When you decide to become self-employed, you might consider establishing a business. There are several forms of businesses that you can establish. Each will have different affects on your liability in reference to the company and its actions and how you do your taxes.
Note: This page is only informational. If you have questions about which business to open you should consult a tax expert and/or corporate lawyer.
The most basic form in which anyone can operate a business. With a sole proprietorship, you own the company and you are responsible for all its assets and actions.
Who is Involved in a Sole Proprietorship?
You are the only owner and you get the designation from the activities you do such as freelance work. If you wish, you can work under a different name, but you will need to register it with the state.
State Filing Requirement for a Sole Proprietorship.
You should obtain the appropriate licenses and permits which will vary by state and locality. You can use the Licensing and Permits tool to find which licenses and/or permits are appropriate for you business.
How are Federal Taxes Affected with Sole Proprietorship?
You and the business are the same. Therefore, the business is not taxed only you are taxed. Income is reported on a Schedule C of a standard Form 1040. The money from the Schedule C transfers to your personal tax return. You are responsible for paying all income taxes, including self-employment and estimated taxes.
Advantage(s) of a Sole Proprietorship
- Simplest business, and inexpensive to form
- You retain complete control as the sole owner
- Business and personal taxes are filed together and the tax rate is the lowest of all business structures
Disadvantage(s) of a Sole Proprietorship
- Complete personal liability, no legal separation between you and the business
- Difficult to get business loans, if needed
Partnerships involve more than just one person. When forming a partnership it is important to develop a legal partnership agreement which addresses; how the business will make decisions, division of profits, dispute resolution, change in ownership and dissolution of the partnership.
There are three different types of partnerships; General, Limited and Joint Venture.
- General Partnerships assumes equal division of everything. If there are unequal distributions the percentages must be documented in a partnership agreement.
- Limited Partnerships (limited liability partnership) allow partners to have limited liability and input in regards to management decisions. The limits are determined by the extent of each partner’s investment into the business.
- Joint Ventures are similar to general partnerships but only last for a limited amount of time such as for a single project. If the partners of joint ventures want to engage in a continuous partnership then the appropriate fillings must be filed.
Who is Involved in a Partnership?
Partnerships are designed when more than one person enters into a business.
State Filing Requirement for a Partnership
Partnerships must be filed with the Sectary of State’s office and a business name must be established. The partnership agreement will have the name of all partners unless the members have established and filed a fictitious name or Doing Business As (DBA).
The partnership must obtain licenses and permits once the business is registered and business starts. You can use the Licensing and Permits tool to determine which federal, state and local permits needed to run a business.
How are Federal Taxes Affected with Partnership?
The partnership must file an annual return to report income, deductions, gains and losses from business operations on Form 1065. The business does not pay taxes, the profits and losses pass through to its members and each partner includes their share of the gains or losses on their tax returns. Partnerships are subject to annual return of income, employment taxes and excise taxes. The partners are subject to income tax, self-employment tax and estimated taxes
Advantage(s) of a Partnership
- Partnerships are easily formed and inexpensive
- Each member is equally invested in the success or failure of the business unless otherwise stated in the partnership agreement
- Partnerships have the advantage of allowing employees to become partners, which often attracts highly qualified individuals (think law firms)
Disadvantage(s) of a Partnership
- Partnerships are subject to joint and individual liability because the partners retain full and shared liability among themselves. Partners are responsible for their own actions and the actions of their partners.
- Shared profits despite unequal contribution of time, effort and resources in some cases
A cooperative is an organization owned and operated for the benefit of those who use its services. Profits generated by the cooperatives are distributed amongst the members of the cooperative.
Who is Involved in a Cooperative?
An elected board of directors and officers run the cooperative while the rest of the members have the ability to vote to control the direction of the cooperative. Members can become partners by purchasing shares however; this does not increase the weight of the vote.
State Filing Requirement for a Cooperative
Cooperatives do not have to incorporate, but if they do, Articles of Incorporation will be filed through the Secretary of State office. A membership application and draft proposed bylaws should be created after which Charter members will meet and an election of directors will take place to further discuss and amend the bylaws. If the board of directors are not named in the Articles, then by the end of the first meeting declare them in amended bylaws. You can use the Licensing and Permits tool to find which licenses and/or permits are appropriate for you business.
How are Federal Taxes Affected with Cooperative?
