Choosing a Business Structure
When starting a small business, there are many questions that need to be answered. Questions, such as what type of business structure should I use? The process can be overwhelming at times, but my hope with this article is to at least provide information that can help you decide which structure would be best for your business.
Deciding what form of business structure to establish is one of the first decisions to be made. The form of business structure will determine which income tax return you will be required to file. The common forms of business structure are the sole proprietorship, partnership, corporation, S corporation and the Limited Liability Company (LLC). There are legal and tax considerations for each.
Sole Proprietorships
Sole proprietorships are the simplest business structure to form since they are not separate tax or legal entities. A taxpayer is a sole proprietor if they are self-employed and the sole owner of the unincorporated business. The owner reports all transactions of the business on their own individual income tax return.
Advantages
(1) Minimal start-up costs
(2) Lower legal and accounting costs
(3) Can easily be converted to another form of entity
(4) Profits & losses pass through to the owner
(1) Personal liability
(2) Self-employment tax
Partnership
A partnership is the relationship between two or more people who together carry on a trade or business with each person contributing money, property, labor or skill, and each expecting to share in the profits and losses of the business. A partnership must file an annual information return to report the activity from its operations, but it does not pay income tax. Instead, profits or losses “pass through” to its partners. Each partner includes his/her share of the partnership’s income or loss on his/her tax return. An Employer Identification Number (EIN) is required for all partnerships. You can request an EIN from the IRS at www.irs.gov.
Advantages
(1) Income is taxed to the partners
(2) Losses and credits generally pass through to the partners
Disadvantages
(1) Liability of general partners is not limited
(2) Partners are taxed on current earnings even is the earnings are not distributed to the partners
Corporation
In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.
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. Shareholders cannot deduct any loss of the corporation.
Advantages
(1) Limited Liability
(2) Can have unlimited number of owners
(3) Best fringe benefits & retirement plans
Disadvantages
(1) Higher upfront costs
(2) Double taxation – corporation pays tax on profit and shareholders pay tax on dividends
S Corporations
S corporations are corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. An S Corporation is required to file a separate tax return. An Employer Identification Number (EIN) is required for all S Corporations.
Advantages
(1) Can distribute its profits to shareholders with only a single tax
(2) Losses of an S Corporation are currently deductible by the shareholders
(3) Limited Liability
Disadvantages
(1) No opportunity to accumulate corporate earnings
(2) More record keeping required
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation. Profit or loss from an LLC is reported on the member’s income tax return.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
A few types of businesses generally cannot be LLCs, such as banks and insurance companies.
Advantages
(1) Separate Legal entity but one level of tax
(2) No restriction on number of members
Disadvantages
(1) Restricted to certain businesses and professions
(2) Additional taxes and filing fees
Choosing which of these forms of business depends on the following:
(1) The type of business you are starting
(2) How many owners
(3) The potential risk and liability of your business
(4) Your income tax situation and
(5) The investment needs.
As a business owner, you need to choose the structure that best meets your needs.
After learning the basics of each business structure, you may still find that you need help deciding which structure is best for your business. If you require additional assistance, please contact me at Kelly@greenkristcpa.com.
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