If you go into business for yourself and by yourself, your business is a sole proprietorship. A sole proprietorship is the simplest structure you can choose for your business and the easiest to form. It’s the most common form of business because of its simplicity. All you have to do is start operating your business and you have a sole proprietorship. For example, if you decide to start a t-shirt business by yourself, all you would need to do is start designing and selling t-shirts and boom, you are a sole proprietor. If you decide you want to be a consultant or coach, just set up your website and start getting clients and voila you’re a sole proprietor. If you decide that you want to join an MLM as an independent consultant, just pay your join fee and… well you get the point. Additionally, if you work for one company but get paid as an independent contractor instead of an employee or if work a “gig” (Uber, Lyft, Instacart, Doordash, etc) as a side job, you are considered a sole proprietor. I know you may not consider yourself a business owner, but you are in the eyes of tax law. If you start a business by yourself and your business is organized as an LLC, you are still considered a sole proprietor for tax purposes. We’ll discuss LLCs later.
As a sole proprietor you have complete control over your business, however you can also be held personally liable for what happens in your business. This means that if your business gets sued for breach of contract or default on a loan, for example, and your business assets aren’t sufficient to cover a judgement, you can lose your personal assets.
Sole proprietorships don’t usually require separate tax filings from their owners. This means that your business income is reported on the same form as your personal income. For the federal return, you will report your income and expenses on a Schedule C and that net profit or loss will flow through to your Form 1040. You’ll pay regular income tax as well as self employment tax on the profit. If you have a loss, that loss can offset or reduce any other income that you have such as wages. The business itself doesn’t pay tax, which avoids “double taxation”, which will be discussed later. Sole proprietors may be eligible for the Qualified Business Income Deduction, which allows business owners to deduct up to 20% of their net profit from their taxable income.
Because income and expenses from a sole proprietorship are reported on the owner’s personal return, the due date of the return is April 15.
If you decide to go into business with a partner, you are NOT a sole proprietor. The only exception is if you’re going into business with a spouse. Otherwise, your business defaults to a partnership unless you organize it as an LLC or corporation. Partnerships don’t require formal organization and can be formed as easily as sole proprietorships. Want to start a t-shirt business with your bestie? Start designing and selling them together and you’ve created a partnership. Mother/daughter coaching team? Partnership. If you start a business with a partner and organize as an LLC, you are considered a partnership for federal tax purposes.
In a general partnership (GP), all of the partners are called general partners. As a general partner, you are personally liable for the partnership’s debts much like a sole proprietor in a sole proprietorship. General partners are jointly and severally liable. Joint and several liability means that a creditor can go after all partners or just one partner for all of the partnership debt. If you are the partner with deep pockets, the creditor may choose to collect their judgement from you alone. In that case, you can request to recoup a share from the other partners. Although you don’t need a formal agreement to form a general partnership, it is strongly suggested to have one. An agreement should spell out how income, expenses, gains, losses, etc are split between the partners as well as what happens when a partner withdraws, retires, dies, or becomes disabled or bankrupt.
In a limited partnership (LP or Ltd), there only needs to be one general partner (but there could be more). All other partners are called limited partners. As a limited partner, you are only liable up to the extent of what you have invested in the partnership. Some states allow even more specialized partnerships to limit the liability of general partners, but we won’t cover those here. A limited partnership must have a formal written agreement.
A partnership is considered a pass-through entity, which means the business itself does not pay tax at the federal level and most states. There are some states that impose income tax on partnerships and many states that impose other taxes such as franchise tax. Partnership income and expenses are reported on a Form 1065 and flow through to each partner on a Schedule K-1. The partner then reports their share of the partnership activity on their personal return using Schedule E. Partners report their share of the net profit even if they do not take any distributions from the business. General partners pay self employment tax on their share of the partnership’s ordinary income and any guaranteed payments. Partnerships are also eligible for the Qualified Business Income deduction.
While partners can (and often do) work in the partnership, they can not be considered employees or put on payroll. Instead, any payments that the partner receives for specific work performed in the partnership (for example, an accountant partner being paid for keeping the partnership’s books) are reported to the partner as guaranteed payments on their Schedule K-1. These payments reduce the overall income that is shared between all of the partners.
Because the income and expenses of a partnership flow through to the partners, the partnership return has to be completed before the partner’s return can be filed. The partnership return for a calendar year-end partnership is due March 15.
