In a recent announcement, the IRS is reminding would-be entrepreneurs of the importance of understanding the tax implications of setting up their own businesses. To start with, you have to choose a form for your business. Your choice has many implications for taxation and management. Here are some examples:
Sole proprietorship: This is the simplest form. It’s an unincorporated business owned by an individual; there’s no distinction between the taxpayer and the business. You will typically file the usual Form 1040, including Schedule C, Profit or Loss from Business (Sole Proprietorship). You may need to pay estimated taxes through the year, because, unlike an employee, you’re not having taxes automatically deducted from regular paychecks.
Partnership: This is an unincorporated business with ownership shared between two or more members. A partnership must file an annual information return to report the income, deductions, gains and losses, from its operations, but it does not pay income tax. Instead, it “passes through” profits or losses to its partners. Each partner reports their share of the partnership’s income or loss on their personal tax return. However, partners are not employees and shouldn’t be issued a Form W-2.
Limited Liability Company: This is a business structure established under state statute. These tend to be very flexible. Owners of an LLC are called “members,” and most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities. Unlike with an S corporation (see below), there is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner. The tax situation can be complex. For example, depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it affirmatively elects to be treated as a corporation.
S Corporation: This structure passes corporate income, losses, deductions and credits through to the shareholders, similar to partnerships. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level. There are many restrictions concerning who can be an S corporation shareholder, and as S corporation cannot have more than 100 shareholders.
What else is there?
So is this all you need to know? Not even close! There are numerous tax provisions and options, and of course state rules. Careful thought should be given when selecting an entity type that fits your needs. The best advice? Work closely with tax professionals to get your business off to a good and compliant start.