Choosing which entity to operate your business involves two fundamental choices: 1) will you remain personally liable for business debts; 2) how will you and your business pay tax?
There’s no “pat” answer, and in many cases you’ll want more than one entity. Consider these options as starting points:
This is a business you operate yourself, in your own name or trade name, with no partners or formal entity. You remain personally liable for business debts. You report income and expenses on your personal return and pay income and self-employment tax on your profits. These are best for startups and small businesses with no employees in industries with little legal liability.
This is an association of two or more partners. General partners (“GPs”) run the business and remain liable for partnership debts. Limited partners (“LPs”) invest capital, but don’t actively manage the business and aren’t liable for debts. The partnership files an informational return and passes income and expenses to partners. GP distributions are taxed as ordinary income and subject to self-employment tax; LP distributions are taxed as passive income.
This is a separate legal person organized under state law. Your liability for business debts is generally limited to your investment in the corporation. The corporation files its own return, pays tax on profits, and chooses whether or not to pay dividends. Your salary is subject to income and employment tax; dividends are taxed at preferential rates. These are best for owners who need limited liability and want the broadest range of benefits.
This is a corporation that elects not to pay tax itself. Instead, it files an informational return and passes income and losses through to shareholders according to their ownership. Your salary is subject to income and employment tax; pass-through profits are subject to ordinary income but not employment tax. These are best for businesses whose owners are active in the business and don’t need to accumulate capital for day-to-day operations.
Limited Liability Company (“LLC”)
This is an association of one or more “members” organized under state law. Your liability for business debts is limited to your investment in the company, and LLCs may offer the strongest asset protection of any entity. Single-member LLCs are taxed as proprietors, unless you elect to be taxed as a corporation. Multi-member LLCs choose to be taxed as partnerships or corporations. This flexibility and asset-protection strength makes LLCs the entity of choice for many new businesses.
If you expect your business to lose money at first, consider a proprietorship, LLC, or “S” corporation. Losses from these entities (up to your basis in the business) offset outside income from salaries, investments, and other businesses. If losses exceed that income, they generate net operating losses (“NOLs”) that you can carry back two years or forward 20.
The IRS offers checklists for starting and dissolving your business at www.irs.gov. Go to the “Businesses” page and look for “Topics.” They also offer a free “Small Business Resource Guide” CDROM with forms, instructions, and publications.
About the Author
Dominique Molina is President of the American Institute of Certified Tax Coaches, an organization of tax professionals who are trained to help their clients rescue thousands of dollars in wasted tax. In addition to her blogging and speaking engagements, Dominique provides CPA continuing education as a registered educator with the National Association of State Boards of Accountancy (NASBA).