Before you consult with a tax advisor or consultant you may want to do some research yourself. One of your first decisions as a business owner is what form of business you choose. This decision is very important because it can affect how much you pay in taxes, the amount of paperwork your business is required to do, the personal liability you face and your ability to borrow money. Business formation is controlled by the law of the state where your business is organized.
The most common forms of businesses are:
- Sole Proprietorships
- Limited Liability Companies (LLC)
- Subchapter S Corporations (S Corporations)
While state law controls the formation of your business, federal tax law controls how your business is taxed. All businesses must file an annual return. The form you use depends on how your business is organized.
The answer to the question "What structure makes the most sense?" depends on the individual circumstances of each business owner. One form is not necessarily better than any other. Each business owner must assess their own needs. Here is a brief look at the various business forms.
A sole proprietorship is the most common form of business organization. It's easy to form and offers complete control to the owner. But the business owner is also personally liable for all financial obligations and debts of the business.
As a sole proprietor you can operate any kind of business as long as you are the only owner. It can be full-time or part-time work. This includes operating a:
- Shop or retail trade business
- Large company with employees
- Home-based business
- One-person consulting firm
Every sole proprietor is required to keep sufficient records to comply with federal tax requirements regarding business records.
Your net business income or loss is combined with your other income (other income could be your salary if you also work for someone else, or your investments) and deductions and taxed at individual rates on your personal tax return.
Sole proprietors do not have taxes withheld from their business income so you may need to make quarterly estimated tax payments. You generally have to make estimated tax payments if you expect to owe tax of $1,000 or more when you file your return. Use Form 1040-ES, Estimated Tax for Individuals, to figure and pay your estimated tax.
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
Each partner reports his share of the partnership net profit or loss on his personal tax return. Partners must report their share of partnership income even if a distribution is not made.
Partners are not employees of the partnership and so taxes are not withheld from any distributions. Like sole proprietors, they generally need to make quarterly estimated tax payments if they expect to make a profit.
A corporate structure is more complex than other business structures. It requires complying with more regulations and tax requirements.
Corporations are formed under the laws of each state and are subject to corporate income tax at the federal and state level. In addition, any earnings distributed to shareholders in the form of dividends are taxed at the individual tax rates on their personal annual tax returns.
The corporation becomes an entity that handles the responsibilities of the business. Like a person, the corporation can be taxed and can be held legally liable for its actions. If you organize your business as a corporation, you are generally not personally liable for the debts of the corporation. (Exceptions may exist under state law.)
Limited Liability Company
A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute.
LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. Most states also permit "single member" LLCs, those having only one owner.
Subchapter S Corporation
The Subchapter S Corporation is a variation of the standard corporation. The S corporation allows income or losses to be passed through to individual tax returns, similar to a partnership.
Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income.
This information provides a brief overview from the Internal Revenue Service of issues and decisions involved in owning a small business and avoiding common pitfalls.