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When beginning a business, you must decide what form of business entity to establish. Your form of business then determines the potential risks, liability and income tax ramifications. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation, and a Limited Liability Company (LLC).
A sole proprietor is someone who owns an unincorporated business by himself or herself. 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. A partnership must file an annual information return to report the income, deductions, gains, losses, etc., 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.
A corporation is a separate and distinct legal entity. This means that a corporation can open a bank account, own property and do business, all under its own name. A corporation is managed by a board of directors, which is responsible for making major business decisions and overseeing the general affairs of the corporation.
The primary advantage of a corporation is that its owners, known as “stockholders” or “shareholders,” are not personally liable for the debts and liabilities of the corporation. For example, if a corporation gets sued and is forced into bankruptcy, the owners will not be required to pay the debt with their own money. If the assets of the corporation are not enough to cover the debts, the creditors cannot go after the stockholders, directors or officers of the corporation to recover any shortfall.
In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders. 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. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.
Professional corporations (PC) are corporations that provide professional services such as legal or accounting firms. State law and the regulating board determine what constitutes professional services and when you are required to be a professional corporation.
An eligible domestic corporation can avoid double taxation by electing to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated income or loss.
Although an S corporation shares many of the same tax characteristics as an LLC, an LLC has more flexibility and fewer restrictions than an S corporation. An S corporation cannot have more than 100 stockholders, cannot issue more than one class of shares, and is subject to more formalities than an LLC. However, owners of an LLC are required to pay Social Security and Medicare taxes on profits. Corporate stockholders are not required to pay these taxes on profits over and above the stockholders’ salaries.
The advantages of an LLC are that its owners, known as members, are not personally liable for the debts and liabilities of the LLC and an LLC can be taxed as a "pass-through" entity, meaning that the profits "pass through" to the owners who pay taxes at their individual tax rates.
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