Common Tax Problems for Businesses: Choice of Entity

Choice of Entity

One of the first decisions entrepreneurs face is selecting a business entity.  Before selecting an entity, you should be aware of the federal income tax consequences related to the various business entity designations.

Business entities generally fall into the following four categories:

  1. Sole Proprietorships
  2. Partnerships
  3. Corporations
  4. Hybrid Forms (combinations of the first three types)

Before selecting a business entity, you should consider the impact it will have on your:

  • Ownership structure
  • Personal liability
  • Tax obligations

Which business entity is right for you? Here is an overview of how ownership structure, liability limitation and tax implications change depending on the type of business entity you select.

Sole Proprietorship

  • Ownership: It is easy to form and as the sole owner of your business, you bear all the costs and keep all the profits after taxes.
  • Liability Limitation: You are personally liable for the business activity and liability is unlimited.
  • Tax Obligations: Your business profit is taxed only once – at the individual level.
  • Advantages/Disadvantages: A sole proprietorship is easy to form and offers complete managerial control however the owner is personally liable for the business’s financial obligations.

Partnership

  • Ownership: In a partnership, several entrepreneurs come together to set up a business, by pooling money and expertise. A partnership agreement sets out how management decisions are taken, profits are shared etc.
  • Liability Limitations: The partners are personally liable for the business activities and liability is unlimited.
  • Tax Obligations: Your business profit is taxed only once – at the individual level.
  • Advantages/Disadvantages: Partners are taxed at the individual level however partners are personally liable for the business’s financial obligations.

Corporation

  • Ownership: The legal business entity is separate from its owners/shareholders.
  • Liability Limitations: The corporation is liable for the business activities while the individual shareholders have limited liability.
  • Tax Obligations: The business profit is double taxed for C corporations. S corporations avoid double taxation and provides pass-through of taxable income to individuals, similar to a partnership. C or S corporation election is made using IRS Form 2553.
  • Advantages/Disadvantages: Corporations are more cumbersome to form and can incur double taxation however the shareholders are not personally liable for the business’s financial obligations.

Hybrid Entities

  • Limited Partnership (LP): An LP has both limited liability partners and at least, one unlimited liability partner.
  • Limited Liability Partnership (LLP): All partners have limited liability, but partners are taxed as partners, avoiding double taxation.
  • Limited Liability Company (LLC): All members have limited liability and have tax treatment options.
  • Professional Corporation (PC): Used by professionals; has limited liability for owners except in the area of malpractice.
  • Advantages/Disadvantages: Owners are taxed at an individual level and generally are not personally liable for the business’s financial obligations.

More Information

For more common tax problems, see my posting on Employment Taxes.

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