Choosing The Right Business Entity
you decide to start a business, one of the most important
decisions you'll need to make is choosing the right business
FORMS OF BUSINESS
The most common forms of business are Sole
Proprietorships, Partnerships, Limited Liability Companies (LLCs),
and Corporations (C-Corporations). Federal tax law also
recognizes another business form called the S-Corporation.
While state law controls the formation of your business,
federal tax law controls how your business is taxed.
WHAT TO CONSIDER
Businesses fall under one of two federal tax systems:
1. Taxation of both the entity itself on the income it earns
and the owners on dividends or other profit participation the
owners receive from the business. C-Corporations fall under
this system of federal taxation.
2. "Pass through" taxation. This type of entity (also called a
"flow-through" entity) is not taxed, but its owners are each
taxed (more or less) on their proportionate shares of the
entity's income. Pass-through entities include:
- Sole Proprietorships
- Partnerships, of various types
- Limited liability companies (LLCs)
- "S-Corporations" (S-Corps), as distinguished from
The first major consideration when choosing a business entity
is whether to choose one that has two levels of tax on income
or one that is a pass-through entity with only one level
directly on the owners.
The second consideration, which has more to do with business
considerations rather than tax considerations, is the
limitation of liability (protecting your assets from claims of
Let's take a general look at each of the options more closely:
TYPES OF BUSINESS ENTITIES
The most common (and easiest) form of business organization is
the sole proprietorship. Defined as any unincorporated
business owned entirely by one individual, a sole proprietor
can operate any kind of business (full or part-time) as long
as it is not a hobby or an investment. In general, the owner
is also personally liable for all financial obligations and
debts of the business.
Note: If you are the sole member of a domestic limited
liability company (LLC), you are not a sole proprietor
if you elect to treat the LLC as a corporation.
Types of businesses that operate as sole proprietorships
include retail shops, farmers, large companies with employees,
home-based businesses and one-person consulting firms.
As a sole proprietor, your net business income or loss is
combined with your other income and deductions and taxed at
individual rates on your personal tax return. Because sole
proprietors do not have taxes withheld from their business
income, you may need to make quarterly estimated tax payments
if you expect to make a profit. Also, as a sole proprietor,
you must also pay self-employment tax on the net income
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.
There are two types of partnerships: Ordinary partnerships,
called "general partnerships," and limited partnerships that
limit liability for some partners but not others. Both general
and limited partnerships are treated as pass-through entities
under federal tax law, but there are some relatively minor
differences in tax treatment between general and limited
For example, general partners must pay self-employment tax on
their net earnings from self-employment assigned to them from
the partnership. Net earnings from self-employment include an
individual's share, distributed or not, of income or loss from
any trade or business carried on by a partnership. Limited
partners are subject to self-employment tax only on guaranteed
payments, such as professional fees for services rendered.
Partners are not employees of the partnership and do not pay
any income tax at the partnership level. Partnerships report
income and expenses from its operation and pass the
information to the individual partners (hence the pass-through
Because taxes are not withheld from any distributions partners
generally need to make quarterly estimated tax payments if
they expect to make a profit. Partners must report their share
of partnership income even if a distribution is not made. Each
partner reports his share of the partnership net profit or
loss on his or her personal tax return.
A Limited Liability Company (LLC) is a business structure
allowed by state statute. Each state is different, so it's
important to check the regulations in the state you plan to do
business in. Owners of an LLC are called members, which may
include individuals, corporations, other LLCs and foreign
entities. Most states also permit "single member" LLCs, i.e.
those having only one owner.
Depending on elections made by the LLC and the number of
members, the IRS treats an LLC as either a corporation,
partnership, or as part of the LLC's owner's tax return. A
domestic LLC with at least two members is classified as a
partnership for federal income tax purposes unless it elects
to be treated as a corporation.
An LLC with only one member is treated as an entity
disregarded as separate from its owner for income tax purposes
(but as a separate entity for purposes of employment tax and
certain excise taxes), unless it elects to be treated as a
In forming a corporation, prospective shareholders exchange
money, property, or both, for the corporation's capital stock.
A corporation conducts business, realizes net income or loss,
pays taxes and distributes profits to shareholders.
A corporate structure is more complex than other business
structures. When you form a corporation, you create a separate
tax-paying entity. The profit of a corporation is taxed to the
corporation when earned and then is taxed to the shareholders
when distributed as dividends. This creates a double tax.
The corporation does not get a tax deduction when it
distributes dividends to shareholders. Earnings distributed to
shareholders in the form of dividends are taxed at individual
tax rates on their personal tax returns. Shareholders cannot
deduct any loss of the corporation.
If you organize your business as a corporation, generally are
not personally liable for the debts of the corporation,
although there may be exceptions under state law.
DID YOU KNOW
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Fidelity is the custodian for more
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An S-corporation has the same corporate structure as a
standard corporation; however, its owners have elected to pass
corporate income, losses, deductions, and credits through to
their shareholders for federal tax purposes. Shareholders of
S-corporations generally have limited liability.
Generally, an S-Corporation is exempt from federal income tax
other than tax on certain capital gains and passive income. It
is treated in the same way as a partnership, in that generally
taxes are not paid at the corporate level. S-Corporations may
be taxed under state tax law as regular corporations, or in
some other way.
Shareholders must pay tax on their share of corporate income,
regardless of whether it is actually distributed. Flow-through
of income and losses is reported on their personal tax returns
and they are assessed tax at their individual income tax
rates, allowing S-Corporations to avoid double taxation on the
To qualify for S-Corporation status, the corporation must meet
a number of requirements. Please call if you would like more
information about which requirements must be met to form an
When making a decision about which type of business entity to
choose each business owner must decide which one best meets
his or her needs. One form of business entity is not
necessarily better than any other and obtaining the advice of
a tax professional is critical. If you need assistance
figuring out which business entity is best for your business,
don't hesitate to call.
If you have any questions about small business taxes, don't hesitate to call the office if you would like more information
about tax planning strategies this year. Help is just a phone call away at
Financial Services at Sullivan & Co. CPAs
Sullivan leads our Financial Services
Division and is here to help you navigate your
financial future. As an Investment Advisor Representative,
he is able to provide an independent opinion on the
investments you already own or are considering buying.
We can structure a portfolio
based on your risk tolerance or we can help you decide how
to invest in your company 401(k) plan. We work with each
client to identify their concerns and to provide solutions
according to their situation.
is also experienced in company retirement plans. If you own
a business that does not have a plan; we can discuss your
options and set up a plan that fits your company.
If your business already has a
plan; we offer a free evaluation of the plan to ensure that
it is up to date and working well for you and your
Our goal is to provide personal, unbiased and independent
advice to help you make well-informed decisions about your
financial life and investments.
Contact Paul Sullivan or Jane Huserova to set up a free
initial consultation (301) 657-8080.
And as always if you have any questions about accounting or
investments and how they effect you or your business, please
give us a call. We can help guide you in the right
you can call our offices if you have any questions about these
or any other accounting, tax, financial planning or insurance
related issues, at 301-657-8080.
Regards, Paul Sullivan, CPA
President, Sullivan & Company