Sole proprietor. Partnership. Corporation. Limited Liability Company (LLC). Subchapter S.
These terms may be foreign to most individuals but are important to small-business owners. If your plans include owning a small business, choosing the appropriate small business form is one of the first steps toward success.
A business form is the legal structure for operating a business. The business form will dictate the formation, management, profit/loss distribution, and taxation requirements as well as the amount of personal liability protection of the owners.
A sole proprietorship is the simplest form of business ownership. As its name implies, one person owns and controls the business and the business is not incorporated—that is, it has not registered with the state's business registration office.
For tax purposes, while the company may pay wages to non-owner employees, the owner simply reports net income (revenues less expenses) as self-employment income on Schedule C, Form 1040, taxed as ordinary income.
In addition to income taxes, the owner must also pay a self-employment tax for Social Security and Medicare at the 2016 rate of 15.3% for the first $118,500 and 2.9% for earnings above that amount. Sole proprietors can deduct half the cost.
If the business pays wages to non-owner employees, the owner must pay the employer's share of FUTA (unemployment), FICA, and Medicare taxes for those employees. He or she must also withhold the employee's share of income, FICA, and Medicare taxes from each employee's wages.
Selecting the appropriate business form has both legal and tax implications.
Sole proprietors are generally required to make periodic (usually quarterly) estimated tax payments if he or she expects to owe more than $1,000 in taxes.
Sole proprietors are legally liable for all of the debts and obligations of the business, including judgments from civil lawsuits. A sole proprietor's home or other personal assets may be attached to pay for business debts.
General partnerships comprise two or more owners. It is a good idea to draw up a written partnership agreement that defines the rights and responsibilities of all partners.
Unless the partnership agreement states otherwise, each general partner has equal control over and authority to act on behalf of the partnership and is personally liable for its debts, including liability for civil judgments.
Some partnerships have both general and limited partners and are called limited partnerships. A limited partnership is formed by filing a Certificate of Limited Partnership with a state's business registration office, usually the Secretary of State's office.
While general partners can obligate the business and have unlimited personal liability, limited partners usually do not have the authority to obligate the business and enjoy limited personal liability. Generally, a limited partner may lose only the amount they have invested in the partnership.
Don't take selection of a business operating form lightly.
Income is not taxed at the partnership level; however both general and limited partnerships must report revenues and expenses on IRS (Internal Revenue Service) Form 1065.
The net profits of the business flow through to the individual tax returns (Schedule E, Form 1040) of the partners based on each partner's percentage of ownership and are taxed at ordinary tax rates.
Partners who work in the business are expected to draw a fair wage, and the business withholds appropriate income and payroll taxes on those wages, as well as on the wages of any employees, as described above.
For-profit corporations (sometimes called C corporations, after Subchapter C of Chapter 1 of the Internal Revenue code) are entities that issue stock to those who purchase shares of the business (called shareholders). One or more individuals may incorporate a business and issue stock to themselves in exchange for money, property, or services contributed to the business.
Corporations are formed by filing Articles of Incorporation with a state's business registration office. A corporation is generally governed by the laws in the state in which it is incorporated ("home" state), which need not be the state in which it is located.
Some states are more business-friendly than others so choose where to incorporate your business wisely. A corporation that incorporates in a different state than its state of domicile is called a Domestic Corporation in its home state and a Foreign Corporation in the state in which it is located.
A sole proprietorship is the simplest form of business ownership.
The shareholders of a corporation elect a board of directors to manage the corporation. The board, in turn, elects corporate officers to manage the daily affairs of the business. The board is also responsible for setting the policies of the business, creating bylaws, and managing the president.
Shareholders, directors, and officers enjoy limited personal liability for, but not total protection from, corporate obligations unless they provide a personal guarantee.
Owners must pay themselves a fair wage if they work for the business. These wages are taxed as W-2 income, just as if the owner worked for another employer. The net income of the corporation is reported on Form 1120 and taxed to the corporation. Tax rates for corporations are greater than those for individual taxpayers.
A corporation may retain its profits or choose to pay some or all out to shareholders as dividends. Dividends are taxable to shareholders at ordinary income tax rates. In effect, shareholders who receive dividends are taxed twice on corporate profits—once at the corporate level (profits) and once at the individual level (dividends).
Shareholders are usually not personally liable for any claims against the corporation unless they personally guaranteed a loan for the corporation.
Like C corporations, S corporations issue stock to their owners in exchange for money, property, or services contributed to the business. However, while a C corporation can have an unlimited number of shareholders, an S corporation may have no more than 100 shareholders.
In addition to a state incorporation filing, S corporations must meet certain IRS eligibility requirements before requesting S status from the IRS on Form 2553. Most states have an equivalent S corporation tax status, meaning the S corporation is taxed in the same manner at the state level as at the federal level.
An owner who is also employed by the business may make money two ways: from wages and net profits. While both wages and net profits are taxed at ordinary rates for the tax year in which they are earned and generated, net profits are not subject to payroll or self-employment taxes.
However, the IRS expects that owner-employees will earn fair wages for their labor. That means owners may not pay themselves less than market wage and take the income in the form of net profits to avoid the self-employment tax. In this situation, the IRS can reclassify all of the earnings and net profits received as wages that are subject to the self-employment tax.
LLCs avoid the double taxation of corporate profits and the civil liability of general partnerships.
Subchapter S corporations report revenues and expenses to the IRS annually on Form 1120S and accompanying schedules.
Net profits from the business then flow through to each owner on a pro rata basis and are reported on Part 2 of Schedule E of each owner's individual tax return. No dividends are paid, and all net profits are reported and taxed in the year in which they are earned. This allows Subchapter S corporation owners to avoid the "double taxation" of corporate profits to which C corporations are subject.
Subchapter S owners are generally only personally liable for judgments against the corporation to the extent of their investment in the company. However, officers can be held individually liable for unpaid withholding taxes and violations of environmental laws.
Limited Liability Company
An unlimited number of owners (called members) may own this business form. Owners receive "interests," similar to shares of a corporation, in return for investments of money, property, or services. An LLC may be run either by its members or by managers elected by the members.
If run by its members, each member has equal control over and authority to act on behalf of the business. If run by managers, the control and authority vests in the managers, and the members are merely investors.
Members usually risk only their investment in the LLC. Generally, a member's personal property cannot be used to satisfy obligations of an LLC. However, as with a corporation, members may be held personally accountable for withholding taxes and environmental violations.
An LLC is formed by filing Articles of Organization with a state's business registration office. Also it is a good idea for the members to enter into an Operating Agreement that governs the membership, management, operation, and income distribution of the business.
The IRS expects that the owner-employee will earn fair wages for her labor.
An LLC can elect to be taxed as a sole proprietor, a partnership, an S corporation, or a C corporation by filing Form 8832 with the IRS. It may avoid the greater taxation of corporate profits, depending on the tax classification chosen.
An LLC's profit or loss is reported on Schedule C of member's Form 1040 if taxed as a sole proprietor, on Form 1065 (informational return) and Schedule E of member's Form 1040 if taxed as a partnership, and on Form 1120 and on member's Form 1040 if taxed as a corporation.
The net profits are taxed as ordinary income but do not incur the self-employment tax. As with the other business forms, a member who works for the LLC must be paid a fair wage. Of course, FICA and Medicare taxes are withheld from the earned income.
It's important not to take the selection of a business form lightly. Each holds tax and legal advantages and disadvantages. A visit to a small business attorney and accountant will help you maximize the chances of success.
Published September 19, 2013