Choosing the business structure that best meets your needs is a critical decision: you must consider both non-tax and tax ramifications. This article looks at three of the most popular choices: sole proprietorships, partnerships and limited liability companies.
Selecting the legal structure for your company is one of the most important and far-reaching decisions that you will make as you start your business.
To make the best decision, you must carefully consider your initial choice of business entity from multiple angles, including ownership/control of the business, asset protection, and tax minimization.
You must also regularly re-evaluate your decision to make sure that it is still the best suited for your business and personal needs.
For example, you may begin running your business as a sole proprietorship. However, as the business grows, you may wish to bring in co-owners or to have a different capital structure. Or, you may want to restructure your business in order to shield your assets from business liability.
The most common business entities are:
- sole proprietorships, including husband and wife joint ventures
- limited liability companies
- regular "C" corporations
- S corporation
Each different entity choice brings its own set of advantages and disadvantages. No one entity is the perfect choice under all circumstances. Selecting the best entity for your business involves considering both tax issues and non-tax issues. The following are some factors that must be considered.
- Annual tax obligations. Will you have to file separate business returns and pay business-level tax?
- Compensation and benefit packages. How can you take income out of the business? What is the tax impact of those payments?
- Reorganizations. How easy is it to modify the capital and ownership structure of your business?
- Business termination. What is the impact of a business termination—this varies considerably based upon the business entity type?
Although tax planning is an important aspect of your growing business, tax considerations should never trump overall sound business decision-making. When selecting a choice of entity, remember to consider nontax issues as well. These include:
- Business expansion. The choice of entity affects can affect how you operate and grow your business.
- Asset protection. Different entity forms offer radically different degrees of protection from business and non-business creditors;
- Estate planning. The choice of entity can impact your estate planning and your estate tax liability.
This article focuses on the annual income tax impact of sole proprietorships (including husband and wife joint venture), partnerships, and limited liability companies. The tax aspects of corporations, both regular and S corporations, are discussed in our article, "S and C Corporations Create Different Tax Consequences."
Sole proprietorships are individual's alter ego
A sole proprietorship is an unincorporated business with only one owner (or which is owned by a husband and wife who elect to be treated as one owner). Although this is the most common form for a new small businesses, it is not necessarily the best choice when both tax and non-tax factors are considered.
For tax purposes, you do not have to elect to have your business treated as a sole proprietorship if there is only one owner. If there is only one owner, the IRS will presume that it's a sole proprietorship—unless you incorporate under state law or form a limited liability company that elects to be treated as a corporation.
A single-member LLC is a 'disregarded entity' for federal tax purposes. (It still provides asset protection.) You report the income and the expenses of the business using Schedule C and carry that information over to your personal Form 1040.
A sole proprietorship is not a taxable entity. All of the business's assets and liabilities are treated as belonging directly to you, the business owner. In the same way, all the business income and expenses are considered to be your income and your expenses.
You reflect income and expenses on either Schedule C, Profit or Loss from Business, or Schedule C-EZ, Net Profit from Business, which is included as part of your annual individual tax return (Form 1040).
Doug operates his tattoo business as a sole proprietorship. His business income was $400,000. Doug reports this income on Part I of his Schedule C. He reports his business expenses, including such expenses as the tattoo inks, his employees wages, advertising and depreciation on Part II of Schedule C. The expenses are then subtracted from the gross income to arrive at the net profit (or loss) figure at the bottom of the form.
The net profit or loss is then carried over from the Schedule C and reported on page one of Doug's Form 1040, U.S. Individual Income Tax Return.
There is no separate tax rate schedule that applies to a sole proprietorship. The business owner's individual tax bracket determines the amount of tax paid on the earnings of the sole proprietorship.
Simplicity is the primary advantage of a sole proprietorship—not only for federal income tax purposes, but for accounting and other record keeping. As the business owner, you can take money out of the business or put it into the business without worrying about tax record keeping or corporate formalities.
Sole proprietors are liable for self-employment tax
While a sole proprietor does not have to worry about withholding and paying employment taxes on funds that you take out of your business, you do have to calculate and pay self-employment tax, if you have more than $400 in net earnings during the tax year. This tax is imposed on all of the business's net profits, over the $400 threshold. You compute the amount you owe using Schedule SE, Self-Employment Tax, which is attached to your Form 1040.
