One of the biggest considerations when starting a new business is how that business is going to be organized legally and for tax purposes. There are four different business entity types to consider.
-Single individual owner (with the exception that a married couple can also file as a sole proprietorship) For federal purposes income for the business is reported on Schedule C which is part of a personal individual 1040 tax return. Generally state income is reported the same way, if you live in a state with state income tax. While it is a good bookkeeping practice to keep track of the business’s money and the individual owner’s money, there really is no distinction between the two. An individual owner can freely put money into the business and freely take money out of the business with no impact on his or her taxes.
-Multiple owners and the owners may be individuals, corporations, LLC’s or other partnerships. There is no limit to the number of partners. Generally there should be a partnership agreement where the partners agree how business profits and losses are to be allocated among themselves. For federal tax purposes all income of the partnership “flows through” to and is reported by the individual partners on their tax returns. While there is no federal income tax paid by the partnership, the partnership does file a separate tax return (Form 1065) to report its profits and losses and to report the allocation of those profits or losses to the individual partners.
Income from the partnership is taxable to the individual owners when it earned and not when it is distributed by the partnership. However there is generally no tax consequence to partners contributing more money to a partnership or for the partnership to distribute funds to the partners.
Joint ventures, limited partnerships and limited liability partnerships are all still partnerships. State taxation of partnerships can vary and is another reason you should consult with a tax professional to understand how a partnership will work in your unique situation.
Corporation (or C-Corp)
-A corporation is a separate legal entity and pays its own separate federal income tax. It can have any number of owners and those owners may be individuals, partnerships, LLC’s or other C-corps. The corporation files a separate tax return (Form 1120) and pays its own federal income taxes. With a few exceptions, most states also tax the income of C-Corps. Because it is a separate taxable entity money that is distributed from a corporation to the individual owners is then taxable to the owners, usually as dividends.
Limited Liability Corporation (or LLC)
-The final type of entity is an LLC. An LLC is a separate legal entity from its individual owners. Owners of an LLC are sometimes called members. The unique thing about an LLC is that for federal income taxes, the owners can choose how they want to be taxed. If one individual owns the LLC, the LLC might be taxed as a sole proprietorship. If several people own the LLC it may choose to be taxed as a partnership or the owners may choose to have the LLC taxed as a C-Corp (although this is fairly uncommon). Once the choice is made, then the LLC will follow the same process discussed above for meeting it’s federal tax obligations. State tax reporting varies from state to state for LLC’s.
What about the S Corp?
Some of you are saying wait, I thought there was another choice what about an S-Corporation (S-Corp). There is often confusion about what it means to be an S-Corp. Generally an S-Corp is not a choice of a legal form of entity. Although some states do have S-Corp statues allowing you to set up what the state calls an S-Corp which only adds to the confusion, but more on that later.
S-Corp is actually a designation for federal tax purposes only. To be an S-Corp for federal taxes you first have to set up a C-Corp or an LLC. So next time you hear the question “should my business be an S-Corp or an LLC?” you can say “be both”. In fact today most S-Corps are LLC’s that have elected to be taxed as an S-Corp.
S-Corps are taxed similar to partnerships, in that all the profits and losses “flow through” to the individual owners and are not taxed at the S-Corp level. Like a partnership an S-Corp files it’s own tax return each year (Form 1120S) to report its taxable earnings and to report how those earnings are allocated among the owners. There are several unique tax situations for S-Corps, including the requirement that profitable S-Corp owners must pay themselves salary from the business. Anyone considering an S-Corp should be sure they understand the tax obligations before they make that choice.
The individual owners of a C-Corp or LLC file a Form 2553 with the IRS to elect to be taxed as an S-Corp. If you happen to live in one of those states that has an S-Corp statute discussed above, you need to know that just because your state says you are an S-Corp, the IRS does not. At least not until you file the Form 2553 and it is approved.
There is no one best type of entity in which to conduct your business and it really should involve a discussion with your CPA and attorney before you decide which is best for your unique situation.