners receive from the business. C-Corporations fall
under this system of federal taxation.
2. "Pass
through" taxation. This type of entity (also called a
"flow-through" entity) is not taxed, but its owners are each taxed
(more or less) on their proportionate shares of the entity's income. Pass-through
entities include:
·
Sole Proprietorships
·
Partnerships, of various
types
·
Limited liability
companies (LLCs)
·
"S-Corporations"
(S-Corps), as distinguished from C-corporations (C-Corps)
The first major
consideration when choosing a business entity is whether to choose one that has
two levels of tax on income or one that is a pass-through entity with only one
level directly on the owners.
The second
consideration, which has more to do with business considerations rather than
tax considerations, is the limitation of liability (protecting your assets from
claims of business creditors).
Let's take a general
look at each of the options more closely:
Types of Business
Entities
Sole Proprietorship's
The most common (and
easiest) form of business organization is the sole proprietorship. Defined as
any unincorporated business owned entirely by one individual, a sole proprietor
can operate any kind of business (full or part-time) as long as it is not a
hobby or an investment. In general, the owner is also personally liable for all
financial obligations and debts of the business.
Note: If you are the sole member of a domestic limited liability
company (LLC), you are not a sole proprietor if you elect to treat the LLC as a
corporation.
Types of businesses that
operate as sole proprietorships include retail shops, farmers, large companies
with employees, home-based businesses and one-person consulting firms.
As a sole proprietor,
your net business income or loss is combined with your other income and
deductions and taxed at individual rates on your personal tax return. Because
sole proprietors do not have taxes withheld from their business income, you may
need to make quarterly estimated tax payments if you expect to make a profit.
Also, as a sole proprietor, you must also pay self-employment tax on the net
income reported.
Partnerships
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.
There are two types of
partnerships: Ordinary partnerships, called "general partnerships,"
and limited partnerships that limit liability for some partners but not others.
Both general and limited partnerships are treated as pass-through entities
under federal tax law, but there are some relatively minor differences in tax
treatment between general and limited partners.
For example, 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.
Partners are not
employees of the partnership and do not pay any income tax at the partnership
level. Partnerships report income and expenses from its operation and pass the
information to the individual partners (hence the pass-through designation).
Because taxes are not
withheld from any distributions partners generally need to make quarterly
estimated tax payments if they expect to make a profit. Partners must report
their share of partnership income even if a distribution is not made. Each partner
reports his share of the partnership net profit or loss on his or her personal
tax return.
Limited Liability Companies (LLC)
A Limited Liability
Company (LLC) is a business structure allowed by state statute. Each state is
different, so it's important to check the regulations in the state you plan to
do business in.
Owners of an LLC are called members, which may include
individuals, corporations, other LLCs and foreign entities. Most states also
permit "single member" LLCs, i.e., those having only one owner.
Depending on elections
made by the LLC and the number of members, the IRS treats an LLC as either a
corporation, partnership, or as part of the LLC's owner's tax return. A
domestic LLC with at least two members is classified as a partnership for federal
income tax purposes unless it elects to be treated as a corporation.
An LLC with only one
member is treated as an entity disregarded as separate from its owner for
income tax purposes (but as a separate entity for purposes of employment tax
and certain excise taxes), unless it elects to be treated as a corporation.
C-Corporations
In forming a
corporation, prospective shareholders exchange money, property, or both, for
the corporation's capital stock. A corporation conducts business, realizes net
income or loss, pays taxes and distributes profits to shareholders.
A corporate structure is
more complex than other business structures. When you form a corporation, you
create a separate tax-paying entity. The profit of a corporation is taxed to
the corporation when earned and then is taxed to the shareholders when
distributed as dividends. This creates a double tax.
The corporation does not
get a tax deduction when it distributes dividends to shareholders. Earnings
distributed to shareholders in the form of dividends are taxed at individual
tax rates on their personal tax returns. Shareholders cannot deduct any loss of
the corporation.
If you organize your
business as a corporation, generally are not personally liable for the debts of
the corporation, although there may be exceptions under state law.
S-Corporations
An S-corporation has the
same corporate structure as a standard corporation; however, its owners have
elected to pass corporate income, losses, deductions, and credits through to
their shareholders for federal tax purposes. Shareholders of S-corporations
generally have limited liability.
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. S-Corporations
may be taxed under state tax law as regular corporations, or in some other way.
Shareholders must pay
tax on their share of corporate income, regardless of whether it is actually
distributed. Flow-through of income and losses are reported on their personal
tax returns, and they are assessed tax at their individual income tax rates,
allowing S-Corporations to avoid double taxation on the corporate income.
To qualify for S-Corporation
status, the corporation must meet a number of requirements. Please call if you
would like more information about which requirements must be met to form an
S-Corporation.
Professional Guidance
When making a decision
about which type of business entity to choose each business owner must decide
which one best meets his or her needs. One form of business entity is not
necessarily better than any other and obtaining the advice of a Blue Springs tax professional is critical. If you need assistance figuring out which business
entity is best for your business, don't hesitate to call.
Taxpayers who are not required to file a tax return may want to do so. They
might be eligible for a tax refund and don’t even know it. Some taxpayers might
qualify for a tax credit that can result in money in their pocket. Taxpayers
need to file a 2017 tax return to claim these credits.
