- Learn about sole proprietorships.
- Find information on partnerships.
- Learn about joint ventures.
- Find the information you need about C-Corporations.
- Learn about the benefits of qualified small business stock.
- Discover the benefits of the Section 1244 election.
- Learn about the S-corporation designation.
- Find information about LLCs (Limited Liability Companies).
When you start a business, there are several possible business entity types you should consider. You want to make sure you start off on the right foot and avoid costly mistakes you must correct later. For instance, some mistakes can have costly tax consequences. You should also consider your own potential personal liability.
Each business entity's choice has its own pros and cons. The following is an overview of each possible business entity.
This is generally the most basic business entity. It is a single-owner entity. For tax purposes, the owner reports the business’ income and expenses as part of their individual tax return, using the 1040 Schedule C. This is simpler than for other business entities where income and expenses must be reported on a separately filed business return. However, that does not mean a sole proprietor cannot have employees and retirement plans like other business entities and qualify for some of the same tax credits and business deductions available to other business entities. The sole proprietor pays income taxes on any net profit from the business, as well as self-employment tax (Social Security and Medicare taxes).
It should also be noted that a 1040 Schedule C has a very high IRS audit risk, unlike Partnership and S Corporation filings.
A partnership is a business entity with two or more owners with equal or different ownership interests in the business. There are many different types of partnerships; General Partnerships, Limited Partnerships, and Limited Liability Companies (LLC) are treated as a partnership as well. We compute the net profit or loss from such an entity on Form 1065. The profit or loss and other tax attributes pass through to the partners on Schedule 1065 K-1. Partners must include them on their individual 1040 returns.
A partnership is much like a sole proprietorship except that we determine the net profit and loss at the partnership level and each partner’s proportionate share passes through to them via the K-1. The major difference? Partners must create a partnership agreement to establish business policies and how they will spend partnership funds. Partners also hold personal responsibility for all the liabilities incurred by any of the partners. We do not consider partners who perform work for the partnership employees. Therefore, they must pay income and self-employment taxes on their share of the profits.
Occasionally, a married couple may be in business together. Spouses who file a joint return may elect out of the partnership rules. Thus, when they make this election, a joint venture between them is not treated as a partnership for tax purposes. We divide all items of income, gain, loss, deduction, and credit between the spouses according to their respective interests in the venture. Each spouse considers their respective share of these items as if they were attributable to a trade or business conducted by the spouse as a sole proprietor. Accordingly, each electing spouse will report their shares on Schedule C.
This rule does not apply to spouses who operate in the name of a state law entity (including a general or limited partnership or a limited liability company). The election can be made only for a business operated by spouses as co-owners that is, or should otherwise be, taxed as a partnership (whether there is a formal partnership). Both spouses must materially participate in the trade or business.
A C-corporation is a legal entity that is separate and distinct from its owners. Under the law, corporations possess many of the same rights and responsibilities as individuals. They may enter contracts, loan and borrow money, sue and be sued, hire employees, and own assets. Domestic corporations in existence for any part of a tax year must file a federal income tax return – generally Form 1120. They must do this even if they do not have taxable income.
Unlike some other business entities, corporations pay taxes on their profits. Shareholders profit through dividends and stock appreciation but are not personally liable for the company's debts. This can result in double taxation since dividends paid are not deductible by the corporation, thus taxable at the corporate level and taxable to the shareholder. Shareholders who perform work for the corporation are considered employees.
Qualified Small Business Stock
One big benefit for smaller C-corporations is the ability for shareholders to exclude up to $10 million from the sale of stock that meets a five-year holding period and the definition of a qualified small business stock.
Section 1244 Election
C-corporations can also make what we call a Sec. 1244 election. This allows an ordinary loss (Form 4797) on the sale of stock from a domestic corporation of up to $50,000 annually ($100,000 on a joint return, even if only one of the spouses owns the stock), even though we would otherwise treat the loss as a capital loss. Gains still qualify as capital gains. There are several requirements to qualify for this treatment, one of which is the stock must be purchased from the corporation.
An S corporation is a corporation that makes an election to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes thus avoiding the double taxation issue discussed previously. Form 1120-S is the federal tax return that S corporations must file. S-corporations use schedule 1120-S K-1 to report each shareholder’s portion of the income/loss, deductions, and credits. Just because an S corporation is a pass-through entity, it does not mean the income can all be passed through to a working shareholder and escape payroll taxes. Working shareholders must take reasonable compensation which is reported on Form W-2 (wages).
The election by a corporation or other entity eligible to be treated as a corporation must be made no more than 2 months and 15 days after the beginning of the tax year for which the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect. If the election was not made within the 2 months and 15 days prescribed to make the election, then a late election is available if certain conditions are met.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a form of state business entity. The IRS did not create a new tax classification for the LLC when states created LLCs. Instead, the IRS uses existing tax entity classifications: C or S corporation, partnership, or sole proprietor (the latter also being termed a disregarded entity). For federal purposes, an LLC is always classified by the IRS as one of these types of entities. Regulation of LLCs varies from state to state. The profits, losses, and tax credits from an LLC pass through to its members (LLC owners are called members, not shareholders). Members then report them on their individual tax returns. As the name implies, an LLC provides the same liability protection to its members as a corporation does to its shareholders.
While you may want to determine the right business entity on your own, we strongly encourage you to consult your Fiducial representative and your legal counsel. The foregoing is only an overview of the possible entity selection. There are a considerable number of issues to consider.