There are several ways to structure your new or existing business. Some are easy, others have tax and liability advantages. Here are the basics:
This is a business owned and operated by one person. A sole proprietorship is the easiest to start. The only thing needed is to go to your City or County tax office and get a business license. All income and losses are the responsibility of the business owner and the business is not a separate legal entity. For tax purposes, the individual will most often prepare a Schedule C to go along with the 1040. Since the assets of the business are not separate from the owner, creditors can go after the owner’s personal assets.
I would not recommend this type of business unless you are very small, have limited liability or plan to form an entity later. If I make any income from blogging this year, it will be as a sole proprietor.
This is a business owned by 2 or more people. The partnership may be informal, but should be operated following a written partnership agreement that spells out partner control and allocation of the profits and losses. Like a sole proprietorship, a partnership is very easy to start, just obtain your business license.
Partners have the implied authority to make decisions for the partnership in the ordinary course of the business. All partners can participate in the management and most decisions are made by majority vote. Unless an partnership agreement states otherwise, partners share equally in profits and losses.
The Partnership needs to prepare its own tax return, a Form 1065. The Partnership will not pay taxes, instead the individual partners will receive a Schedule K and add to their individual tax returns.
Partners are jointly and severally liable for the liabilities and obligations of the partnership. This means a creditor does not need to collect or sue from all partners equally, instead they can sue one partner and the business. It will be up to the partner sued to collect from the other partners.
This is a business owned by 2 or more people that has at least one general partner and one limited partner. Most often a written partnership agreement exists with this type of entity. Forming a Limited Partnership is more complicated than a general partnership since you must file with the Secretary of State in your State (see Georgia as an example.) The general partner(s) have the sole decision making authority of the partnership. The limited partners’ role is limited to voting on decisions that fall outside of the partnership’s ordinary course of business, such as the sale of assets or voting in a general partner.
Unless the partnership agreement states otherwise, both general and limited partners share equally in the entity’s profits and losses. Like a General Partnership, the entity files a separate Form 1065 and the profits and losses flow to the individuals.
The general partner(s) are responsible for all liabilities and obligations of the partnership. Limited partners have no liabilities. Like with the General Partnership above, a general partner’s personal assets are at risk.
I have seen many accounting and legal practices, plus estates use this type of entity.
Limited Liability Company (LLC)
A LLC is an entity separate from its owners. Like with a Limited Partnership, a LLC requires State Filing. A LLC can be managed by members or other managers that are not members.
Unless a member agreement states otherwise, members share equally in the profits and losses. Most often the LLC needs to file a 1065; however, if a single-member LLC, you can prepare using Schedule C on your personal return. I like LLCs because as long as you keep a separate bank account and do not co-mingle funds, you have less legal liability. LLCs can also elect to be taxed as corporations.
Most new corporate entities created are LLCs.
A S Corp is a corporation under State law, but elects to have profits and losses flow through to the shareholders for income tax purposes. S Corps are made for small businesses due to the shareholder requirements. To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)
Like with an LLC and Limited Partnership, creating a S Corporation requires a State Level filing. The entity will prepare a Form 1120S and the shareholders will receive a K-1. Profits and losses are allocated to the shareholders based on their percentage of stock ownership.
Like with a LLC, liability is limited to the corporation and not the individual shareholders.
This entity is different from the above since the profits and losses do not flow through to the individuals. This is unfavorable for small businesses starting up since the losses are carried forward to future years instead of reducing adjusted gross income of the individuals. My tax business is organized this way as a Professional Corporation, thus the $520 in losses carries over as a Net Operating Loss (NOL) and will reduce profits for up to 20 years. Also, if you distribute profits, the corporation is taxed since it does not reduce income and the individual is taxed as dividend income, thus taxing the same income twice.
The C Corporation files a Form 1120 annually. The shareholders are not liable for the corporation’s obligations or liabilities.
If you have any questions on the above, let me know. You may give me my next blog post!