One of the most important decisions when starting a business is selecting the appropriate form of business entity to establish. This selection determines how the owner or the business will be taxed and the liability protection granted to the owner. The most common formations are sole proprietorship, general partnerships, limited liability companies, C-corporations, and S-corporations.
This is the most common business structure. According to the IRS and state laws, the business is not a separate taxable entity. All of the business’s assets belong to the owner and all liabilities are the responsibilities of the owner. The proprietor will have to report all profits, losses, expenses and deductions on their personal income tax return.
Similar to a sole proprietorship, a general partnership is not a separate taxable entity. The business and the owners are legally the same. As such, all assets, liabilities, profits and losses are shared and are the responsibilities of the partners. Nevertheless, the partnership must file an annual information return to report all profits & losses from operations. However, the partnership itself does not pay any income tax. Rather the business “passes-through” its profits, losses and other results of operations to each partner who then reports their share on their personal tax return.
Limited Liability Company (LLC):
Unlike the prior two business formations, a Limited Liability Company (LLC) is considered a separate legal entity. Under state statutes, LLC members are granted liability protection. In addition, for federal income tax purposes, each LLC is unique and their treatment by the IRS will be dependent on the number of members and the election made. For instance, an LLC with one member will be treated as a disregarded entity, similar to a sole proprietor, unless an election is made to be treated as a corporation. But, an LLC with at least two members is treated like a partnership, unless an election is made to be treated as a corporation.
The C-Corporation is a separate legal entity that has been granted liability protection by a state filing. However, the corporation’s earnings are subject to double taxation because the corporation itself pays corporate income tax on its profits and the income that is distributed to its owners, in the form of dividends, is taxable as well. In other words, tax is first paid at the corporate level on its net profits, then again on the dividends received by owners.
Like the C-Corp, an S-Corporation is a separate legal entity created by a state filing. In addition to being granted the benefits of a regular corporation, S-Corps are unique because they are created by a special election with the IRS that allows the corporation to be treated like a partnership or an LLC for federal tax purposes. This election allows them to avoid double taxation on corporate earnings. They are instead subjected to the ‘pass through taxation’ of partnerships and LLCs, which can yield substantial tax savings.