Which entity should I form when starting a new business? – Tax

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As a tax lawyer, friends and acquaintances ask me this question all the time: What type of entity should I form when starting a new business? With so many business options available, it can be difficult to determine which business structure would be appropriate. Below is a general overview of each business structure and the tax responsibilities of each.

Individual business

A sole proprietorship is a person who operates a business but has not registered the business with the Secretary of State of the relevant state. In other words, it is not a legal person. A sole proprietorship is also owned by a person who takes full responsibility for the business. This means that the owner is personally responsible for all the debts of the business.

All income and expenses of a sole proprietorship are reported directly on Schedule C of the owner’s personal income tax return. The owner will pay both the employer and the employee’s share of self-employment tax (FICA) associated with the net income of the business on their personal tax return.

Partnership

A partnership is a relationship between two or more people to operate a business. Typically, each partner brings in money, skills, goods, or labor, and then shares in the profits and losses of the business. While it is good business practice for a partnership to have a formal written partnership agreement, it is not mandatory. Additionally, each state has its own rules for determining whether a partnership should be registered with the state secretary of state.

The partners can bind the partnership to a contract as long as the act falls within the framework of the activities of the partnership. Partners may also be liable for the debt of the partnership depending on the type of partnership.

You have the choice between three types of partnerships: general, limited and limited liability.

  1. A general partnership means that all partners participate in the day-to-day business operations. General partners are personally liable for the debt of the business.
  2. Limited partnerships have a combination of general partners and limited partners. Limited Partners are not involved in the day-to-day business operations and are not personally liable for the debts of the Company. General partners participate in the day-to-day management of the business and are personally liable for the debts of the business.
  3. Limited liability partnerships provide liability protection for individuals
    all partners, whether they are general or limited partners. Generally, limited liability companies are formed by accountants and lawyers.

Partnerships must file an income tax return with the IRS each year. The partnership’s income tax return will show all of the business’s income, deductions, gains and losses for the year. The partnership does not pay taxes on the income of the partnership, but rather it is “passed on” to the partners. The partnership’s return will issue a Schedule K-1 to each partner declaring each partner’s share of income and losses. Each partner will then report the respective income and loss on their personal income tax return.

Limited liability company

By far the most popular business to form is the limited liability company or LLC. A limited liability company is determined by the various states. Each state has different regulations – see a recent change to Ohio LLC regulations, here. However, in general, LLCs can have one or more owners. Owners are called members and there is no maximum number of individuals who can be members.

Limited liability members enjoy the benefits of limited liability, which means that members have no personal liability for the debts of the company. An LLC doesn’t have a lot of regulations and the members have flexibility in how the business is structured and managed. Like partnerships, LLCs should have a formal operating agreement and some states require such an agreement.

The IRS does not recognize an LLC for federal income tax purposes. Therefore, how an LLC is taxed each year depends on several factors. The first factor is whether the LLC is a single member LLC or a multiple member LLC.

A single member LLC is considered an ignored entity by the IRS. This means that, as with a sole proprietor, the sole member will report the income and expenses of the LLC directly on Schedule C of their personal tax.

A multi-member LLC can be taxed in two ways. If no further reporting is made to the IRS, a multi-member LLC is considered a partnership with the IRS and will be taxed as a partnership. The LLC can also elect to be taxed as an S corporation. In order to be taxed as an S corporation, the LLC must file Form 8832 with the IRS and affirmatively elect to be treated as a corporation. In a partnership or S corporation tax, the income and expenses of the LLC are transferred to each member. Each member will receive a Schedule K-1 and will then be required to report their share of the LLC’s income and expenses on their personal income tax return.

company

A corporation is a business structure separate from its owners. Because a corporation is a separate entity, the owners are generally immune from the responsibilities of the corporation. A company is made up of shareholders, a board of directors and officers. Individuals buy shares in the company and become shareholders. The shareholder is then the legal owner of the assets of the company. Shareholders generally do not run the business on a day-to-day basis. The shareholders elect a board of directors which appoints the officers. Officers are responsible for managing the day-to-day operations of the company.

Companies have certain formalities that must be followed. Some of these formalities are annual meetings, keeping company minutes, keeping all written agreements for all transactions, keeping separate bank accounts and complying with the company’s articles of association.

A corporation must file an income tax return each year with the IRS. A company is recognized as a separate tax entity and is taxed on the profits of the company. As a separate tax entity, double taxation may occur. Currently corporations are taxed at a flat rate of 21%, but this is subject to change. When a company distributes dividends to shareholders, the shareholder must declare and pay tax on the dividends on their individual income tax return. No tax deduction takes place for the company when dividends are distributed.

S corporation

The S-corporation, or S-corp, is not an entity formed with the secretary of state of a state. Instead, an S-corp is a tax designation. In order to be taxed as an S-corp, the company must make an election with the IRS which has affirmatively chosen such tax treatment. In addition, an S-corporation has certain requirements that must be met to qualify as an S-corp. These requirements are:

  • Be a national company
  • Have only individuals, certain trusts and estates, and one-member limited liability companies as shareholders
    • Partnerships, multi-member limited liability companies, corporations and non-resident aliens are not allowed to be shareholders.
  • Not have more than 100 shareholders
  • Have only 1 class of stock
  • Not be an ineligible corporation (certain financial institutions, insurance companies and domestic international sales companies)

S-corps are also required to follow the same corporate formalities of a C-corporation while paying a reasonable salary to any shareholder who participates in the management of the business.

An S-corp is required to file a tax return with the IRS each year. The S-corp’s tax return will report all of the business’s income, deductions, gains and losses for the year. In general, the S-corp does not pay taxes on the income of the partnership, but rather it is passed on to the shareholders through a Schedule K-1.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.


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