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A Guide for starting your business: Part 2 Business Structures

There are multiple business structures you can choose, I have my recommendations however, the ultimate decision is up to you. Currently, here are a list of business structures you can select.

  • Sole-Proprietor
  • Partnership
  • Limited Liability Company
  • Corporation
  • S-Corporation*

*Filing form 2553 will allow you to be taxed as a S-Corporation

Sole- Proprietorship:

  • Someone who owns an unincorporated business by himself or herself
  • 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
  • Can be held personally liable for the debts and obligations of the business
  • File taxes on Schedule C of form 1040
  • Can pass a business down to his or her heirs.
  • There are no specific business taxes paid by the company.
  • The owner pays taxes on income from the business as part of his or her personal income tax payments.

Advantages of a Sole Proprietorship

  • A sole proprietor has complete control and decision-making power over the business.
  • Sale or transfer can take place at the discretion of the sole proprietor.
  • No corporate tax payments
  • Minimal legal costs to forming a sole proprietorship
  • Few formal business requirements

Disadvantages of a Sole Proprietorship

  • The sole proprietor of the business can be held personally liable for the debts and obligations of the business. Additionally, this risk extends to any liabilities incurred as a result of acts committed by employees of the company.
  • All responsibilities and business decisions fall on the shoulders of the sole proprietor.
  • Investors don’t usually invest in sole proprietorship.

Partnership:

  • A partnership is the relationship existing between two or more persons who join to carry on a trade or business.
  • A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax.
  • Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return.
  • Partners are not employees and should not be issued a Form W-2.
  • The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.
  • File taxes on Form 1065
  • The partnership income tax is paid by the partnership, but the profits and losses are divided among the partners, and paid by the partners, based on their agreement.

Types of Partners in a Partnership:

General Partners and Limited Partners– GP participate in the management of the business while limited partners invest but does not participate in managing the business.

Equity partners and salaried partners- Some partners may be paid as employees, while others have only a share in ownership.

How Partners are Paid:

Since partners are owners, they typically don’t receive a paycheck. What they receive is a distributive share of income and are taxed individually. You may argue that you should be treated as an employee for tax purposes, but it comes with many risks (more on that later).

LLC:

  • LLC has become one of the fastest and popular business structures because of the limited liability aspect while taking advantage of the tax structure.
  • A Limited Liability Company (LLC) is a business structure allowed by state statute.
  • Each state may use different regulations, and you should check with your state if you are interested in starting a Limited Liability Company.
  • Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a ‘disregarded entity’).
  • Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation.
  • And 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 purposes of employment tax and certain excise taxes), unless it files Form 8832 and affirmatively elects to be treated as a corporation.

Advantages of a Limited Liability Company:

  • Less paperwork than corporations
  • Only limited to the amount capital invested, not personal assets
  • Flexible tax treatment
  • No double taxation

Corporations:

  • In forming a corporation, prospective shareholders exchange money, property, or both for the corporation’s capital stock.
  • A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income.
  • A corporation can also take special deductions
  • For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity.
  • 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.
  • File taxes on Form 1120

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.
  • S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
  • File taxes on form 1120-S

How to Qualify for S-Corp Status:

  • Be a domestic corporation
  • Have only allowable shareholders
  • May be individuals, certain trusts, and estates and may not be
  • partnerships, corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e. certain financial institutions,
  • insurance companies, and domestic international sales corporations).
  • File form 2553

How does S-Corp owners get taxed?

  • The owners pay taxes based on the distribution of ownership that flows through their 1040.
  • Even though owners pay income tax on the distribution, they are not considered self-employed.
  • The sweet deal of being an S-corp owner:
  • It can save you social security and Medicare taxes. An S corporation shareholder who performs more than minor services for the corporation will be its employee for tax purposes, as well as a shareholder. What this means is you are considered an employee and a shareholder, if you pay yourself a reasonable salary, the distributions can be free from Social Security and Medicare taxes. For example, if you pay yourself 20K in salary but take a 150K distribution, that can get you in trouble with the IRS.

If you want to learn more about starting a business, download our business start-up Guide.

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