Basically, three separate categories of entities exist: partnerships, corporations, and limited liability companies. Each category has its own advantages, disadvantages, and special rules. It is also possible to operate your business as a sole proprietorship without organizing as a separate business entity. Now that you've decided to start a new business or buy an existing one, you need to consider the form of business entity that's right for you.
A sole proprietorship is the most straightforward way to structure a business entity. Sole proprietorships are easy to set up--no separate entity must be formed. A sole proprietor's business is simply an extension of the sole proprietor.
Sole proprietors are liable for all business debts and other obligations the business might incur. This means that your personal assets (e.g., your family's assets) can be subject to the claims of your business's creditors.
For federal income tax purposes, all business income, gains, deductions, or losses are reported on Schedule C of your Form 1040. A sole proprietorship is not subject to corporate income tax. Sole proprietor's work are often selected when net income (after expenses) is less than $ 35,000.
- Simple and easy to operate.
- Lower fees for accounting and administrative costs
- Only one level of federal income tax
- Home office deduction is permitted
- Section 106 health insurance plans and section 105 medical expense reimbursement plans are permitted for spouses who are legitimately employed in the business
- No FICA tax is required for the sole proprietor's children under age 18 and no FUTA is required for children under age 21
- A sole proprietorship may convert to an LLC or corporation without a taxable event.
- Unlimited Self-employment tax
- Unlimited personal liability
- Limited fringe benefits
- Higher Audit Risk
If two or more people are the owners of a business, then a partnership is a viable option to consider. Partnerships are organized in accordance with state statutes. However, certain arrangements, like joint ventures, may be treated as partnerships for federal income tax purposes, even if they do not comply with state law requirements for a partnership. Partnerships report their income and expenses on Form 1065.
In a partnership, two or more people form a business for mutual profit. In a general partnership, all partners have the capacity to act on behalf of one another in furtherance of business objectives. This also means that each partner is personally liable for any acts of the others, and all partners are personally responsible for the debts and liabilities of the business.
It is not necessary that each partner contribute equally or that all partners share equally. The partnership agreement controls how profits are to be divided. It is not uncommon for one partner to contribute a majority of the capital while another contributes the business acumen or contacts, and the two share the profits equally.
Partnerships are a recognized entity in the sense that the entity can obtain credit, file for bankruptcy, transfer property, and so on. However, the partnership itself is generally not subject to federal income taxes (it does, however, file a federal income tax return). Instead, the income, gains, deductions, and losses of the partnership are generally reported on the partners' individual federal income tax returns. The allocation of these items among the partners is governed by the partnership agreement, subject to certain limitations.
- There is no double taxation as income and expenses retain their character and are taxed at the individual partner level.
- No double tax upon the sale of assets and liquidation of the partnership.
- Partnerships are allowed to specially allocate income and expenses as well as make disproportionate distributions.
- Elections can be made to allow a step-up in the basis of assets upon the death of a partner, or upon the sale or exchange of a partnership interest.
- The partnership is not subject to the accumulated earnings tax, alternative minimum tax, nor the personal holding company tax.
- A partner's basis includes the partner's capital account and his or her share of the partnership debt.
- Home office deductions can be taken by more than one partner.
- Section 106 health insurance plans are permitted for spouses who are employed by the partnership
- Unlimited liability for general partners
- Partner fringe benefits are not excludable from income of the partner.
- All partner earnings from a trade or business are subject to FICA tax even if the earnings are not distributed.
- Partners cannot take advantage of lower C corporation tax brackets.
- A partnership must use a tax year that is the same as the majority of the partners, which is generally a calendar year-end.
A limited partnership differs from a general partnership in that a limited partnership has more than one class of partners. A limited partnership must have at least one general partner (who is usually the managing partner), but it also has one or more limited partner. The limited partner(s) does not participate in the day-to-day running of the business and has no personal liability beyond the amount of his or her agreed cash or other capital investment in the partnership.
Limited liability partnership
Some states have enacted statutes that provide for a new type of partnership, the limited liability partnership (LLP). An LLP is a general partnership that provides individual partners protection against personal liability for certain partnership obligations. Exactly what is shielded from personal liability depends on state law. Since state laws on LLPs vary, make sure you consult competent legal counsel to understand the ramifications in your jurisdiction.
Corporations offer some advantages over sole proprietorships and partnerships, along with several important drawbacks. The two greatest advantages of incorporating are that corporations provide the greatest shield from individual liability and are the easiest type of entity to use to raise capital and to transfer (the majority stockholder can usually sell his or her stock without restrictions).
However, corporations are generally subject to federal income tax. So, the distributed earnings of your incorporated business may be subject to corporate income tax as well as individual income tax.
A corporation that has not elected to be treated as an S corporation for federal income tax purposes is typically known as a C corporation. Traditionally, most incorporated businesses have been C corporations. C corporations are not subject to the same qualification rules as S corporations and thus typically offer more flexibility in terms of stock ownership and equity structure. Another advantage that a C corporation has over an S corporation is that a C corporation can fully deduct most reasonable employee benefit costs, while an S corporation may not be able to deduct the full cost of certain benefits provided to 2 percent shareholders. Virtually all large corporations are C corporations. C Corporations report their income and expenses on Form 1120.
