While there are several types of business entities to choose from when establishing a business, different business structures have different benefits and risks. The sources of tax and legal liability are different depending on which business form you choose to create. This information should help give you a basic understanding of the most common business structures.
If you are the only owner of your business, and you choose not to register the business as its own entity (either a corporation of a Limited Liability Company), then it will automatically be considered a sole proprietorship. A sole proprietorship is basically a “pass through” entity, meaning that the owner pays the income taxes on the earnings from the business and can deduct business expenses on their personal income tax return. One tax benefit a sole proprietorship enjoys is that the owner is only taxed once on business income. However, despite being taxed once the sole proprietor must also pay self-employment taxes. Another benefit is that net losses can be “carried” over to other tax years, in order to offset potential tax liability in the future. One of the biggest risks in a sole proprietorship is the legal liability the owner may face in the event of a lawsuit or creditor claim.
Very similar to a sole proprietorship, a partnership is the default structure of an entity with more than one owner which has not registered as a corporation. Also, like a sole proprietorship, capital gains and income are taxed to the business owners on their personal income tax returns. Partners are only taxed once and they can “assign” property, income, and debts to other partners. Yet another benefit is that property disbursement taxes can be avoided with a partnership, because the assets are more easily transferred from the business. However, a partner may still be subject to self-employment taxes, and the legal liability of a partner will depend upon whether the individual is considered a "limited partner" or a "general partner."
The IRS recognizes basically two types of corporations for tax purposes: S-Corporations and C-Corporations. An S-Corporation operates much like a sole proprietorship or partnership, as the income is passed through to the owners. Profits and losses are also allocated proportionally. Business owners have the option of filing IRS Form 2553, which indicates they want to be taxed as a small business corporation or S-Corporation. A C-Corporation, on the other hand, is a unique separate legal entity that is responsible for filing its own tax return and paying corporate tax on the profits of a business. The owners of a C-Corporation are not taxed until there is a distribution made to the partners. This results in a double-taxation on the business earnings: once when the Corporation pays tax on its own tax return, and again when the income is distributed to the business owners. But while double-taxation may be an additional cost to the owners, the liabilities of the corporation cannot generally be attributed to the owners.
Limited Liability Companies (LLCs) are business entities established by state statutes. LLCs offer extreme flexibility for owners, as they can elect to be taxed as “pass-through” entities, such as S-Corporations or general partnerships, or to be taxed as corporate entities. Most business owners choose the LLC to be treated as a "pass-through" entity because it provides a way to avoid double taxation. The flexibility of a limited liability entity also allows the business owners to assign income and losses in the most tax-friendly way possible. While the tax consequences of a chosen business entity are important, the type of business entity you choose must depend on several other factors, as well. LLCs can provide greater liability protection for its owners than a sole proprietorship or partnership, although not as much as a corporation.
When deciding upon a business structure and choosing the type of entity with which you want to operate, an attorney should sit down and discuss the benefits, costs, risks, and attributes of these business entities.
If you have questions regarding business entities, or any other small business planning needs, please contact Anderson, Dorn & Rader, Ltd., either online or by calling us at (775) 823-9455.