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.
Forms of Business
The most common forms of business are Sole Proprietorships, Partnerships, Limited Liability Companies (LLC), and Corporations. Federal tax law also recognizes another business form called the S-Corporation. While state law controls the formation of your business, federal tax law controls how your business is taxed.
What To Consider
Businesses fall under one of two federal tax systems, and the first major consideration in choosing the form of doing business is whether to choose an entity that has two levels of tax on income or a pass-through entity that has only one level directly on the owners:
- Taxation of the entity itself on the income it earns and the owners on dividends or other profit participation the owners receive from the business. C-Corporations fall under this system of federal taxation.
- “Pass through” taxation. The entity (called a “flow-through” entity) is not taxed, but its owners are each taxed (more or less) on their proportionate shares of the entity’s income. Pass-through entities include:
- Sole Proprietorships
- Partnerships, of various types
- Limited liability companies (LLCs)
- “S-Corporations” (S-Corps), as distinguished from C-corporations (C-Corps)
The second consideration, which has more to do with business considerations rather than tax considerations, is the limitation of liability (protecting your assets from claims of business creditors).
We’ll take a general look at each of the options more closely. This month the focus will be on Sole Proprietorships and next month, on Partnerships, LLC’s and S – and C- Corps.
Sole Proprietorships
The sole proprietorship is the most common (and easiest) form of business organization. Defined as any unincorporated business owned entirely by one individual. A sole proprietor can operate any type of business (full or part-time) as long as it is not a hobby or an investment. In general, the owner is also personally liable for all financial obligations and debts of the business.
If you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.
Types of businesses that operate as sole proprietorships include retail shops, farmers, large companies with employees, home-based businesses, and one-person consulting firms.
As a sole proprietor, your net business income or loss is combined with your other income and deductions and taxed at individual rates on your personal tax return. Because sole proprietors do not have taxes withheld from their business income, you may need to make quarterly estimated tax payments if you expect to make a profit. As a sole proprietor, you must also pay self-employment tax on the net income reported.
Seek Professional Guidance
When making a decision about which type of business entity to choose each business owner must decide which one best meets his or needs. 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.
