Business Entity Choices
One of the first decisions you’ll have to make as a new entrepreneur is what type of business entity you should form.
There are four main business entity structures to choose from, each with their own benefits and drawbacks - the sole proprietor, a partnership, a corporation and a limited liability company. The choice you make will have legal and tax ramifications, so taking the time to learn about the various options available could save you from a headache down the road.
Sole Proprietor
A Sole Proprietor has one owner and is the simplest entity to form, maintain and dissolve. Income and expenses are reported on IRS Form Schedule C on the individual tax return. In addition to income taxes calculated on the net profits of the company, the owner is subject to self-employment taxes at a rate of 15.3% of net income. Self-employment taxes are contributions to the social security and medicare systems. The business owner is liable for all business debts and actions of the company. To maintain a level of personal privacy, it is recommended that the sole proprietor register a DBA (doing business as) with their local county or state government.
Partnership
A Partnership is an entity type that has two or more owners. Business income and expenses are reported on IRS Form 1065, with the net income or loss flowing through to the partners onto their individual tax return. Similar to the sole proprietorship, in addition to income taxes at regular rates, self-employment taxes are calculated on the net income of the company for general partners. In lieu of wages, the partners take guaranteed payments. General partners are personally liable for all partnership debt.
Corporation
A Corporation carries its own legal status, separate and distinct from its owners. A corporation can elect to be taxed as an S-Corporation, which most small to medium sized businesses choose to do. Business income and expenses are reported on IRS Form 1120-S. Similar to a partnership, the S- Corporation itself does not pay taxes. Rather, net income or loss flows through to the shareholders’ individual returns on Schedule E. Owners are required to take a reasonable salary through payroll. Different from sole proprietorships and partnerships, net income is not subject to self-employment taxes. This is because social security and medicare taxes are withheld through paychecks. If the shareholder has basis in the company, they can take distributions of profit in addition to payroll. Shareholders are not personally liable for debts of the corporation unless they signed a personal guarantee.
Limited Liability Company
An LLC is a liability-limiting entity formed under state law. It is treated as a disregarded entity for federal income tax purposes. By default, the owners of an LLC will be taxed as a sole proprietor or partnership, depending on the number of owners. They can however, elect to be taxed as an S-Corporation if they so choose. This election can be made at any time and does not have to be made when the entity is formed. The degree of liability protection for LLC members varies from state to state. Generally, an LLC has the limited liability characteristics of a corporation.
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