Entity Formation Fundamentals
Entity Formation Fundamentals One of the most important steps in any tax strategy is determining what entity should be formed to hold your businesses and investments. For legal purposes, there are four basic types of entities: sole proprietorship, partnership, corporation and limited liability company. The entity you choose should take into account both the tax effects of the entity and the legal aspects of the entity.
-Sole Proprietorship- Let's examine the tax and legal aspects of each entity, beginning with the sole proprietorship. A sole proprietorship is not really an entity. It's what happens when you don't have an entity and you don't have any partners. Sole proprietorship is the simplest form of business. You simply report your income on Schedule C of your personal income tax return. You don't have to keep a balance sheet and only a limited income statement. Sounds good, right? Wrong! This is one of the worst forms of business both from a tax and a legal standpoint.
From a tax standpoint, not only will you pay income taxes at your highest marginal tax rate on all of your income, you will also pay self-employment taxes on 100% of your income. And you will be at least 4 times more likely to be audited by the IRS than any other business structure. So unless you have a loss in your business, you will pay the highest rate of tax in a sole proprietorship.
If that's not bad enough, the legal side of a sole proprietorship is even worse. Not only are you liable for all of your actions, you are personally liable for all of the actions of your employees. Don't take our word for it; ask your attorney. They will confirm that a sole proprietorship provides absolutely NO asset protection.
So when would you use a sole proprietorship? ALMOST NEVER. About the only time you might want to use a sole proprietorship is for a side business where you are the only owner, the only employee and there is very little taxable income or even a loss. However, if you do use a sole proprietorship because your business will have little taxable income or even a loss, consider using an LLC for legal purposes - it can still be a sole proprietorship for tax purposes. LLCs are discussed in more detail below.
-Partnerships- For tax purposes, there are two types of partnerships: general partnerships and limited partnerships. General partnerships are the simplest form of partnership. In a general partnership, two or more people share all of the management and operating responsibilities of the partnership. In a limited partnership, only the general partners share the management and operating responsibilities. The limited partners are passive investors.
For tax purposes, income and deductions of the partnership are reported on Form 1065, which is a separate tax return just for partnerships. The partners each receive a form K-1 that shows their share of each item of income or loss. The income or loss from their K-1 is reported on their personal income tax return. The partnership does not normally pay any income taxes. Distributions from a partnership are not normally taxed to the partners.
General partners are typically liable for all of the debts of the partnership. This means that they can lose more than the amount they have invested. If there is a lawsuit against the partnership, the general partners normally are "on the hook" for any judgments that are more than the partnership itself can pay. Limited partners typically are only liable for the amount of their actual investment.
General partners must pay social security taxes on their share of all of the ordinary earnings from the partnership. Limited partners normally are not subject to social security taxes on any of their share of income from the partnership.
-Corporations- For tax purposes, there are two types of corporations: S corporations and C corporations. S corporations are taxed a lot like partnerships. The income is reported on a separate tax return, an 1120S and the shareholders all receive a K-1 that shows their share of each item of income or loss. The income or loss from their K-1 is reported on their personal income tax return. The S corporation does not normally pay any income taxes. Distributions from an S corporation are not normally taxed to the shareholder. In addition, they are not normally subject to social security taxes.
C corporations are different. C corporations have their own set of tax laws, tax rates and they pay their own taxes. They report their income on a form 1120 and pay tax directly to the IRS. Shareholders of a C corporation are only subject to tax on distributions from the corporation. These distributions are referred to as dividends and they are often taxed at lower rates than other income.
Shareholders of corporations are not normally liable for the debts of the corporation unless they personally guaranteed the debt. This means that shareholders normally can only lose the amount they have invested in the corporation
-Limited Liability Companies- For tax purposes, limited liability companies can be taxed as whatever tax entity the owners want them to be. The IRS allows a limited liability company to decide how it wants to be taxed. There are some fundamental principals that apply to how LLC's are taxed.
Single-member LLC's, those with only one owner, are normally taxed as sole proprietorships. The IRS calls this a "disregarded entity." So, for tax purposes, the LLC is ignored. However, the owner of an LLC can elect to have the LLC taxed as a C corporation or an S corporation (subject to the rules of ownership for S corporations).
Multi-member LLCs, those with two or more owners, are normally taxed as partnerships. They can be taxed either as a general partnership or a limited partnership, depending on the responsibilities of the various members (owners). However, the owners of an LLC can elect to have the LLC taxed as a C corporation or an S corporation (subject to the rules of ownership for S corporations). Whether and how distributions from an LLC are taxed depends entirely on how the members have elected to tax the LLC, i.e., as a partnership, S corporation or C corporation, and follow the distribution rules for the respective tax entity.
Like a corporation, owners of an LLC generally are not liable for the debts of the company unless they personally guarantee the debt. This means that LLC members normally can only lose the amount they have invested in the corporation.
About the Author:
Tom Wheelwright is not only the founder and CEO of Provision, but he is the creative force behind Provision Wealth Strategists. In addition to his management responsibilities, Tom likes to coach clients on wealth, business, and tax strategies. Along with his frequent seminars on these strategies, Tom is an adjunct professor in the Masters of Tax program at Arizona State University. For more information please visit www.provisionwealth.com
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