Sole proprietors must pay estimated tax
For each quarter, a sole proprietor generally needs to make an estimated tax payment that includes income tax and self-employment taxes.
Joint ventures operated by spouses can be sole proprietorships
The sole proprietorship is, by definition, a single-owner business. However, many spouses operate family business and both consider themselves to be an owner of the business.
When spouses consider themselves joint owners of a business, the IRS considers this joint operation to be a "partnership" — even if there is no formal partnership agreement. As a result, the IRS takes the position that the couple should file a partnership return and issue Schedule K-1s to themselves, rather than reporting the business income and expenses on a Schedule C. This can add unpleasant complexity at tax return time.
However, there are three options that you can use to avoid having to file a partnership tax return for your business. Which one makes the most sense for you and your spouse depends on the level of involvement each of you have in the business.
- One spouse is minimally involved. If only one of you is deeply involved in running the business, then your business is a classic sole proprietorship. This means that you can file as a sole proprietor, even if your spouse does a minimal amount of work for the business or if you consult him or her before making major decisions.
- Both spouses actively work in the business. If both you and your spouse put significant amount of effort into the business, you might want to treat one of you as the owner for tax purposes and treat the other as an employee or independent contractor. You would want to talk through both scenarios—employee versus independent contractor—with a tax professional and run the numbers to see which option is best. Either one will save you the hassle of partnership returns and can generate additional deductible business expenses.
- Both spouses are true owners. If both you and your spouse are actually co-owners of the business, then you can make a special election to be treated as a "spousal" joint venture.
The spouse of a sole proprietor will get the same amount credited toward Social Security as the sole proprietor does. Before 2007, a spouse had to file his or her own Schedule C or draw a paycheck to get credit. As a result, many spouses weren't accumulating credits toward Social Security. Now, both spouses will get equal credit from a joint tax return.
Electing qualified joint venture treatment
If you and your spouse each are active in the business and you file a joint return, you can elect to have the business treated as a qualified joint venture rather than as a partnership for tax purposes. The two spouses can be the only members of the joint venture. If there are other individuals in the enterprise (even other family members, such as children), the provision does not apply. Additionally, both spouses must materially participate in the business.
If this election is made, each spouse takes into account his or her share of income, gain, loss, and other items as a sole proprietor. Instead of filing Form 1065 (and issuing yourselves Schedule K-1s reporting your shares of the income and expenses) you each file a Schedule C (or Schedule C-EZ) and report the income and deductions directly on your joint return. This election will continue to be in effect unless you receive the IRS's permission to change it or you no longer meet the conditions for making the election.
Under many state marital property laws, both spouses may be considered to be owners of the business assets in case of divorce, regardless of whose name is listed as the owner on the tax forms or the property records.
Partnerships and LLCs pass through income, deductions
Partnerships and limited liability companies (LLCs) are not separate taxable entities. This means that no federal tax is paid at the partnership or LLC level: All business income and deductions are passed through to the partners or members.
However, the non-tax ramifications of partnerships versus LLCs are significant.
From the standpoint of asset protection, a partnership is an extremely risky way to operate your business. Not only can your business creditors get to your personal assets, you are personally liable for the actions of your partners. See our article, Sole Proprietorships and General Partnerships Can Be Risky Business Forms, for more information.
Partnerships pass through income and deductions
A partnership is an unincorporated business with two or more owners. If your unincorporated business has more than one owner, the IRS will treat your business as a partnership, unless you elect to be taxed as a corporation by filing IRS Form 8832, Entity Classification Election.
A partnership is not a taxable entity under federal law. This means that there is no separate partnership income tax, as there is a corporate income tax. Instead, income and losses from the partnership are divided among the partners and each partner reports his/her share on his/her individual tax return and pays taxes at the individual tax rates.
Although it is not required to pay federal income tax, a partnership is required to file Form 1065, U.S. Return of Partnership Income, to report its income and loss to the IRS. The partnership also reports each partner's share of income and loss on Schedule K-1 of the Form 1065.
