Choosing the right business structure can be a difficult task. To assist taxpayers who are starting their own business, the Treasury Department releases a fact sheet that lists the differences between the most common forms of business entities. The Treasury advises that each business structure should be evaluated from a tax, liability and recordkeeping perspective.
The Treasury's fact sheet summarizes some of the important traits of the four most commonly utilized business entities operating in the U.S. today:
The sole proprietorship is one of the most common types of business structure entities, in part because it is easily formed. The owner of a sole proprietorship is personally liable for the debts and other obligations of the entity. Additionally, a sole proprietor must pay self-employment tax and, since taxes are not withheld, must make quarterly estimated tax payments. Generally, a sole proprietor files Form 1040, Schedule C on their personal income tax return.
A partnership is a popular "pass-through" entity organized by two or more individuals.
Income, credits, deductions, profits, and losses pass through the partnership to the partners, who must report the information on their individual income tax returns (Form 1040).
No tax is paid at the partnership level, although a Form 1065, U.S. Return of Partnership Income, is filed in the name of the partnership. Since no tax is withheld at the entity level, partners must make quarterly estimated tax payments.
The LLC enjoyed a meteoric rise to popularity in the 1990s. The LLC is a creature of state law and every state, as well as the District of Columbia, has adopted statutory provisions governing the formation and operation of LLCs. The LLC is popular because, like a corporation, its members enjoy limited personal liability for the debts and other obligations of the entity, and like a partnership, it is a pass-through entity business structure.
All items of income, profits, loss, deductions, and credits pass through to individual members. In general, a LLC can have a single member or multiple members. A single member LLC is generally taxed, for federal tax purposes, as a sole proprietorship and a multi-member LLC is taxed as a partnership.
Like LLCs, the formation of a corporation business structure is governed by state law. Generally, corporations pay tax at both the state and federal levels. A corporation files Form 1120, U.S. Corporation Income Tax Return, and pays tax at rates. Corporate earnings that are distributed to shareholders as dividends are taxed at individual rates on shareholders' individual income tax returns. However, shareholders are shielded from personal liability as liability for the debts and other obligations of the entity rest with the corporation.
A Subchapter S corporation (commonly referred to as an S-corp) is a legal entity that follows state law like a corporation and the shareholders have only limited liability. However, it is similar, in some respects, to a partnership because income passes through the S-corp to individual shareholders, who report income and other items on their individual income tax returns.
To be treated as an S-corp for federal tax purposes, a corporation must file Form 2553, Election by a Small Business Corporation. An S-corp files Form 1120S, U.S. Corporation Income Tax Return for an S Corporation. This is an information return only. The income "flows through" to each shareholder's individual income tax return.
If you'd like a more detailed explanation of the strengths and weaknesses of a particular business entity, please contact my office.
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