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Choosing a Business Structure

The type of legal organization selected is an important choice when starting a business. The most common forms of businesses are:

The decision of which entity to use can affect:

State law where the business is organized controls the formation of the business. But Federal tax law controls how the business is taxed. Federal tax law also recognizes an additional choice, the Subchapter S Corporation.

No form of entity is necessarily better than another. Each business owner must assess their own needs and which structure best suits their business. Advice from business experts and professionals may be helpful or necessary when considering the advantages and disadvantages of a form of business entity.

Sole proprietorship

A sole proprietorship is any unincorporated business owned entirely by one individual.

Liability

The owner is personally liable for all liabilities, financial obligations and debts of the business.

Returns and tax treatment

Generally, sole proprietors file Schedule C or C-EZ, Profit or Loss from Business, with their Form 1040. Sole proprietor-farmers file Schedule F, Profit or Loss from Farming. Net business income or loss is combined with other income and deductions and taxed at individual rates on the owner's personal tax return.

Distributions do not trigger a tax event. There are no tax free fringe benefits.

Partnership

A partnership exists when two or more persons jointly carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

A limited partnership is formed by filing a Certificate of Limited Partnership with the state.

A limited liability partnership or limited liability limited partnership is elected by filing an annual registration.

Liability

A general partnership is managed by all the partners, and all partners are liable for all liabilities, financial obligations and debts of the business, including those resulting from acts of other general partners without their knowledge and or consent.

A limited partnership is managed by the general partners, who are liable for all liabilities, financial obligations and debts of the business. Limited partners may not participate in management and are not liable for liabilities, financial obligations and debts of the business.

There are other options, including a limited liability partnership and limited liability limited partnership that alter the partners liability. A limited liability partnership or limited liability limited partnership makes an initial filing that must be renewed annually and all the general partners have limited liability.

Returns and tax treatment

A partnership files Form 1065, U.S. Return of Partnership Income, to report income and expenses. But, this is an information return and the partnership does not pay income tax at the partnership level. See IRS Form 1065 – Frequently Asked Questions updated 3/10/09

The partnership passes the information to the individual partners on Schedule K-1, Partner's Share of Income, Credits, and Deductions, and the partners report their share of income and expenses on their own returns (generally Schedule E of an individual's form 1040, personal income tax return). Partnerships are often referred to as pass-through or flow-through entities for this reason.

Partners must report their share of partnership income even if no distribution is made.

Distributions do not trigger a tax event. There are no tax free fringe benefits.

Corporation

A corporation is formed under the laws of each state and is treated as a separate entity responsible for operation of the business.

A corporate structure is generally more complex than other business structures. It requires complying with more regulations and tax requirements, and may require more tax preparation services than a sole proprietorship, partnership, or limited liability company.

Liability

Shareholders are generally not personally liable for the liabilities and debts of the corporation, but exceptions exist. These exceptions include: inadequate capitalization, co-mingling corporate funds and assets with personal funds and assets, or for actions they personally participate in.

Returns and tax treatment

A corporation is a separate tax-paying entity. Income earned by a corporation is taxed at the corporate level using corporate tax rates. Regular corporations are called C corporations because Subchapter C of Chapter 1 of the Internal Revenue Code ("IRC") is where general tax rules affecting corporations and their shareholders are codified.

A corporation files Form 1120 or 1120-A, U.S. Corporation Income Tax Return.

Any earnings distributed to non-corporate shareholders in the form of dividends are taxed at individual tax rates on their personal tax returns (but are not deducted by the corporation in determining its taxable income). A corporate shareholder pays only income tax for any dividends received, which may be subject to a dividends-received deduction.

Subchapter S Corporation

An S corporation has the same corporate structure as a standard corporation. It is a legal entity, chartered under state law, and is separate from its shareholders and officers.

Liability

Shareholders are generally not personally liable for the liabilities and debts of the corporation, but exceptions exist. These exceptions include: inadequate capitalization, co-mingling corporate funds and assets with personal funds and assets, or for actions they personally participate in.

