Your Business Form
If you are starting a new business you must decide which legal structure is best for you and your business. If you are already in business, you should periodically review your business form to see if it is still the best choice.
The form of business entity that you choose can make a difference in the taxes you pay, the costs of doing business, and the amount of paperwork and red tape you’ll have. Here is some basic information to help you understand the differences in the various legal entities from which to choose.
Sole Proprietorship A sole proprietorship is owned and operated by one individual. It is the least complicated and usually the least expensive way to set up and run a business. A sole proprietorship has no legal existence apart from its owner.
The owner controls the business, makes decisions without having to consult co-owners or partners, and is entitled to all of the profits (or losses).
The business income for a sole proprietorship is taxed to the owner via a Schedule C and subject to self-employment tax on Schedule SE both of which are attached to the individual’s Form 1040. Income taxes are not withheld on business income, though quarterly estimated taxes may be required.
Payroll taxes apply to any employees of the business. The sole proprietor pays self employment tax rather than social security tax (and gets a tax deduction of 50% of the tax paid). No social security tax needs to be paid on the owner’s children under the age of 18 who work in the business.
A major disadvantage to the sole proprietorship form of operation is unlimited liability, not only for debts of the business but for lawsuits brought against the business as well. Liability extends to the proprietor’s personal as well as business assets.
The ability to raise capital for the business is also limited to the amount the individual can secure personally. Since under-capitalization is a major cause of failure this factor can be significant.
Continuity of a sole proprietorship is limited. Since the individual is the business, the business enterprise may be crippled or terminated if the owner becomes ill or dies.
A sole proprietor can establish a retirement plan. Plan options include an IRA, a SEP, a SIMPLE, or a Keogh. Each type of plan has its own restrictions and requirements.
The deductibility of fringe benefits is very limited in a sole proprietorship. In fact, this area comes under close scrutiny by the IRS because of concern that personal expenditures might be deducted as business expenses.
A partnership can have any number of partners. Partners bring to a business more creativity, skills, capital base, and experience than any one person is likely have.
Every partnership should have a written agreement (though there is no legal requirement to have one). The agreement should specify how the partnership will operate, how it will be financed, how responsibilities will be divided among the partners, how profits and losses will be shared, and what happens to the partnership if one partner withdraws, becomes disabled, or dies.
A partnership files an information tax return (Form 1065), but pays no income tax itself. The income or losses are passed through to the partners who report them on their individual tax returns in shares agreed upon by the partners – not necessarily equally. Partners, like sole proprietors, pay self-employment tax on net income rather than social security taxes on wages.
A major drawback to a partnership is that liability is unlimited. In fact, partners can be held liable for the actions of fellow partners.
Partners have similar options in the area of fringe benefits and retirement plans as those available to sole proprietors.
Limited Partnership. In a limited partnership, a general partner or partners run the business and are fully liable for partnership obligations. Limited partners do not participate in the business and are generally liable only to the extent of their investment.
Limited Liability Company
A relatively new business entity is the limited liability company (LLC). A properly structured LLC combines the general flexibility and income tax treatment of a partnership with the limited liability of a corporation. Like a corporation liability is limited to invested capital, with the added benefit of allowing foreign managers and or investors as members, while avoiding corporate income taxes.
A corporation, the most complex of the business structures, is a distinct legal entity apart from the shareholders who own it. Formed under the requirements of the state in which it will do business, a corporation limits its owners’ liability to their investment in the company; personal assets are generally not at risk. However, a corporate form does not provide complete protection where personal services are involved.
Ownership interest in a corporation is easy to transfer via the sale or transfer of stock, and the corporation has relative stability and permanence.
If you set up a corporation and are employed by it, the corporation must withhold and pay payroll taxes on your wages along with those of any employees.
A corporation files its own tax return (Form 1120) and pays its own income tax. In the past corporate tax rates could be as high as 35% depending on income. This all changed with the “2017 Tax Cuts and Jobs Act.” Beginning January 1, 2018, the tax rate for corporation’s changes to a flat rate of 21% this coupled with the existing lower rates on “qualified dividends” means many businesses should take a new look at regular corporations.
Another benefit is income received by shareholders as dividends is only taxed to the shareholders when received by the shareholders.
A Sub Chapter S Corporation is a regular corporation that has filed an election with the IRS to be treated as a pass-through entity. It files it’s tax return on Form 1120S, and shareholders receive a K1 reporting their share of the corporations earnings. It offers both limited liability to shareholders and pass-through of income and is not subject to tax at the corporate level. Except for the tax aspects it is just like a regular corporation.
Personal Services Business is a business that has employee-owners performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
The “2017 Tax Cuts and Jobs Act.” (P.L. 115 -97) Beginning January 1, 2018, Creates a deduction of as much as 20% of the Qualified Business Income for the owners, shareholders, and partners of qualified pass-through business including; Trusts, Sole Proprietorships, S-Corporations, and Partnerships. The deduction is taken on the personal tax returns of the owners, shareholders, partners and trust beneficiaries, and can effect each differently.
This deduction phases out for Personal Service Businesses owned by married taxpayers with gross income of more than $315,000 and for all others when gross income exceeds $157,000.
Warning the rules here are complex so be sure to consult your tax advisor.