When starting up your business, there are many issues you will face. Business solutions are easy to find but figuring out the tax implications and a business ownership structure that best fits the needs of your company can be confusing and frustrating at times. If reading through legal documents is giving you a headache; don’t fret. I will guide you through the taxing process of each structure.
The Different types of legal business structures
1. Sole Proprietorship
A “sole proprietorship” refers to a legal structure where there is no legal distinction between owner and business. As you can guess, this means that the owner has liability for the business (including the debts and legal actions against the business). The business’ liabilities are the owner’s liabilities. In sole proprietorships, among other business structures, the profit is “passed through” to the owner.
Many people claim that a sole proprietorship is the most simple business organization. The sole proprietor doesn’t have to worry about filing specific legal forms like corporate taxes on business income and the startup fees for a sole proprietorship are relatively low. There are a few disadvantages to establishing a sole proprietorship:
a) the owner is held responsible for all company debts and liabilities
b) it is harder to acquire capital from investors.
c) it may be difficult to transfer ownership.
The business profits are documented on the individual tax return, Form 1040-ES (Estimated Tax for Individuals). The profits or losses are calculated on Schedule C. The sole proprietor must fill out the Schedule SE as part of the Form 1040, or the self-employment tax. The self-employment tax contributes to Social Security and Medicare. This tax can be calculated by multiplying net earnings from self-employment by the self-employment tax rate. The self-employment tax rate for 2011 is 13.3% (10.4% for Social Security and 2.9% for Medicare). You may, however, deduct half of your self-employment tax contribution by filing a Form 1040 Schedule C (line 27). Visit http://www.irs.gov/individuals/article/0,,id=130102,00.html to determine eligibility for the Earned Income Tax Credit (EITC).
For sole proprietorship forms visit http://www.irs.gov/businesses/small/article/0,,id=98202,00.html
A partnership is defined as a business that has two or more people carrying on trade or business together. Similar to a sole proprietorship, a partnership “passes through” profits or losses to its partners. These partners then pay taxes on their personal share of the profits in individual income tax returns.
Instead of the Form W-2, the partnership must turn in a Schedule K-1 and the Return of Partnership Income (Form 1065).Then, each partner reports their profit and losses with the individual tax return (Form 1040) and Schedule E.
In a corporation, shareholders exchange money, property, or both for the corporation’s capital stock, taking the same deductions as a sole proprietorship for its taxable income. Unlike partnerships or sole proprietorships, corporations must file a document called “the articles of incorporation.”
3. C Corporation
C corps and general corporations are often lumped into the same category. The term “c corp” is any corporation that is taxed in both shareholder income and corporate income (unlike the “passing through” that occurs in a sole-proprietorship, partnership, and S corp). This is called the “double tax.”
As a result of this “double tax,” an owner of a c corp can implement a financial strategy called “income splitting”: the owners keep some of the income in the corporation as “retained earnings” to minimize their individual taxes. These retained earnings are reported on Form 1120.
Forms for c corp: http://www.irs.gov/businesses/small/article/0,,id=98240,00.html
4. S Corporation
S corps are corporations that pass corporate income, losses, deductions, and credit through to their shareholders. They are therefore not subject to self-employment tax.
A Form 2553 Election by a Small Business Corporation establishes your corporation as an s corp. The “passing through” of an s corp can be done through a Schedule K-1 in Form 1040 (Federal Income Tax).The salary paid to the owner is subject to employment taxes (940), but the remaining income, the distribution from the s corp, is not subject to employment tax. The IRS requires that the salary allotted is “reasonable” (this is often called “reasonable compensation”) as to prevent owners from giving themselves extremely low salaries in order to attribute the rest of their earnings to distributions and avoid high employment tax.
5. Limited Liability Company
A high risk company should be structured as an LLC, or Limited Liability Company. Through an LLC, the owner can protect their personal assets from the business’ debts and claims. There really aren’t any tax advantages (or disadvantages) to forming an LLC. Because the federal government does not identify LLC as a business classification or structure, the owner of an LLC will need to file taxes as a corporation, partnership, or sole proprietorship. A Form 8832 is filed to establish a business classification. Owners of an LLC may also have to pay additional “franchise taxes” plus an income tax.
Though taxes are tedious and complicated, hopefully this short list of the five business structures and their taxing forms has helped you better understand the legalities.
James Kim is a writer for Choosewhat.com. ChooseWhat is a company that provides product reviews and test data for business services and products. Their goal is to help small companies make informed buying decisions on business solutions that help their business.