When you start a business, you have to choose a business structure for that business. The business structure you choose determines your business’ tax structure. At the federal level, the most common business structures are the corporation, partnership, S corporation and sole proprietorship. The Limited Liability Company (LLC) is a common business structure, but it exists according to state statute. Understanding these business structures and their tax implications, will help you decide on the appropriate business structure.
Sole Proprietorship
A sole proprietorship is, essentially, an unincorporated business owned by an individual. However, if that individual is the only member of a domestic limited liability company (LLC), that individual is not a sole proprietor if they choose to treat their LLC as a corporation. A sole proprietor is liable for income tax and self-employment tax.
The business itself pays no taxes. Taxes are “passed through” to the owner.
Though sole proprietorships are very simple structures, their basic limitation is that they do not shield the sole proprietor’s personal assets from liabilities sustained by the business. So, if your business is in debt, effectively, your personal assets are at risk.
Partnership
A partnership is a commercial relationship between two or more people. Each partner contributes capital, skill, labour,or property and shares in the partnership’s profits and losses. There are three types of partnerships: general partnerships, limited partnerships and limited liability partnerships.
Partnerships are pass-through entities, like sole proprietorships. So the business itself is not taxed. Rather, the tax burden is passed onto the partners. The downside of partnerships is that the liabilities incurred by one partner can affect your personal assets. WHo your partners are is very important to your future economic health.
Corporation
Corporations are formed when people exchange capital for shares in a business. A corporation is a distinct legal entity. Consequently, it completely segregates the liabilities of the business from the assets of the shareholders. A corporation pays taxes and in doing so, makes the same deduction as a sole proprietorship. A corporation is often used to create holding companies. Holding company taxation is distinct from that of the shareholders. Corporations are a unique taxpaying entity. A corporation may distribute dividends to its shareholders. Shareholders pay income tax for those dividends. Shareholders cannot make deductions on losses suffered by a corporation.
Limited Liability Company
A limited liability company (LLC) is created according to state statute, so the regulations surrounding LLCs vary according to state. You can elect to treat the LLC as a corporation, partnership, or as a “disregarded entity”, in which case its tax liability is assumed by yourself.
Members, who are the owners of an LLC, are not personally liable for the liabilities incurred by the LLC. Ownership is generally not restricted, so members can be individuals, or other business structures. Given that it is created by state statute, an LLC has a degree of flexibility when it comes to federal regulations that other business structures lack.
You should check with your state to understand the regulations and tax implications of having an LLC.
