One of the most important decisions to make when starting a business is the legal form (sole proprietorship, corporation, limited liability company, etc.) in which you will operate. And as your business grows, you may want to change forms to accommodate more owners, a different capital structure, or shield your growing wealth from business liability. Be sure to weigh the tax considerations associated with the business type you choose.
Choosing an incorporation type
You have many choices when it comes to incorporating a business, including:
Sole proprietorship tax considerations
The business and the owner are legally the same. From the IRS's perspective, the business is not a taxable entity. Instead, all of the business assets and liabilities and income are treated as belonging directly to the business owner.
General partnership tax considerations
As with sole proprietorships, the business and the owners (two or more) are legally the same. A partnership is not a taxable entity under federal law. There is no separate partnership income tax, as there is a corporate income tax. Instead, income from the partnership is taxed to the individual partners, at their own individual tax rates. For tax purposes, all of the income of the partnership must be reported as distributed or “passed-through” to the partners, who will then be taxed on it through their individual returns.
Limited liability company (LLC) tax considerations
A separate legal entity created by a state filing. Under state laws, LLC owners are given the liability protection that was previously afforded only to owners of a corporation (shareholders). Now, LLCs are treated like partnerships for federal tax purposes (unless they elect to be treated like a corporation, which most don’t). LLCs have “pass-through” taxation, which means that no tax on the LLC’s income is paid at the business level. Income/loss is instead reported on the personal tax returns of the owners, and any tax due is paid at the individual level. Keep in mind, even though LLCs are treated as partnerships for federal tax purposes, the same is not always true for state tax purposes.