In a recent announcement, the IRS reminded would-be entrepreneurs of the importance of understanding the tax implications of setting up their own businesses. To start with, you have to choose a form of entity, for your business. Your choice has many implications for taxation and management, and as such, we encourage you to give this a lot of thought and seek the advice of a tax professional.
Here are some forms of entity to consider for your new business:
Sole Proprietorship
This is the simplest form of entity structure. It’s an unincorporated business owned by an individual; there’s no distinction between the taxpayer and the business. You will typically file a Form 1040, including Schedule C, Profit or Loss from Business (Sole Proprietorship). You may need to pay estimated taxes through the year, because, unlike an employee, you are not having money automatically deducted from regular paychecks.
Partnership
This is an unincorporated business with ownership shared between two or more members. A partnership must file an annual information return to report the income, deductions, gains, losses, and so forth from its operations, but it does not pay income tax at the federal level. Instead, it “passes through” profits or losses to its partners on a Form K-1. Each partner reports their share of the partnership’s income or loss on their personal tax return. Certain states may impose taxes at the partnership level. Partners are not employees and should not be issued a Form W-2, as employees typically get.
Limited Liability Company (LLC)
This is a business structure established under state statute. These tend to be very flexible. Owners of an LLC are called “members,” and most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities. Unlike with an S corporation (see below), there is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner.
The tax situation can be complex. For example, depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it affirmatively elects to be treated as a corporation.
S Corporation
If selected as the entity structure, an S corporation passes corporate income, losses, deductions and credits through to the shareholders, on a K-1, similar to partnerships. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. Certain S corporations are responsible for tax on built-in gains at the entity level. Unlike a Partnership, shareholders of an S corporation do receive W-2’s and must be paid a reasonable wage for services they provide to the company. There are many rules about who can be an S corporation shareholder. In addition, an S corporation cannot have more than 100 shareholders.
Important Considerations
There are many more tax provisions and options, and of course state rules to consider. It is very important to think about the above factors before you establish your business and consider how the business may evolve in the future. The best advice is to work closely with tax professionals to get your business off to a good—and compliant—start.
HAVE QUESTIONS?
If you need assistance or have any questions on the information in this article, please call your CironeFriedberg professional. You can reach us by phone at (203) 798-2721 (Bethel), (203) 366-5876 (Shelton), or (203) 359-1100 (Darien) or email us at info@cironefriedberg.com.