Limited Liability Company
Whether you go into business by yourself or with partners, you can formally organize your business as a Limited Liability Company (LLC). LLCs are formed at the state level and they provide the liability protections of a corporation and tax advantages of a flow-through entity. LLCs are not a recognized entity for federal tax purposes, so they are considered “disregarded” for federal tax purposes unless an election is made to be “regarded” (called a “check the box” election). If no election is made, how the LLC is taxed is determined on how many members (owners) the LLC has.
A disregarded single member LLC (SMLLC) is an LLC with one member and is taxed as a sole proprietorship by default (see sole proprietorships, above). A disregarded multi-member LLC (MMLLC) is an LLC with more than one member and is taxed as a partnership by default (see partnerships, above). Both SMLLCs and MMLLCs can choose to be treated as a corporation or s-corporation for federal tax purposes by filing a Form 8832.
How LLCs are taxed at the state level varies by state. Some states follow federal treatment, while some states have their own forms.
A corporation is an incorporated business that is completely separate from its owners, called shareholders. Corporations are formed under state law, so you cannot just start operating a corporation like a sole proprietorship or partnership. Corporations are typically known to be big businesses, however, there are advantages for your small businesses to be formed as one. For example, the new lower tax rate for corporations may make it more advantageous for your small business to be formed as a corporation versus a flow-through entity where the income and expenses are taxed at your marginal tax rate which may be higher.
There are two main types of corporations – C corporations and S corporations. C Corporations will be covered here, and S Corporations will be covered in the next section.
The main disadvantage to C corporations is double taxation. As mentioned above, the corporation pays tax on its net profit at the new flat rate of 21%, and any dividend that is distributed to the shareholders may get taxed again. Shareholders are generally not taxed on the income of the corporation unless and until they take a distribution and distributions from corporations are not subject to self-employment tax. Now, you may be thinking, “Cool, I just won’t issue myself dividends. Problem solved.” However, the tax law does impose a 20% penalty on the excess accumulation of cash. Unless you have a reasonable business need for cash, the penalty kicks in when your cash accumulation exceeds $250,000 for most businesses. That may seem like a lot right now, but as your business grows and becomes more and more successful you may hit that number pretty easily.
Because a corporation is not a flow-through entity, if the C corporation experiences a loss on their tax return the loss cannot be deducted on the shareholder’s personal return. Instead, the loss can be carried forward to shelter future income generated by the income from tax (think Amazon not paying tax on $11 billion of income generated in 2018). Additionally, C corporations are not eligible for the new Qualified Business Income Deduction.
Corporation income and expenses are reported on Form 1120 and are due by April 15. Dividend distributions are reported to shareholders on Form 1099-DIV and reported on the shareholder’s Form 1040.
An S corporation isn’t actually a legal business entity. Instead, it’s a designation that the IRS provides that allows certain corporations to be taxed differently than regular corporations. All incorporated businesses start as regular C corporations, and an “S election” must be made within 75 days of the corporation’s formation to be treated as an S corporation from the onset of the business. This election is made by filing a Form 2553. A corporation that has already been in existence can elect S corporation tax treatment by filing the Form 2553 within 75 days of the beginning of the tax year in order to be considered an S corp for that year. The corporation would be treated as a C corporation for the previous years.
S corporations are subject to ownership restrictions. There can be no more than 100 shareholders. Spouses are considered one shareholder. However, this can cause issues in the event of a divorce. If a couple divorces, they are no longer considered one shareholder, and if the S corp is already at the shareholder limit the S election can be automatically revoked. Only US citizens and permanent legal residents of the US can be shareholders in an S corporation.
Although S corporations are corporations legally, they generally receive similar flow through tax treatment as partnerships. Because of the flow through tax treatment, S corporations are not subject to double taxation like a C corporation is. The business’s income and expenses are reported on a Form 1120S and the shareholder’s share is reported on a Schedule K-1. The income is taxed on the shareholder’s tax return, not the business’s, and the shareholders may be allowed to take the Qualified Business Income deduction. There are several situations in which an S corporation will have to pay tax, but we will not discuss them here.
Honorable Mention: Benefit and B Corporations
As of 2018, over 30 states have started to recognize a newer form of corporation: the benefit corporation. Benefit corporations are for-profit corporations that are committed to having a positive impact on its employees, communities, environment, and society.
Benefit corporations receive no special tax treatment. They are treated as either C corporations or S corporations, depending on the tax treatment they choose.
A “B corporation” is a corporation that is certified by B Lab to show that they meet certain standards for social and environmental performance, accountability, and transparency. B corporations can be incorporated as regular corporations or benefit corporations. They are not a legal business entity.
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