The way you structure your business determines more than just the extension at the end of your title. Each entity attracts a specific type of investor and falls under a distinct tax category with the IRS.
As a sole owner in your business, you are personally responsible for all profits and liabilities. There’s no distinction between you and your company, so all revenue and deductions go right on your individual tax return. Use Schedule C for income, expenses and cost of goods sold, and then transfer the bottom-line net amount to line 12 of your 1040. You are also responsible to budget for and report federal withholdings. Self-employment tax transfers from Schedule SE. This is the simplest entity structure, and it’s easy to form, but you personally take on all liabilities, including debt and employee-related obligations. Furthermore, it’s difficult to attract investors. Venture capitalists are interested in ownership equity, thus few are willing to fund sole owners.
This structure involves two or more owners. Like a sole proprietorship, a partnership is not a separate entity and does not pay taxes. However, you are still required to have a federal ID number and file a 1065 for informational purposes. Losses and profits are recorded and allocated using Schedule K-1, and the final numbers are transferred to each owner’s individual 1040. Assume, for example, that you and your sister operate a retail store that generates $60,000 in revenue and $30,000 in expenses. You would assume $15,000 in net income from Schedule K-1 and add that amount to the taxable income on your personal 1040. Each partner contributes to all management decisions and thereby assumes a share of all profits and losses. Partnerships are relatively easy to establish, with the bulk of the work centering on the agreement. A joint financial commitment also lowers individual liability, and you’re more likely to attract highly skilled professionals looking for a shot at partnering. Nonetheless, owners still assume liability, and disagreements are common.
This is an independent business entity owned by an unlimited number of shareholders. Each business must file a separate corporate tax return and pay all applicable federal, state and local taxes. Profits are taxed once through the business and then again as dividend income on each shareholder’s personal return. On top of double taxation, corporations can be costly, timely and difficult to establish. Nonetheless, personal liability remains protected. Corporations are also attractive to both investors and potential employees, and owners only pay taxes on salaries, bonuses and dividends.
This distinct entity is formed through a specific IRS tax election, but you may not have more than 75 shareholders. Only shareholder wages are subject to tax. All other income is paid as a distribution. Plus, many employee and shareholder expenses can be written off. C Corporations are relatively complex. They’re subject to strict operational procedures and specific compensation requirements. The IRS will look very closely at how much each shareholder is being paid, and any discrepancies will likely result in a costly audit.
Limited Liability Company (LLC)
The IRS views each LLC as a sole proprietorship, partnership or a corporation. An LLC is not a separate entity. All profits and losses are passed through to members who report net income on their individual returns. Each member must also pay all self-employment tax for Social Security and Medicare. You may file form 1120 under the corporate status as long as you have two or more members. However, you will default to a partnership if you don’t make a specific election. Like corporate shareholders, LLC members enjoy a degree of protection against bad business debt. This hybrid structure offers the liability benefits of a corporation as well as the tax benefits of a partnership. For more questions on tax law, get in touch with an attorney or accountant.
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