One of the most important steps in any tax strategy is
determining what entity should be formed to hold your
businesses and investments. For legal purposes, there are
four basic types of entities: sole proprietorship,
partnership, corporation and limited liability company. The
entity you choose should take into account both the tax
effects of the entity and the legal aspects of the entity.
- Sole Proprietorship -
Let's examine the tax and legal aspects of each entity,
beginning with the sole proprietorship. A sole
proprietorship is not really an entity. It's what happens
when you don't have an entity and you don't have any
partners. Sole proprietorship is the simplest form of
business. You simply report your income on Schedule C of
your personal income tax return. You don't have to keep a
balance sheet and only a limited income statement. Sounds
good, right? Wrong! This is one of the worst forms of
business both from a tax and a legal standpoint.
From a tax standpoint, not only will you pay income taxes
at your highest marginal tax rate on all of your income,
you will also pay self-employment taxes on 100% of your
income. And you will be at least 4 times more likely to be
audited by the IRS than any other business structure.
If that's not bad enough, the legal side of a sole
proprietorship is even worse. Not only are you liable for
all of your actions, you are personally liable for all of
the actions of your employees. Don't take our word for it;
ask your attorney. They will confirm that a sole
proprietorship provides absolutely NO asset protection.
So when would you use a sole proprietorship? ALMOST NEVER.
About the only time you might want to use a sole
proprietorship is for a side business where you are the
only owner, the only employee and there is very little
taxable income or even a loss.
- Partnerships -
For tax purposes, there are two types of partnerships:
general partnerships and limited partnerships. General
partnerships are the simplest form of partnership. In a
general partnership, two or more people share all of the
management and operating responsibilities of the
partnership. In a limited partnership, only the general
partners share the management and operating
responsibilities. The limited partners are passive
investors.
For tax purposes, income and deductions of the partnership
are reported on Form 1065, which is a separate tax return
just for partnerships. The partners each receive a form K-1
that shows their share of each item of income or loss. The
income or loss from their K-1 is reported on their personal
income tax return. The partnership does not normally pay
any income taxes. Distributions from a partnership are not
normally taxed to the partners.
General partners are typically liable for all of the debts
of the partnership. This means that they can lose more than
the amount they have invested. If there is a lawsuit
against the partnership, the general partners normally are
"on the hook" for any judgments that are more than the
partnership itself can pay. Limited partners typically are
only liable for the amount of their actual investment.
General partners must pay social security taxes on their
share of all of the ordinary earnings from the partnership.
Limited partners normally are not subject to social
security taxes on any of their share of income from the
partnership.
- Corporations -
For tax purposes, there are two types of corporations: S
corporations and C corporations. S corporations are taxed a
lot like partnerships. The income is reported on a separate
tax return, an 1120S and the shareholders all receive a K-1
that shows their share of each item of income or loss. The
income or loss from their K-1 is reported on their personal
income tax return. The S corporation does not normally pay
any income taxes. Distributions from an S corporation are
not normally taxed to the shareholder. In addition, they
are not normally subject to social security taxes.
C corporations are different. C corporations have their own
set of tax laws, tax rates and they pay their own taxes.
They report their income on a form 1120 and pay tax
directly to the IRS. Shareholders of a C corporation are
only subject to tax on distributions from the corporation.
These distributions are referred to as dividends and they
are often taxed at lower rates than other income.
Shareholders of corporations are not normally liable for
the debts of the corporation unless they personally
guaranteed the debt. This means that shareholders normally
can only lose the amount they have invested in the
corporation
- Limited Liability Companies -
For tax purposes, limited liability companies can be taxed
as whatever tax entity the owners want them to be. The IRS
allows a limited liability company to decide how it wants
to be taxed. There are some fundamental principals that
apply to how LLC's are taxed.
Single-member LLC's, those with only one owner, are
normally taxed as sole proprietorships. The IRS calls this
a "disregarded entity." So, for tax purposes, the LLC is
ignored. However, the owner of an LLC can elect to have the
LLC taxed as a C corporation or an S corporation (subject
to the rules of ownership for S corporations).
Multi-member LLCs, those with two or more owners, are
normally taxed as partnerships. They can be taxed either as
a general partnership or a limited partnership, depending
on the responsibilities of the various members (owners).
However, the owners of an LLC can elect to have the LLC
taxed as a C corporation or an S corporation (subject to
the rules of ownership for S corporations). Whether and how
distributions from an LLC are taxed depends entirely on how
the members have elected to tax the LLC, i.e., as a
partnership, S corporation or C corporation, and follow the
distribution rules for the respective tax entity.
Like a corporation, owners of an LLC generally are not
liable for the debts of the company unless they personally
guarantee the debt. This means that LLC members normally
can only lose the amount they have invested in the
corporation.
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Tom Wheelwright is not only the founder and CEO of
Provision, but he is the creative force behind Provision
Wealth Strategists. In addition to his management
responsibilities, Tom likes to coach clients on wealth,
business, and tax strategies. Along with his frequent
seminars on such strategies, Tom is an adjunct professor in
the Masters of Tax program at Arizona State University. For
more information, please visit
http://www.provisionwealth.com
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