You must obtain an EIN/tax ID from the IRS and register with the state and local revenue agencies. Cooperatives, like corporations, receive a pass-through and do not pay federal income taxes. Members of the cooperative pay pass-through taxes on their personal tax returns when they file. There are specific tax codes and rules and regulations individuals must follow to receive the appropriate tax treatment. Find the appropriate tax code in Subchapter T Cooperatives, here.
Advantage(s) of a Cooperative
- Cooperatives that are incorporated are not taxed on surplus earnings that are refunded to members which means, the members are only taxed once on the income of the cooperative and not at the individual and corporate level.
- Cooperative do not dissolve or require a lot of effort with the removal or addition of members
- Cooperatives are run like a democracy; all member votes are equal regardless of the members’ initial monetary investment. This is particularly appealing when there are a number of investors that have contributed different start-up capital.
Disadvantage(s) of a Cooperative
- If all members do not participate the cooperative does not function at full capacity
Corporation (Regular or C Corporations)
Corporations or C Corporations is a legally independent entity owned by shareholders. Regular corporations are called C Corporation because the general tax rules affecting corporations and their shareholders are found in Subchapter C of Chapter 1 of the Internal Revenue Code. For liability purposes, the corporation itself and not the shareholders are legally liable for the actions and debts the business incurs. Corporations have complex tax and legal requirements and costly administrative fees.
Who is Involved in a C Corporation?
Corporations are usually suggested for established companies that have multiple employees. Corporations have the ability to sell ownership stock through initial public offerings (IPO’s). IPO’s are a major selling point for attracting investment capital. Selling shares of the corporation to individuals creates shareholders who become part owner of the company.
State Filing Requirement for a C Corporation
Forming a corporation starts with filing Articles of Incorporation with the Secretary of State. Some states will require the establishment of directors and the issue of stock certificates to initial shareholders during the registration process. Once the business is registered you will need to obtain a business licenses which will vary by industry, state and locality. Use the Licensing and Permits tool to find which licenses and/or permits are appropriate for your business.
How are Federal Taxes Affected with C Corporation?
You must register for EIN/tax ID number with the IRS, here. When the corporation is established, a separate taxpaying entity is established. This means the corporation must pay federal, in addition to state and local taxes if applicable on their profits. In some cases the corporation is taxed twice; once on profits and again when dividends are paid to shareholders on their personal tax returns. Corporate revenues are reported on Form 1120 or 1120-A Corporate Income Tax Return to the IRS. The corporation will pay one half of their employees Social Security and Medicare taxes.
Shareholders who are also employees will pay income taxes on their wages and pay one half of their Social Security and Medicare taxes. Both of these are usually deductible expenses for the entities.
Advantage(s) of a Corporation
- Limited liability of corporations means the only asset each individual can be accountable for is their investment in stock of the company. Aside from that, business actions and debts are separate from the individual
- Corporate tax treatment because the corporation files it’s taxes separately from owners. Owners only pay taxes on the profits paid in the form of salaries, bonuses and dividends. Any other profits are taxed a corporate tax rate, which is usually lower than personal taxes
Disadvantages of a Corporation
- Corporations can be costly and time-consuming to start and operate, they may require some start-up tax cost other entities are not subject to
- Double taxation because in some cases corporations are taxed twice, when the company makes a profit and when dividends are paid to share holders
- Corporations are highly regulated by the federal, state and local agencies which causes increased paperwork and record keeping.
S Corporation (S corp)
S Corporations, or S corps, is a special type of corporation created by tax election to the IRS. S corps receives a Subchapter S designation from the IRS which allows them to avoid the double taxation C corporations are subject to.
You must establish a business as a corporation first, and then select the designation for Subchapter S. S corps are still considered a unique entities apart from the those who own it. The difference between the C and S corporations is the profits and losses can pass through to the owners’ personal tax return. The business itself is not taxed, only the shareholders.
Who is Involved in a S Corporation?
The important note about s corporations is any shareholder that works for the company must him or herself “reasonable compensation”, this is generally considered fair market value. If reasonable wages are not taken the IRS might classify additional corporate earnings as wages.
State Filing Requirement for a S Corporation
Before attempting to use the S corporation designation, make sure your company will qualify under IRS stipulation. If the business will qualify, file as a regular corporation first, and then the shareholder(s) must sign and file Form 2553. Once the business is registered you must also obtain the proper business licenses and permits. Regulations can vary, use the Licensing and Permits tool to find which licenses and/or permits are appropriate for your business.