Returns and tax treatment

The difference between a C corporation and an S corporation is that the S corporation files an election on Form 2553, Election by a Small Business Corporation, to be treated differently for federal tax purposes. An S corporation generally does not pay federal income tax other than tax on certain capital gains and passive income. The rules for Subchapter S corporations are found in Subchapter S of Chapter 1 of the Internal Revenue Code.

An S corporation files Form 1120S, U.S. Corporation Income Tax Return for an S Corporation. The income flows through to be reported on the shareholders' individual returns. Schedule K-1, Shareholder's Share of Income, Credits and Deductions, is completed with Form 1120S for each shareholder. The Schedule K-1 tells shareholders their allocable share of corporate income and deductions. Shareholders must pay tax on their share of corporate income, regardless of whether it is actually distributed.

Shareholders must report their share of corporate income even if no distribution is made.

There are restrictions on the number of shareholders and who can be a shareholder, and on certain benefits that can be provided to shareholder-employees.

Limited Liability Company (LLC)

LLC are formed by filing Articles of Organization with the state. Much of the control over operations and relations of the members is set out in the Operations Agreement between the members, which is not filed with the state. Absent an Operating Agreement, state statues control the operations and relationship.

Owners of an LLC are called "members". Most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities.

Most states also permit "single member" LLCs, i.e., having only one owner (a husband and wife are counted as one).

Liability

Limited Liability Company (LLC) members generally are not personally liable for the liabilities, debts and actions of the LLC. LLCs provide management flexibility and the benefit of pass-through taxation.

Returns and tax treatment

An LLC with two or more members can choose to be taxed as a corporation (including making an S election) and filing form 1120 or 1120S, or a partnership filing Form 1065.

A single member LLC can choose to be classified as either a corporation or disregarded as an entity separate from its owner ("disregarded entity"). As a disregarded entity, the LLC does not file a separate return. Instead, all the income or loss is reported by the single member/owner on its annual return (generally Schedule C of Form 1040 for individuals).

Members must report their share of LLC income even if no distribution is made.

Returns

All businesses must file an annual return.

In Missouri, corporations must file an annual report listing the officers and directors, and franchise tax returns. Sole proprietorships, partnerships and LLCs are not required to file annual reports or franchise tax returns.

All businesses with employees must file federal and state quarterly employment tax forms 941 and annual form 940, including making deposits as payroll is paid. They must also file reports with the state division of employment security.

Self Employment tax

Sole proprietors must also pay self-employment tax on the net income on Schedule C or Schedule F, calculated on Schedule SE, Self-Employment Tax. You may also be able to deduct one-half of SE tax on your 1040.

General partners must pay self-employment tax on their net earnings from self employment assigned to them from the partnership. Net earnings from self-employment include an individual's share, distributed or not, of income or loss from any trade or business carried on by a partnership.

Limited partners are subject to self-employment tax only on guaranteed payments, such as professional fees for services rendered.

If an LLC is taxed as a partnership or "disregarded entity" (not a corporation), the members pay self-employment tax.

A shareholder-employee pays income tax on his wages, the corporation and the employee each pay one half of the social security and Medicare taxes, and the corporation can deduct its half. Shareholder-employees do not pay self-employment taxes.

Withholding and estimated taxes

Sole proprietors, partners and LLC members do not have taxes withheld from their business income, so generally they need to make quarterly estimated tax payments if they expect to make a profit. These estimated payments are required for both income tax and self-employment taxes for Social Security and Medicare.

Partners are not employees of the partnership and so taxes are not withheld from any distributions. Like sole proprietors, partners generally need to make quarterly estimated tax payments if they expect to make a profit.

If an LLC is taxed as a partnership (not a corporation), the members need to make estimated tax payments as General Partners do.

A shareholder-employee pays income tax on his wages through wage withholding by the corporation-employer.

Other considerations

Other considerations are important.

It is easy to change form of organization from a sole proprietorship, partnership or LLC to another of those forms or to a corporation. Change form of organization from a corporation to a partnership or LLC can trigger tax.

There may be state law or professional licensing restrictions on the type of entity that can be used.

new 11/21/08