Tax & Business Services

How you structure your small business will determine how you run the operations, employ workers, and pay state and federal income taxes.

There are many different types of business entities: sole proprietorship, general partnership, C Corporation, S Corporation and LLC (Limited Liability Companies). Learn more about each of these options and see which is the best choice for your business.

Sole Proprietorships
A sole proprietor is an individual operating a small business as a self-employed person. The owner is liable for all business debts and actions and receives all the profits and losses from the business. If the proprietor's net self-employment income is $400 or more, he or she also pays self-employment tax.

Advantages

• A sole proprietorship is an easy start-up business to organize.
• There are few legal restrictions.
• The proprietor has total decision-making control.
• Recordkeeping and accounting are relatively easy.
• If the owner wishes to dissolve the small business, he or she can do so easily and with minimal federal income tax consequences.

Disadvantages

• The proprietor (and spouse, if a joint return is filed) bear(s) the total legal and financial risk for the small business.
• The owner's liability extends beyond the business property to his or her personal property.
• The owner may have trouble raising needed capital.
• Business skills are limited to the owner's (and his or her employees') ability.
• Personal federal income tax cannot be deferred by retaining profits.

Partnerships
A partnership, either general or limited, is a contractual association of 2 or more persons carrying on a business. Each partner contributes property or services and shares in the profits. Partnership formation can be informal and inexpensive.

Limited partnerships differ in that a limited partner has only a limited amount of liability in the company. That limited liability is equal to the amount that the partner has invested into the company.

Advantages

• A partnership is an easy start-up business to organize. It provides a vehicle under which spouses can be considered equal owners in a business.
• Because children may be partners, some income may be taxed at lower rates than if it were all reported on the parents' federal income tax return(s).
• A partnership offers better financial strength than a sole proprietorship, and more than 1 person's skills and judgments are available.
• A partnership has legal status.
• Each partner has an interest in the small business, and active partners may use losses to offset other income.
• The partnership may or may not dissolve on the death of a partner, and partnership interests may be sold to others.

Disadvantages

• The partners generally take all the risks in a partnership, and general partners are liable to the extent of both business and personal property.
• Limited partners' losses are subject to the passive loss rules. For purposes of the passive loss rules, income must be divided into 3 categories: active income, passive income and portfolio income. Passive income is income for assets such as real estate. General partners must be able to show material participation to avoid passive loss limitations.
• Shared decision-making may create problems among the small business decision-makers.
• General partners must pay self-employment tax on the partnership's trade or business income.
• Federal income tax cannot be deferred by retaining profits at the partnership level; partners pay tax on partnership income whether it is distributed or not.
• Disagreements among partners may be difficult or impossible to resolve.
• State and federal reporting requirements apply.
• The business terminates if more than 50% of the ownership changes.

Taxable (C) Corporations
A corporation is a business entity with its own legal identity, rights and liabilities. Characteristics of a corporation include continuity of life, central management, limited liability of the owners (stockholders or shareholders), and free transferability of ownership. In general, a corporation is formed by incorporating under state law by filing articles of organization and paying the state's incorporation fees.
Advantages

• A corporation exists until it is dissolved; it does not dissolve at the death of a shareholder.
• A corporation may have 1 or many shareholders.
• Ownership transfers through stock sales have no tax effect on the company and are easy to accomplish.
• Capital can be raised through stock sales.
• Management duties are shared.
• A corporation offers limited liability; in general, a shareholder is liable only to the extent of his or her investment in the corporation and for debts he or she personally guarantees.
• A corporation can offer tax-sheltered fringe benefits to its employees, including shareholder-employees.
• Corporate tax rates may be lower than individual rates.
• Children can own stock.

Disadvantages

• Corporate income is taxed twice, once at the corporate level and again at the shareholder level as dividends. Although the Jobs and Growth Act of 2003 has reduced the federal income tax paid on qualified dividends, the double tax still applies.
• Personal service corporations are taxed at a rate of 35%.
• Corporations can be difficult and expensive to organize, and the corporate charter restricts the types of business activities a corporation can pursue.
• Corporations can have complex legal and accounting requirements, which is not bad unless the stock is publicly traded.
• Shared decision-making may create problems among the decision-makers.
• A corporation cannot simply stop doing business but must liquidate, and liquidations and distributions of corporate assets are taxable events.
• The corporation's losses can only offset corporate income. Corporate losses are not passed through to shareholders but instead are carried to years when the corporation has profits.

S Corporations
An S corporation is a "pass-through" entity formed by filing Form 2553 with the IRS. S-corporation income and losses are passed through to the shareholders; income is taxed at the individual level. An S corporation must meet certain restrictions regarding its shareholders and cannot be included on a consolidated return. However, an S corporation can be a partner in a partnership or own all or part of other corporations. S corporations must satisfy state incorporation requirements.

Advantages

• S corporations offer limited liability. In general, a shareholder is liable only to the extent of his or her investment or debt he or she personally guarantees.
• Net S corporation income is not taxed at the corporate level.
• It is possible to shift income by giving children shares of S corporation stock.
• The business does not dissolve at the death of a shareholder. Some or all beneficiaries in a family S corporation can actively carry on the business.
• Materially participating shareholders can offset other income with S corporation losses.
• Shareholder-employees are not subject to self-employment tax on S corporation profits, and income is taxed only at the shareholder level (unless the S corporation has accumulated C-corporation earnings and profits).

Disadvantages

• An S corporation can have no more than 100 shareholders and cannot have nonresident alien shareholders. The S corporation can have only individuals, estates and certain trusts as shareholders.
• An S corporation only has limited flexibility in choosing a tax year.
• Shareholders are taxed on S corporation profits, whether the profits are distributed or not.
• Children are employees of the corporation, so the FICA/FUTA exemptions for children employed by their parents do not apply.
• Shareholder-employees who perform services and are paid little or no wages are likely to have distributions reclassified as wages.
• Fringe benefits provided to more-than-2% shareholders are subject to tax. Qualified retirement plan contributions are based on the employee shareholder's wages, not on the overall profits of the company.

LLCs
A limited liability company (LLC) is a hybrid organization combining the pass-through ability of a partnership with the limited liability features of a corporation. LLCs are organized under state law; there are filing fees associated with the organization of the LLC. LLCs with 2 or more members are taxed as partnerships unless they elect to be taxed as corporations. A single-member LLC is taxed as a sole proprietorship unless it elects to be taxed as a corporation.

Advantages

• An LLC can have more than 100 owners. It can be owned by a corporation or be part of an affiliated group.
• LLCs need not make a special IRS election to receive LLC treatment (unlike S corporations with Form 2553).
• Gains, losses and other tax attributes are not taxed at the entity level but pass through to the LLC members.
• In general, no gain is recognized on the transfer of property to the LLC by from its members or on distributions of property other than cash to a member until the member disposes of property.

Disadvantages

• LLC managers are subject to self-employment tax on the entity's trade or business income.
• Members must pay income tax on LLC profits even if the profits are retained by the LLC.
• LLCs must set termination dates and must terminate if their ownership changes by 50% or more in a 12-month period.
• An LLC may need to file as a tax shelter if it has members who are treated as limited partners or "limited entrepreneurs" (persons who are not limited partners and do not actively participate in the LLC's management).