Ethan Zook writes:
Starting a business can be both exciting and stressful for any new entrepreneur, and perhaps nothing adds more initial stress than the word “taxes.” Understanding how a business will be taxed is among the many considerations entrepreneurs need to keep in mind when choosing a type of business entity for their company. Below is a basic overview of the types of business entities typically used by entrepreneurs and a brief discussion of related tax considerations that entrepreneurs should keep in mind.
- Sole Proprietorships: A sole proprietorship is an unincorporated business owned by one owner who is referred to as a “sole proprietor.” A sole proprietor reports income or losses from the business on his or her personal tax return and the business itself is not taxed. Because income and losses pass through the business to the owner without being taxed at an entity level, this type of tax structure is often called “pass-through taxation.”
- Partnerships: A partnership is generally defined as an association of two or more persons to carry on as co-owners of a business. Much like sole proprietorships, partnerships experience pass-through taxation whereby the owners report income or losses from the business directly on their personal income tax returns, often based on each owner’s percentage of ownership in the business. Unlike sole proprietorships, however, a partnership must file an information return, known as a Form 1065, which lets the government know about its annual income or losses.
- Corporations: Corporations are formed under state law and are generally subject to what is commonly referred to as “double-taxation.” Double taxation is effectively the opposite of pass-through taxation and requires that both the entity and its shareholders pay tax on each dollar of income. For example, if a corporation reports positive earnings in any given year, it will generally be required to pay taxes on those earnings at the entity level. In turn, when the corporation distributes some or all of those earnings to its shareholders, they must report those amounts on their personal tax returns and pay taxes on those amounts. However, if a corporation meets certain criteria relating to, among other things, the type of stock it issues to its shareholders and the number and type of shareholders it maintains, it may elect to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. A corporation that makes this election is known as an “S Corporation.” S Corporations have the benefit of avoiding double-taxation and are taxed on a pass-through basis, whereby any earnings at the entity level are passed through to the individual shareholders, much like partnerships.
- Limited Liability Companies (LLCs): For tax purposes, LLCs are perhaps the most versatile form of entity. LLCs are formed under state law and are owned by “members.” In cases where an LLC has only one member and unless the member elects otherwise, the LLC will be treated as a “disregarded entity,” meaning that the LLC will be disregarded for tax purposes and any income or losses of the LLC will be passed through to the members who then pay taxes on those amounts, much like a sole proprietorship. If there are two or more members of an LLC, the LLC and its members have the ability to elect whether the LLC will be taxed as a partnership or even as a corporation. LLCs having at least two members will typically elect to be taxed as partnership and receive the benefit of pass-through taxation. Why would an LLC elect to be treated as a corporation and subject itself and its members to double taxation for tax purposes? There are many reasons, but this election is often seen in cases where an LLC desires to keep a significant amount of retained earnings in the LLC.
Please note that the above is a general summary of federal tax considerations for an entrepreneur to consider when choosing an entity. State tax considerations, along with other topics such as protection from individual liability and ease of administration, should also play an important role in making this decision. It is crucial that an entrepreneur have a general understanding of the types of entities available and their tax treatment so that he or she can work more effectively with legal and financial advisors to make informed decisions.