Your decision to start a business should start with tax planning. You need to meet with a tax professional to discuss your decision to start a business, to purchase a business, or to purchase a franchise. This should be the most important step. As a potential business owner, you must know how to choose a business entity, another important step. The business entity that you choose will determine the type of tax form that is required to file the business tax return.
At the federal level you have four (4) choices:
- Sole Proprietorship
- Partnership
- Corporation
- S Corporation
You may be asking, what about LLCs, LLPs, LLLPs, and all of the other business entities that are out there? Federal tax law does not have separate categories for those business entities. For federal tax purposes, these alternative business forms are taxed under the old categories listed above.
In most cases, you get to choose the federal tax treatment you want for your business, which gives you a lot of flexibility in designing your business entity to meet your specific needs. If you have already chosen your business form, it may be wise to reevaluate your decision from time to time. As your business develops and changes, you may find you should change business form as well. Further, to make things more complicated, Congress tends to change tax rates, laws, and the availability of tax benefits, so it is always worth checking to see if your circumstances have changed.
Research and planning could save business owners a lot of money. The topic of business entities is too complex to completely discuss it in this article.
However, we provide you with an overview in this article.
States Create Business Entities
Each state establishes its own laws for business entities. Your state will decide the types of entities that are available to you, as well as the fees and the laws that govern the entities. When you plan to form a particular business entity, such as a corporation or a limited liability company (LLC), the first thing you need to do is determine which types are available in your state.
First Consider State Law. You have a lot of issues to weigh at the state level, such as liability protection, fees, transferability of ownership, and state regulation of your industry. Consider these state level issues before you think about federal tax law. For the most part, you can usually still choose the federal tax treatment you want.
Federal Tax Law Categories
As stated above, federal tax law reduces all of the different state level business entities into four main categories:
- Sole Proprietorships
- Partnerships
- C Corporations
- S corporations
C Corporations and S Corporations
Federal tax law requires some business to pay taxes as corporations. Other businesses get to choose.
Under the mandatory rule, if state law refers to your business as a “corporation,” then you have to use corporate taxation.
Under the optional rule, if you set up a business entity (such as an LLC) in your state, you can choose to use federal corporate taxation.
C Corporations. If you have a C corporation (the default choice), you pay tax twice. Technically, the corporation pays tax when it files the Form 1120, and then you pay another tax when you receive distributions like dividends. You are then dealing with double taxation.
S Corporations. If you meet certain requirements, you can elect to make your corporation an “S corporation.” Only you, the shareholder or shareholders, pay tax. The S Corporation files Form 1120S, also known as information return because on the Form 1120S you have the Schedules K-1 to tell the IRS how you, the shareholder or shareholders, report income and losses for the tax year. This means your corporation does not pay tax. The S corporation becomes a pass-through entity.
Sole Proprietorships and Partnerships
If you do not choose to be a corporation, you will have a sole proprietorship or a partnership. Which one do you have? The answer depends on how many people share in the ownership of your business.
One owner. You have a Sole proprietorship. The tax code refers to your sole proprietorship as a “disregarded entity,” which means that all of the business’s income and deductions end up on your individual tax return. You file a Schedule C, attached to your Form 1040.
More than one owner. You have a Partnership. The partnership does not pay taxes as an entity, but the partnership files Form 1065, also known as information return because on the Form 1065 you have the Schedules K-1 to tell the IRS how the partners divide income and losses for the tax year. As one of the partners, you will use that information (Schedule K-1) to file your individual return (Form 1040).
Husband and wife businesses. In most states, your spouse counts as a separate owner. Thus, if you co-own a business with your spouse, the two of you have a partnership, not a sole proprietorship. In Florida, at the federal level, a husband and wife have a partnership.
You and your spouse can simplify your partnership reporting by opting to classify your business as a Qualified Joint Venture. Even better, if you happen to live in one of the community property states, then you and your spouse also have the option to classify your business as a sole proprietorship.
References:
- Reg. Section 301.7701-2(a) and (b). The regulation refers to “sole proprietorships” as “disregarded entities.”
- Reg. Section 301.7701-2(b)(1). You also have a “per se corporation” if the statute under which you organized your business refers to the entity as “incorporated,” “body corporate,” or “body politic.”
- Reg. Section 301.7701-2(b)(2).
- See IRC Section 1361.
- IRS Pub. 541, Partnerships, posted March 9, 2011, p. 3.
- IRC Section 761(f).
- The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. See IRS Pub. 555, Community Property
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