A Tutorial on Business Entities
Posted on | August 29, 2009 | 1 Comment
A TUTORIAL ON BUSINESS ENTITIES
- Sole Proprietorship: This is a business you operate yourself, in your own name or a trade name, with no partners or formal business entity. You remain personally liable for business debts. You report income and expenses on your personal tax return by filing a Schedule C. You pay self-employment taxes (Medicare and social security) on your net profits. Self employment taxes are 15.3% of your net income, in addition to regular income tax you pay. Because of the higher taxes and total personal liability, a sole proprietorship is not the best choice for most businesses.
- Partnership: This is an association of two or more partners. General partners (GP’s) run the business and remain liable for partnership debts. Limited partners (LP’s) invest capital, but don’t actively manage or participate in the business and are not liable for business debts. The Partnership files an informational return (Form 1065) with the IRS and passes income and expenses through to each partner, via Form K-1, which is generated on the partnership tax return. GP distributions are taxed as self employment income (the 15.3% mentioned above). LP distributions are not subject to self employment taxes and are taxed as passive income.
- “C” Corporation: This is a separate legal entity organized under WA State law. Your liability for business debt is generally limited to your investment in the corporation. The Corporation files its own tax return (Form 1120), pays profits on its income at corporate tax rates. If any of the profits are distributed to the shareholders (owners) they are also taxed as dividends at a 15% tax rate. This double taxation makes a “C” Corporation a bad choice.
- Limited Liability Company (LLC): This is an association of one or more “members” organized under state law. Your liability for business debts is limited to your investment in the company, and LLC’s offer the strongest asset protection of any entity. Single-member LLC’s are taxed as sole proprietors, unless they elect to be treated as a corporation. Multi-member LLC’s can choose to be taxed as a partnership or a corporation. As an active member of the LLC, net income would be subject to self employment taxes of 15.3% as previously mentioned.
- Subchapter “S” Corporation: This is a corporation, formed under state law that makes an election with the IRS to be treated as a partnership and not pay taxes itself. Instead, it files an informational tax return (Form 1120S) and passes all income and losses through to shareholders on Schedule K-1, generated on the Form 1120S. Subchapter S owner employees must pay themselves a “reasonable” salary. That salary is subject to the 15.3% self employment tax. Any additional pass-through profits are not subject to self employment taxes. This type of business entity is best for businesses whose owners are active in the business and don’t need to accumulate capital for day-to-day operations. In addition, there is an immediate tax savings, over other business entities, because most Subchapter S business owners pay themselves a salary of 40-60% of the business income. The definition of a “reasonable salary” is subjective. The IRS has not issued specific guidance on this subject.
As you can see, there are several types of business entities to choose from. The right choice depends on a number of factors and each business owner must carefully look at each before deciding on the right one.
Category: Business entities
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December 3rd, 2009 @ 4:44 am
great post as usual .. thanks .. you just gave me a few more ideas to play with