Choosing the right business entity for your business is an important consideration. The business entity you choose can determine many things, including how your business operates and the legal protections you have.Another key consideration in choosing your business entity is taxes. Each of the business entities has different tax mechanisms and implications. In order to choose wisely, it’s important to have the right information about the tax policy that your business will fall under.
Here is a closer look at four common business entity types and their tax rules.
What Is a Business Entity?
A business entity or business structure is the legal framework for your business. It’s an important factor for entrepreneurs launching a business.
While the business entities does not have a major impact on your day-to-day business operations, it can greatly shape how ownership is defined, the legal liability implications of ownership and tax management.
Determining a business entity type is important. It allows you to register the business, if applicable in your state, open a business banking account, apply for financing, hire employees and enter into contracts.
A sole proprietorship is the simplest business entity type. It involves a single individual starting a business that is unincorporated. The business may hire employees but is typically managed by the proprietor themselves.
Essentially, the sole proprietorship entity type makes no distinction between the owner and the business. The business owner is entitled to any profits generated by the business. However, the owner is also responsible for any debts, liabilities and business losses. Creditors and claimants in lawsuits can come after the owner’s personal property, such as houses, cars, savings and other assets.
From a tax standpoint, a sole proprietorship keeps it simple. The business owner enters all their business income and losses on their personal tax return. There are no additional taxes levied at the federal or state level.
Money that you earn is all taxable, whether or not it’s in your personal or business bank account. It’s also smart to make quarterly tax payments.
As a business owner, sole proprietors are able to deduct expenses from your business on Schedule C. Those costs include:
- Business-related travel
- Operating expenses
- Payments to independent contractors
- Legal and professional services
- Insurance payments
- Office supplies
- Repairs and maintenance
Sole proprietors may also be responsible for paying self-employment taxes to Medicare and Social Security.
There are several types of partnership business entities you can select as your business entity. Each has its own traits and advantages. All partnerships are businesses shared by multiple owners. The most basic partnerships do not need to be registered with the state where you operate but other partnership entities do.
The partnership is legally inseparable from its owners. Profits, losses, debts and liabilities all pass through to the owners’ personal income tax returns. They are less costly and easier to create than corporations.
Here are the four partnership types.
The general partnership is the most basic partnership type. Partners typically form the business by forming a partnership agreement. Typically, ownership and profits are split evenly, although different terms may be drawn up in the partnership agreement.
All partners have the power to enter into contracts that legally bind the business. Each partner is also personally liable for any debts or legal obligations issued against the business.
Limited partnerships have at least one general partner, who is responsible for the business, and one or more limited partners who provide financing for the business but do not have an active role in the day-to-day operations. The limited partners invest in the business for financial reasons and are not responsible for any debts or liabilities.
These silent partners can share in the business’ profits but may not incur any losses beyond their initial investment. If limited partners become active in the management of the business, they may lose their status as a limited partner and the related protections.
Limited Liability Partnership
A limited liability partnership (LLP) acts like a general partnership but all partners are actively involved in managing the business. The partners, however, are limited in the liability they incur from the actions of their fellow partners.
Partners bear full responsibility for any debts or other liabilities but are not responsible for the mistakes of other partners. Some states do not allow LLPs or limit them to certain business types, such as physician practices, law firms or accounting firms.
Limited Liability Limited Partnership
This newer entity type is available in some states. It operates like a limited partnership with a general partner that runs the business. However, the general partner’s liability is also limited in the same way it is for limited partners. Because they are not approved in all state, the LLLP is not a good choice if your business operates in multiple states.
Tax Implications for Partnerships
Simple partnerships are treated like sole proprietorships, with the business income and expenses reflected on each partner’s individual tax return. If there are distributions of losses and revenue laid out in a partnership agreement, those proportional amounts are also reflected on personal tax returns.
The partnership itself will file information about its annual income, deductions, losses and gains but is not subject to a separate tax levy. Instead, the information is stored on the Schedule K-1 form that each partner will file with their personal return. The Schedule K-1 is similar to, but less detailed than, the Schedule C filed in a sole proprietorship. Cost information is filed with a partnership’s annual reporting on Form 1065.
Limited Liability Company
The limited liability company (LLC) business entity type is one of the most popular, with good reason. In an LLC, the business is easy to form and maintain, with less administration and paperwork required.
Owners are “members” and the business can be operated by either members or a manager hired for that purpose. An LLC can be a single- or multi-member entity. To establish an LLC, some entrepreneurs opt to file the appropriate paperwork themselves. Many business owners, however, choose instead to use a registered agent service that handles the paperwork of filing and managing the official paperwork delivered by the state or a third party related to a lawsuit.
Many consider the LLC to be a hybrid business entity or “the best of both worlds,” because it has features of other business entities. The owners can make elections that determine both how the business operates but also how it is perceived legally.
Because the LLC is a separate legal entity, individual owners are not personally liable for any debts or legal judgements against the business.
From a tax perspective, an LLC has interesting characteristics. The LLC owners can choose the way in which the Internal Revenue Service (IRS) treats the business – as a corporation, partnership or disregarded entity, meaning the LLC is taxed on an owner’s individual return, much like in a sole proprietorship. A single-member LLC can be treated as either a sole proprietorship or a corporation. A multi-member LLC can be treated as either a partnership or a corporation.
Corporations are business entities that are formed as independent legal entities. There are two common corporation business types:
- C-corporation (C-corp). Independent of its founders, the C-corporation structure means founders are not liable as individuals. The C-corporation is bound by more government oversight than other business types. The corporation must have bylaws and a board that meets regularly. The C-corporation is a good option for founders who want to pass along the business to heirs
- S-corporation (S-corp). An S-corporation provides founders with the same liability protections as a C-corp. However, growth can be limited as the S-corp is limited to 100 shareholders
From a tax perspective, the corporation is a complex business entity. The corporation will file its own tax return and be subject to taxation at business rates at the federal and state levels. As an owner, you are not taxed on the corporation’s profits.
However, corporations are criticized for being subject to double taxation. That’s because the C-corporation structure means owners are taxed on amounts the corporation pays you via dividends or salary. The corporation gets taxed and then you are taxed. It’s a situation that often dissuades some small businesses from choosing this business entity type.
The S-corporation is different, in that the taxes are factored in on the owners’ individual tax form, like for that of a sole proprietorship.
Business entities are varied, diverse and unique. Choosing the right business entity for your business is an important consideration. Factoring in the tax implications of business entities needs to be a key part of your decision-making process.