- Income--splitting between family members.
- Provide deductible fringe benefits to shareholders/employees
- Availablity of a fiscal year.
- Build up working capital using lower graduated corp income tax rates. (ie.. there are low tax rates on the first $75,000 of annual income for non personal service corporations)
- Dividend received deductions.
- Dividend distributions are taxed at the recipients capital gain tax rates.
- Section 1244 ordinary loss deductions for a failed small business C Corporation.
- Double taxation of appreciated assests on sale or disposition
- IRS audits can result in the creation of constructive dividends resulting in double taxation.
- C Corps can be subject to the alternative minimum tax.
- Transfers of property to a shareholder creates a "deemed sale" transaction which could result in double taxation.
- High corporate income tax rates on annual income in excess of $75,000
A corporation must satisfy several requirements to be eligible for treatment as an S corporation for federal income tax purposes. However, qualification as an S corporation offers a potential tax benefit unavailable to a C corporation. If a qualifying corporation elects to be treated as an S corporation for federal income tax purposes, then the income, gains, deductions, and losses of the corporation are generally passed through to the shareholders. Thus, shareholders report the S corporation's income, gains, deductions, and losses from schedule K-1 on their individual federal income tax returns, eliminating the potential for double taxation of corporate earnings in most circumstances.
However, many employee benefit deductions are not available for benefits provided to 2 percent shareholders of an S corporation. For example, an S corporation can provide a cafeteria plan to its employees, but the 2 percent shareholders cannot participate and receive the tax advantages that such a plan provides.
It is important to note that S corporation treatment is not available to all corporations. It is available only to qualifying corporations that file an election with the IRS. Qualifying corporations must satisfy several requirements, including limitations on the number and type of shareholders and on who can own stock in the corporation.
- Active S Corporation shareholders, unlike sole propiertors, and active partners in a partnership, are not subject to FICA tax on the S Corporation's net income. The shareholders are subject to FICA and other payroll taxes only on their salaries and wages from the company. (This assumes that shareholders are paid a reasonble salary for the services performed).
- Income earned by an S Corporation is taxed only one time at the shareholder level, and avoids double taxation.
- Pre-contribution gain on appreciated assets put into an S Corporation is not allocated to the contribution shareholder. This provides planning opportunities not possible with an LLC, which is treated like a partnership.
- S corp shareholders who materially participate and have incurred debt to acquire the stock of the corporation are able to deduct the interest expense as business interest. C corporation shareholders may only deduct such interest as investment interest.
- Tax years must generally be on a calendar year.
- Fringe benefits received by ore-than-2% shareholders are included in shareholder income.
- Dissident or new shareholders can cause the termination of the S election through a disqualified transfer of stock
- Losses passed thru to shareholders are limited to "basis".
- Higher audit risk as the IRS is now beginning to examine more S Corporation returns.
Limited liability company
A limited liability company (LLC) is a type of entity that provides limitation of liability for owners, like a corporation. However, state law generally provides much more flexibility in the structuring and governance of an LLC as opposed to a corporation. In addition, most LLCs are treated as partnerships for federal income tax purposes, thus providing LLC members with pass-through tax treatment. Moreover, LLCs are not subject to the same qualification requirements that apply to S corporations. LLC's and LLP's report their income and expenses on Form 1065.
- The liability of the owner (member) is limited to his or her investment.
- A limited liability company organized as a LLP for professionals protects each member (partner) from liability for claims involving the wrongful acts of another partner when thy hav no knowledge of those acts. Members (partners) remain personally liable for their own negligent acts.
- Contributing members caqn make nontaxable contributions of appreciated property whithout regard to whether the contributing members are in control. Additionally the LLC or LLP can make diproportionate distributions of money and property to its members.
- Members get basis for third party indebtnedness which S corporations do not enjoy.
- LLC's work especially well short-term real estate ventures (development, contstruction, etc) or investment companies (real estatte, stocks, bonds, etc.)
- Organizational and operating requirements vary from state to state.
- State tax treatment may not follow federal tax treatment.
- Limited fringe benefits available to members.
- Due to the relative newness of LLC's there is a noticable void of relaiable case law and many unclear tax issues.
- Many states requrie the LLC to dissolve upon death, retirement, expulsion, bankruptcy or dissolution of any member, unless all remaining members consent to reinstate the LLC .
Choosing the best form of ownership
There is no single best form of ownership for a business. That's partly because the limitations of a particular form of ownership can often be compensated for. For instance, a sole proprietor can often buy insurance coverage to reduce liability exposure, rather than form a limited liability entity.
Even after you have established your business as a particular entity, you may need to re-evaluate your choice of entity as the business evolves. An experienced attorney with our assistance can help you decide which form of ownership is best for your business.
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