The Tax Club Report

When starting a new business, choosing the right business entity is critical to the success of your new endeavor. There are many factors to consider when selecting the right organizational structure for your business. The tax consequences, growth potential, the level of liability protection needed and the operating requirements of the business are all evaluated when making this decision.

Based on the needs of the business, the structure could be in the form of a sole-proprietorship, partnership, corporation or an LLC. There are two types of corporations, a C corporation and an S corporation. Each business structure has its advantages and disadvantages, so it is important to review each one before making a decision.

Sole Proprietorship

A sole proprietorship, also known as a disregarded entity for tax purposes, is a business owned by only one individual and is very easy to form and maintain. The sole proprietorship is “disregarded” as a separate entity and therefore shares the same identity as its owner. The profits or losses of the business are reported on Schedule C on the owner’s individual tax return. The business income is subject to employment tax of 15.3% in addition to federal and state income tax. Although this disregarded entity is the easiest to form and maintain, it provides the least liability protection to its owner.

Partnership

A partnership is an entity formed with two or more partners. The formation and operation of this entity requires more paperwork, in that a proper Operating Agreement needs to be written and updated for any changes. Partnership income or loss flows through to its partners through a schedule K-1 and the taxes are paid on each partner’s individual income tax return.  The partner’s share of income or loss is determined by the entity’s Operating Agreement.  One advantage that a partnership has is that the partner’s share of income or loss is not required to be based on each partner’s business ownership percentage. For example, a two-member partnership with equal ownership (50/50) can have income allocation of 30/70 and loss allocation of 40/60. It is very important that the allocation of income and losses is provided for in the Operating Agreement to be able to claim this special treatment.

The partners are not considered employees and therefore cannot be paid wages, nor have any fringe benefits. However, partners can receive guaranteed payments for their service as long as it is stipulated in the partnership agreement. Like the sole proprietorship, partnership income for general partners is subject to employment tax of 15.3%. The employment tax is paid in addition to income tax and this is why the owners must make estimated tax payments to avoid paying underpayment penalties. 

C-Corporation

A corporation is an entity that is formed under the laws of a particular state and exists separately from its shareholders. It files and pays its own income taxes and it could have one or multiple shareholders, both foreign and domestic. Business losses can be carried forward 20 years or carried back 2 years. They never “flow through” to the shareholders. 

The shareholders of a C corporation could be compensated through dividends, wages or both. This business entity allows various fringe benefits such as health insurance and 401K memberships to be provided tax-free to employees who are also shareholders of the company. A corporation is required to maintain proper financial records, file annual reports and hold regular shareholder meetings. The meetings need to be documented in the shareholder meeting minutes and kept in the corporate binder. The major drawback with a C corporation is the double taxation of income when it is first taxed at the corporate level and then at the individual level when the corporation issues dividends to its shareholders. The corporate tax rate is typically higher than the individual tax rate, but it provides the most liability protection.

S-Corporation

An S corporation is incorporated in the same manner as a C corporation. The corporation’s shareholders file IRS Form 2553 electing to be taxed as an S corporation within the prescribed time period to get the subchapter S treatment.  It can have a maximum of 100 shareholders who are required to be legal residents or citizens of the United States. Only individuals can be shareholders of an S corporation. Similar to partnerships, an S corporation is a “flow-through” entity, and all its income or loss is reported and taxed on each of the shareholder’s individual tax return.  Unlike the partnership and the sole proprietorship, the income that “flows through” is not subject to employment taxes. This important distinction can dramatically reduce taxes and is the main reason why it has become a popular entity of choice. Shareholders who are actively participating in the business are required to be compensated in the form of wages. Tax- free fringe benefits are available to shareholders with less than 2% ownership. An S corporation is required to maintain proper financial records, file annual reports and document annual shareholder meetings and minutes. 

Limited Liability Company

Lastly, a Limited Liability Company is a hybrid of all the entities previously mentioned. An LLC is a type of unincorporated association and it can exist as a single member LLC taxed as a sole proprietorship, or a multi-member LLC taxed as a partnership. Corporations and S corporations can also choose to be taxed as Limited Liability Companies if properly registered with the state and the right application is filed with the IRS. The LLC provides limited liability to the member(s) or shareholder(s) of the business. The tax treatment and filing requirements of an LLC are based on the type of business entity it is registered as. An LLC is typically formed to hold high valued assets such as real estate, and to protect its members from personal liability. It is important to note that the members of an LLC can be found personally liable if fraudulent activity is found to exist or if there is commingling of business and personal funds. Thus, it is very important to conduct the business in accordance with federal and state laws and to avoid commingling of funds.

Choosing the right business entity is a very important decision that an owner must make. Schedule an appointment with one of The Tax Club’s specialists to determine the best business structure for your business.

The Tax Club is committed to educating the public to the best of its abilities. If you would like to speak with one of our associates for a free consultation, please contact us at 866-840-1829 x5438

This entry was posted on Tuesday, November 10th, 2009 at 3:35 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.