You can operate your business as a sole proprietorship, partnership, corporation or limited liability company. Many people begin as a sole proprietorship and then change to one of the other business entities. Others choose to start as a partnership, corporation or limited liability company.
There are many factors — both tax and nontax — which influence your decision concerning which business entity to choose.
The main nontax factors that affect your decision are:
- Limited liability
- Ease of obtaining financing
- Availability of fringe benefits and retirement plans
The main tax factors that affect your decision to choose a business entity are:
- Applicable tax rates
- Double taxation
- The pass through of losses to the owners
Sole Proprietorships
Sole proprietorships are the easiest form of business to operate. All you do is include Schedule C and Schedule SE with your individual tax return. Your income minus your business expenses are taxed at your individual tax rate bracket and are subject to self-employment tax. If you incur a loss, the loss offsets your other income, such as wages, interest, and dividends, if you have been active in the business.
There are disadvantages, however, of operating as a sole proprietorship. For example, you, as the sole proprietor, are at risk for liabilities arising from the business. The main risks are lawsuits initiated by creditors, vendors, customers, and employees. Not only might you lose the business, but you could lose personal assets, such as your home, car, or savings. Insurance provides some protection, but many people choose to incorporate their businesses or operate as limited liability companies to help avoid this risk.
Corporations
There are two types of corporations, a C corporation, and the S corporation. Both types of corporations are legal entities that are completely separate from their owners. The existence of both types of corporations is made possible by state law. These laws, which vary from state to state, govern the creation, operation, and dissolution of the corporations. Regular corporations can have one shareholder or many shareholders. A regular corporation, as a separate tax entity, must file its own tax form, either Form 1120 or the simpler Form 1120-A. S Corporations are limited to 100 shareholders and file Form 1120-S.
The primary reason business owners choose to operate as a corporation is limited liability. Corporations, as separate legal entities, protect your assets from corporate liabilities. The reverse is also true: the corporate assets are protected from your personal liabilities. In other words, if you are a corporate shareholder and you comply with the numerous corporate formalities, such as keeping corporate minutes and holding shareholder meetings, you can generally only lose your investment in the corporation, not your personal assets.
Regular corporations: Currently, the income tax rates that apply to regular corporations are another advantage of operating as a corporation. Individual income tax rates on $50,000 of taxable income are at least 25%. Corporations with $50,000 of taxable income are taxed at a 15% rate. Individual income tax rates can be as high as 35%. The maximum corporate income tax rate is 35%. These differences mean that individuals can use corporations to shelter income from tax. This is often done by splitting income between a corporation and an individual to avoid paying tax at the highest income tax rates.
You earn $110,000 in your retail business. Because of your other income, you are in the 35% tax rate bracket. You would pay $38,500 ($110,000 x 35%) of Federal income tax on your retail business income. If your business was incorporated, it could pay you a $60,000 salary. You would pay $21,000 ($60,000 x 35%) of Federal income tax on your salary, and your corporation would pay $7,500 (($110,000 - 60,000) x 15%) of Federal income tax. Thus, you would decrease the Federal income tax $10,000 ($38,500 - ($21,000 + $7,500)).
Congress, in an effort to curb this income-splitting maneuver, eliminated the lower tax rate brackets for personal service corporations. In other words, corporations owned and operated by doctors, lawyers, accountants, and engineers are subject to a flat 35% tax rate. For other corporations, however, income splitting is possible.
A second reason you may choose to operate as a regular corporation is the availability of nontaxable fringe benefits, retirement plans, and incentive compensation plans. As an employee of the corporation, you can take advantage of nontaxable fringe benefits, such as life and health insurance and cafeteria plans. Corporations can also offer many types of retirement plans, including pension and profit sharing plans. To attract and retain quality people, many corporations also offer incentive compensation, such as restricted stock and stock options. Sole proprietorships, partnerships, limited liability companies, and S corporations cannot offer the full range of compensation packages that are available through a regular corporation.
One of the biggest advantages of choosing the regular corporate form is the numerous options for raising money. Your corporation can borrow money by getting loans from people or banks or by issuing bonds. Your corporation can also raise money from the general public or people involved in the business by issuing different types of common and preferred stock, including voting and nonvoting stock.