For tax purposes, all of the income of the partnership must be reported as distributed to the partners, and they will be taxed on it through their individual returns. This is true whether or not the partners actually received their shares of the income, and even if the partnership agreement requires that the money be retained in the business as partnership capital.
Partnerships are generally one of the most flexible forms of business for tax purposes because the share of income and losses distributed to each partners can vary and the percentage of profits and differ from the percentage of losses—provided that you can show a business purpose other than tax avoidance for the division.
For example, one partner can receive 40 percent of any profits, but 60 percent of any losses. This can be very helpful in the early years, when most businesses generate losses, not profits. The partnership allocations can allow one partners to use these losses to offset other income that he or she has from investments or another job.
One caveat: the partners may not deduct losses that exceed the amount of their investment in the business. But any losses that can't be deducted as a result of this rule can be deducted in subsequent years if the partner increases his or her investment.
Tax treatment is determined at partnership level
Although the individual partners (not their partnership) are the ones paying the income tax, most of the choices affecting how income is computed must be made by the partnership, rather than the individual partners on their own returns.
These choices include:
- elections of general methods of accounting,
- methods of depreciation, and
- accounting for specific items such as organization and business start-up expenses and installment sales.
Partners are required to treat partnership items in the same way on their individual tax returns as they were treated on the partnership return.
There are a number of nontax factors that may influence your decision as to whether a partnership is the right form of business for you, and we recommend that you seek legal advice in setting up a partnership and writing up the partnership agreement.
LLCs pass through income, deductions to members
The limited liability company (LLC) is an entity created and governed by state law that has characteristics of both a corporation and a partnership. Under state laws, LLC owners generally have the protection from liability that used to be available only to corporate shareholders. Every state has enacted legislation providing for limited liability companies, although there are slight variations from state to state.
Federal tax law determines the taxation of an LLC by either:
- a default classification based upon the number of members that the LLC has
- an election by the LLC to be taxed differently than the default treatment.
Most—but not all—states will honor the federal classification and tax the LLC accordingly. However, this is not true in all cases. You'll need to check your state tax laws to learn the rules for your state.
Number of members determines default classification
A single member LLC is disregarded for federal tax purposes and is treated as a sole proprietorship whose owner must file a Schedule C with their Form 1040. If there is more than one member, then, by default, the LLC is treated as a partnership. This means that the LLC must file a Form 1065, U.S. Partnership Return of Income and send each member a Schedule K-1. The members report the amounts shown on their Forms K-1 on their own Forms 1040.
Electing out of default treatment
If you do not want your LLC taxed under the default classification, then you can file Form 8832, Entity Classification Election, and elect to be taxed as a corporation. This form needs to be filed only if you don't want the default classification to apply for federal tax purposes.
How do LLCs compare to S corporations?
While S corporations also provide limited liability for their owners and favorable pass-through tax treatment, LLCs do provide some additional advantages to growing businesses. Like a partnership, an LLC has the ability to make disproportionate distributions to its owners (for example, a LLC member may have a 50 percent ownership interest in LLC assets but be entitled to 60 percent of the income, if the operating agreement so provides).
In contrast, S corporations must generally make all distributions pro-rata in accordance with the number of shares held by each owner. Also, an LLC can have an unlimited number of investors, whereas an S corporation is limited to 100 shareholders.
However, there are also a number of potential downsides to operating as an LLC that is taxed as a partnership. Recent law changes require the prudent tax planners (and business people) revisit the conventional wisdom that the default LLC classification is the best tax choice. An S corporation shareholder can receive both salary and dividend income from the business.
This provides for three significant advantages.
- Dividend income is not subject to the self-employment tax.
- Dividend income is not included in determining your earnings for purposes of the 0.9 percent surtax on earning income over $200,000 per year ($250,000 for a married couple).
- Dividend income from your active trade or business is not considered net investment income that may be subject to the 3.8 percent net investment income tax.
Other factors to consider. There are a number of nontax factors that may influence your decision as to whether a LLC is the right form of business for you. We recommend that you seek legal advice in setting up a LLC and writing up the operating agreement.