Introduction to the types of business entities, their formation and taxation
January 28, 2013 Leave a comment
“Nobody likes taxes, but they’ve been around forever. Taxes date back all the way back to the year one, when baby Jesus was visited by two wise men and an IRS agent, who demanded half the family’s frankincense.” -Jimmy Kimmel.
So there is nothing much we could do about existence of taxes and the fact that they are going to remain forever but what we could do is trying to know more about various options available when we start our business as to type of business structure available, their tax impact so that we go for one that best suits our circumstances. To start with, it will be interesting to go through the following to understand the types of business entities that are available.
- Sole Proprietorship – Sole proprietorship refers to the form of business when someone in his/her individual capacity engages in to business activity. There are no legal formalities required to start sole proprietorship except that registration may be required with city or county. All the income from business as a sole proprietorship is reported on individual tax returns of the owner as income from business. The main advantage of this form of business is that it is simple to start. The disadvantage is that the individual is personally liable for the liabilities of the business.
- Partnerships – When two or more person join together to do business then it is called a partnership. Like sole proprietorship there are no legal formalities required to start a business in partnership. Typically partners enter in to a formal agreement that specifies the terms of the partnership. Partnerships are flow through entities which means that the income of the partnership is not taxed at partnership level and flows to individual tax returns of the partners for their respective share of income where they pay taxes for their respective share though partnership does need to file a separate tax return which is an information return. Partners are jointly and severally personally liable for the liabilities of the partnership. There are two kind of partnerships; general and limited partnership. In general partnership all the partners have unlimited liability whereas in limited partnership, which needs to have one general partner at least, only general partners have unlimited liability. Some states do permit LLP (limited liability partnerships) to protect the liability of general partners.
- Limited Liability Companies (LLC’s) – LLC is formed under the State law by filing charter of the Company with the Secretary of State. The owners of the LLC’s are called members. Some states allow one member LLC to be formed. One member LLC is a disregarded entity as per the tax laws that means LLC does not file any separate tax returns and all the income of the LLC is reported on member’s personal tax returns. Two or more members LLC’s are taxed like partnerships i.e. they are flow through entities which means that the income of the LLC is not taxed at the corporate level and flows to individual tax returns of the members for their respective share of income where they pay taxes for their respective share though LLC does need to file a separate tax return which is an information return. LLC, with one or more members, can choose to be taxed as a C-Corporation by making a specific election with the IRS within the specified time limit. The liability of the members is limited.
- C Corporation – C-corporation is formed under state law by filing charter of the company with the Secretary of the State. The owners of the Corporation are called stockholders. The income of the C-Corporation is taxed at a corporate level and if any distribution is made to stockholder after tax paid income that also becomes subject to taxes as dividend income. The stockholder of C-corporation has limited liability.
- S Corporations- S Corporation is initially formed as a C-Corporation under state law by filing a charter document with the Secretary of State and thereafter, an election if filed with the IRS requesting the entity to be taxed as S Corporation. The owners are called stockholders and have limited liability. S Corporation is a flow through entity which means the income of the S Corporation is not taxed at corporate level and flows to individual tax returns of the partners for their respective share of income. S Corporation needs to file a separate return which is an information return.