How are Federal Taxes Affected with S Corporation?
Not all states tax S corps equally, most recognize them similar to the federal government and tax shareholders accordingly. But, some states will tax the profits above a certain amount differently; some states do not recognize the S corp election at all but rather treat the S corp exactly like a regular corporation, and some states tax both S corps profits and shareholder profits. Make sure to check with your state and a tax attorney to ensure you are creating the best business for your company.
You must file Form 2553 to elect the S corp status within 2 months and 15 days after the beginning of the tax year for the status to be in effect.
Advantage(s) of an S Corporation
- S corporations offer taxes savings for the business and the individual. Only the wages paid to the S corp shareholder are subject to the employment tax, the remaining income is paid to the owner as a distribution which is taxed at a lower rate, if at all
- Some expenses that shareholder(s)/employee(s) incur can be written off as a business expense tax credits, but his excludes health and life insurance
- S corporations have an independent life from its shareholders. Shareholders can leave the company or sells shares and the operations are undisturbed. This draws a line between the corporate entity and the individual which offers protections to its shareholders
Disadvantage(s) of an S Corporation
- Shareholder compensation requirements must be reasonable. If the IRS takes notice of shareholder(s) taking low salaries and high distributions combinations, those distributions can be reclassified as wages and you will be subject to a higher employment tax and audit results.
Limited Liability Company (LLC)
Limited liability companies (LLC’s) is a hybrid legal entity which provides the limited liability of a corporation and the tax efficiencies and operation flexibility of a partnership. LLC members report the profit and losses on their personal federal tax return similar to the owners of a partnership.
Who is Involved in an LLC?
Owners are referred to as members and the members can be one or more person(s), corporations and other LLC’s.
State Filing Requirement for an LLC
The establishment of an LLC is done through the Secretary of State unless otherwise posted, and usually with forms called Articles of Organization. Your business name must not have certain restricted words in your state (examples include “bank” or “insurance”). In addition to the Articles of Organization you will need to obtain Licenses and Permits. Use the Licensing and Permits tool to find which licenses and/or permits are appropriate for you business. If you are operating the LLC with another person, another recommended document is an Operating Agreement to structure the LLC’s finances and organization and provides rules and regulations for operations.
How are Federal Taxes Affected with an LLC?
An LLC is not a separate tax entity therefore; the federal income taxes are passed on to the LLC’s members and paid through their personal income taxes. Some states might tax an LLC so investigate your states’ law and/or talk to a tax attorney.
All LLC members must file as a corporation, partnership, or sole proprietorship on their tax return. Certain LLC’s are automatically, classified and taxed as a corporation by federal law. For guidelines on how to classify an LLC check the IRS website here.
For an LLC to elect or change its classification, the LLC member(s) must file Form 8832. For tax purposes, LLC members should file one of the following forms as appropriate:
- A single-member LLC files Form 1040 Schedule C like a sole proprietor.
- Partners in an LLC file a Form 1065 partnership tax return like owners in a traditional partnership.
- An LLC designated as a corporation files Form 1120/1120 s** depending on designation, the corporation income tax return.
- **If you are combining the benefits of an LLC with an S Corp you must file the special election to the IRS using Form 2553. You must file Form 2553 to elect the S corp status within 2 months and 15 days after the beginning of the tax year for the status to be in effect.
- The LLC will remain an LLC for legal purposes even though it is taxed as an S Corp.
Advantage(s) of an LLC
- Members are protected from personal liability for business decisions and actions of the LLC. This means a members’ personal assets are usually exempt if the business is sued
- LLC’s record keeping is less than that of a S corp
- There are fewer restrictions on profit-sharing within an LLC
Disadvantage(s) of an LLC
- In many states if a member leaves the LLC the business is dissolved and the members either make a new LLC or part ways. To prevent having to dissolve the business, create an operating agreement to handle such situations
- Members of an LLC are considered self-employed and are subject to self-employment tax contributions towards Social Security and Medicare. The entire net income of the LLC is subject to self-employment tax
As a note, single person entities will generally choose to establish either and LLC or S corp, but you should always talk to a tax lawyer before making any decisions. For a list of all the State Secretary offices click here and to get an EIN from the IRS after filing click go to the IRS Registration page.