Ready to start a new business? Before you do, know that the structure you choose will affect how your business is taxed and your potential liability exposure.
If you are the only owner, you can choose to operate your business as a sole proprietorship. (It is also possible for spouses to conduct a single business as a sole proprietorship.) For federal income-tax purposes, you report your business income and expenses on Schedule C, an attachment to your personal return (Form 1040). Net earnings from the business are subject to both self-employment taxes and income taxes.
One significant issue for a sole proprietorship is the lack of liability protection. The sole proprietor’s personal assets can be used to satisfy the claims of business creditors.
A corporation is a separate legal entity that transacts business in its own name. Although a corporation can be large and have thousands of shareholders, even a small business with one owner can incorporate.
C corporations. The corporation files its own income-tax returns and uses a corporate tax rate schedule to figure the taxes due.
The two main ways that the owner takes money out of a corporation are through a salary and dividends. Generally, the owner’s salary may be deducted by the corporation as a business expense. The corporation may also choose to distribute corporate earnings as dividends to the shareholders. However, the income will be taxed a second time to the shareholders, and the corporation will receive no deduction for the dividend payments.
Assets of the corporation are separate from those of the shareholders, so creditors may generally look only to the corporate assets for satisfaction of their claims.
S corporations. An S corporation offers the limited liability of a corporation without the double taxation associated with dividend distributions from a C corporation. The S corporation files income-tax returns but generally does not pay federal income taxes itself. Instead, the shareholders are taxed individually on their respective shares of the corporation’s taxable income.
When S corporation shareholders perform services for the entity, the IRS may treat dividends paid in lieu of reasonable compensation as wages subject to employment taxes.
A partnership has two or more owners. It must have at least one general partner who is liable for the partnership’s debts and obligations, though other investors may limit their potential liability by taking limited partnership interests.
Partnerships do not pay federal income taxes but must file an informational return with the IRS. Profits and losses are divided among the partners according to the terms of the partnership agreement and are taxed to them individually.
Limited Liability Company
A limited liability company (LLC) is a separate legal entity that can have one or more owners (called “members”). Depending on the elections made by the LLC and its members, the IRS will treat it as a corporation, a partnership, or as part of the LLC owner’s individual tax return.
Source: Freeman & Goldberg
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