One of the most important decisions you’ll make when starting a business is choosing the right business entity. It’s a decision that impacts many things–from the amount of taxes you pay to how much paperwork you have to deal with and what type of personal liability you face. Last month I discussed Sole Proprietorships and this month we’ll take a closer look at Partnerships and Limited Liability Companies (LLC).
Partnerships
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor, or skill and expects to share in the profits and losses of the business.
There are two types of partnerships: Ordinary partnerships, called “general partnerships,” and limited partnerships that limit liability for some partners but not others. Both general and limited partnerships are treated as pass-through entities under federal tax law, but there are some minor differences in tax treatment between general and limited partners.
For example, general partners must pay self-employment tax on their net earnings from self-employment assigned to them from the partnership. Net earnings from self-employment include an individual’s share, distributed or not, of income or loss from any trade or business carried on by a partnership. Limited partners are subject to self-employment tax only on guaranteed payments, such as professional fees for services rendered.
Partners are not employees of the partnership and do not pay any income tax at the partnership level. A Partnership reports income and expenses from its operation and passes the information to the individual partners (hence the pass-through designation).
Because taxes are not withheld from any distributions, partners generally need to make quarterly estimated tax payments if they expect to make a profit. Partners must report their share of partnership income even if a distribution is not made. Each partner reports their share of the partnership’s net profit or loss on their personal tax return.
Limited Liability Companies (LLC)
A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state is different, so it’s important to check the regulations in the state in which you plan to do business. Owners of an LLC are called members and may include individuals, corporations, other LLCs, and foreign entities. Most states also permit “single-member” LLCs with only one owner.
Depending on elections made by the LLC and the number of members, the IRS treats an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return. A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it elects to be treated as a corporation.
An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for employment tax purposes and certain excise taxes) unless it elects to be treated as a corporation.
Seek Professional Guidance
One form of business entity is not necessarily better than any other and obtaining the advice of a tax professional is critical. If you need assistance figuring out which business entity is best for your business, don’t hesitate to call. Come back next month for my discussion of corporations.
Choosing the Correct Business Entity, Part 2
