The business entity that you choose for your company can make a difference in the taxes you pay, the costs of doing business, and the amount of paperwork and red tape you’ll have. Here is a quick look at the main entities that businesses can choose for their operations.
A sole proprietorship is owned and operated by one individual. It is the least complicated and usually the least expensive way to set up and run a business.
The business income is taxed to the owner on Schedule C of his or her personal tax return. Payroll taxes apply to any employees of the business.
The sole proprietor pays self-employment tax rather than social security tax (and gets a tax deduction for 50% of the tax paid).
One of the major disadvantages to a sole proprietorship is unlimited liability, not only for debts of the business, but for lawsuits brought against the business. Liability extends to the proprietor’s personal as well as business assets.
The ability to raise capital for the business is limited to the amount the individual can secure personally. Since under-capitalization is a major cause of business failure, this factor can be significant.
The deductibility of fringe benefits is very limited in a sole proprietorship.
A partnership can have any number of partners. Partners bring to a business more creativity, skills, capital base, and experience than any one person is likely to have.
A partnership files an information tax return (Form 1065), but pays no income tax itself. The income or losses are passed through to the partners who report them on their individual tax returns in shares agreed upon by the partners – not necessarily equally. Partners, like sole proprietors, pay self-employment tax on net income.
The major disadvantage to a partnership is that liability is unlimited. In fact, partners can be held liable for the actions of fellow partners.
Partners have similar options in the area of fringe benefits and retirement plans as those available to sole proprietors.
A corporation, the most complex of the business structures, is a distinct legal entity apart from the shareholders who own it. Formed under the requirements of the state in which it will do business, a corporation limits its owners’ liability to their investment in the company; personal assets are generally not at risk. The corporate form does not provide complete protection where personal services are involved.
If you set up a corporation and are employed by it, the corporation must withhold and pay payroll taxes on your wages.
A corporation files its own tax return (Form 1120) and pays its own income tax. Therein lies the major drawback to the corporate form: business profits may be taxed twice – once at the corporate level and again at the shareholder level when paid out as dividends or a liquidating distribution.
The corporate form allows for more fringe benefits, deductible by the corporation and tax-free to employees (including shareholder-employees).
Another drawback to the corporate form is the complexity of rules and regulations governing corporate operations (including the tax laws). Personal service corporations (PSCs) have the added drawback of being taxed at a flat rate (the top corporate rate) rather than at the graduated rates available to other corporations.
A corporation is allowed to elect S status only if it meets certain qualifications. An S corporation generally does not pay its own income tax. It files Form 1120S and distributes K-1s to shareholders. Shareholders then report their pro rata share of income, losses, and credits on their individual tax returns. The double taxation that regular corporations face is thereby avoided with an S corporation.
The big advantage of S status is that it combines the limited liability of a regular corporation with tax treatment similar to that of a partnership. A disadvantage is that S corporations have some fringe benefit restrictions for owner-employees.
Limited Liability Company
The limited liability company (LLC) combines the general flexibility and income tax treatment of a partnership with the limited liability of a corporation.
There are other factors not mentioned in this quick review that should be considered in choosing your business entity. For more information, contact our office and your attorney.
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