Although there are many advantages of operating in the regular corporate form, there are two significant disadvantages. First, it is possible for corporate income to be taxed twice. Double taxation occurs when a corporation is taxed on its income and then pays you, the shareholder, a nondeductible dividend. You pay taxes a second time on the dividends. This negative aspect of corporate taxation is overemphasized for two reasons. First, if dividends are paid, you pay tax at a 15% (0% for 2008 and 5% for 2007 if you are in the 10% or 15% marginal tax rate bracket) income tax rate. Second, you can avoid paying a second level of tax by not paying dividends. Your corporation can make deductible payments to you and other shareholders in a variety of ways, including wages, interest payments, and rent payments. Although the Internal Revenue Service will scrutinize deductions that are unreasonable, making payments deductible in these ways leads to one level of taxation. This is similar to the taxation of a sole proprietorship or partnership.
The second disadvantage of operating in the corporate form is that you cannot deduct the losses of regular corporations on your individual tax return. The losses are trapped inside the corporation where they may be carried back or forward to other years when the corporation has income. The losses of active owners of sole proprietorships, partnerships, S corporations, and limited liability companies are deductible on the owner's individual tax returns. Because of the way losses are treated, the corporate form may not be the best alternative for start-up businesses.
S Corporations: For state law purposes, S corporations are not distinguished from regular corporations. However, the Federal tax laws treat S corporations differently. Although the S corporation may owe some taxes at the corporate level, generally the net income of an S corporation passes through to you, the shareholder. It is taxed on your individual income tax return. S corporations file Form 1120-S and report your share of the income on Schedule K-1.
The tax advantages of S corporations are:
- Income is only taxed at the individual level.
- Non-wage income is not subject to employment taxes.
- Losses pass through to the individual owners.
The disadvantages are:
- S corporations cannot have more than 100 shareholders.
- S corporations cannot provide the range of tax-free fringe benefits that a corporation can to its owners.
Partnerships
If you and another individual own and share the profits and losses of a business, you may be a partnership and not realize it. As a partnership, your relationships with your partners and with the public are governed by state law. In a general partnership, all partners have equal status and are at equal risk, though their shares of partnership profits and losses may be different. In a limited partnership, one or more partners run the business and assume a substantial portion of the risk. The other partners, by agreeing not to play an active role in the business, limit their risk to the amount they invest in the partnership. Although partnerships are merely reporting entities that do not pay taxes, both general and limited partnerships must report their income and expenses on Form 1065. You, as a partner, show your share of partnership income or loss on your individual tax return.
The main advantages of operating in the partnership form are:
- The possibility of losses passing through to you
- Lack of formality governing the business operations
- Taxation of partnership income at only the individual level
Disadvantages of operating as a partnership include:
- The risk of loss because of the lack of limited liability
- Pass through income subject to self-employment tax
- Limitations on fringe benefits that can be offered
Limited Liability Companies
Limited liability companies (LLCs) and limited liability partnerships (LLPs) are the newest forms of business entities. LLCs and LLPs offer you liability protection similar to corporations and flow-through of income and losses similar to partnerships and S corporations. This is an almost perfect blend of the attributes of corporations and partnerships. LLCs and LLPs offer an advantage over S corporations because the number of owners is not restricted. However, similar to S corporations and partnerships, LLCs and LLPs cannot offer the tax-free fringe benefit packages available to corporate employees.
Although LLCs and LLPs are probably the entities of the future, at this time there are many unresolved issues. The rules governing LLCs and LLPs in the various states are not the same. In other words, LLC and LLP owners may not have personal liability protection in states where the rules are different from those in the LLC's or LLP's home state.
In summary, choosing the best business form for your situation is important in the formative years of your business. If you are considering forming a business entity, talk to a CPA or an attorney about the consequences of that business form in your state. Tax consequences vary from state to state, and there may be tax consequences when changing the form of ownership of your business.
Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LL.M., CPA, CFP, are the authors of 101 Tax-Saving Ideas, 9th edition, published by Wealth Builders Press. To order ($27.95), call 816-561-1400, fax 816-561-6296 or email
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