The Basics To Forming A Business
Step 1: Choose A Legal Entity
A legal entity is a legal business formed and recognized under state law. Choosing a legal entity will determine the legal rights, responsibilities, ownership structure, and liability of the business.
Step 2: Choose A Tax Election
A tax election, also known as a tax structure, refers to the method by which a legal entity chooses to be taxed under federal tax laws.
Analogy:
Think of the legal entity as the type of car you drive (e.g., sedan, SUV, or truck). It represents the structure and outward identity of the business, including its legal rights, liabilities, and ownership.
The tax election is like the engine that powers the car—it determines how the vehicle performs or operates under different conditions (e.g., fuel efficiency, speed)
LLC
-
An LLC, or Limited Liability Company, is a popular business structure. Profits and losses of the business can pass directly through to the owners’ personal income without being subject to corporate taxes. Meanwhile, the owners—also known as members—have limited liability, meaning their personal assets are protected from business debts and legal actions. LLCs are flexible in terms of management and require fewer ongoing formalities than corporations, making them an attractive option for small to medium-sized businesses.
-
• Ownership: Owned by one person or entity.
• Taxation: Typically, it’s taxed as a sole proprietorship, meaning the income and expenses of the LLC are reported on the owner’s personal tax returns. However, it can elect to be taxed as a corporation.
• Liability: Offers limited liability protection, meaning the owner’s personal assets are generally protected from the LLC’s debts and legal liabilities.
• Management: Managed by the single owner, simplifying decision-making and operations.
-
• Ownership: Owned by two or more members, who can be individuals, corporations, other LLCs, or any combination thereof.
• Taxation: Usually taxed as a partnership, with profits and losses passing through to members’ personal tax returns in proportion to their ownership interests. Like a Single Member LLC, it can also elect to be taxed as a corporation.
• Liability: Provides limited liability protection to all members, protecting their personal assets from the LLC’s business obligations.
• Management: Can be managed by its members (member-managed) or by appointed managers (manager-managed), which allows flexibility but can require more complex governance structures and agreements among members regarding decision-making and profit distribution.
-
Single Member LLC
• Default Taxation: Sole Proprietorship Treated as a “disregarded entity” for tax purposes. The owner reports all business income and expenses on their personal tax return using Schedule C, and income is taxed at the owner’s personal income tax rates.
• Self-Employment Tax: The net earnings from the LLC are subject to self-employment taxes, which include Social Security and Medicare taxes. The current self-employment tax rate is 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare.
• Corporate Tax Option: If a Single Member LLC elects to be taxed as a corporation, particularly an S corporation, the business can pay the owner a reasonable salary, which is subject to employment taxes, with any remaining profits paid as distributions that are taxed at lower dividend rates but not subject to self-employment taxes.
Multi-Member LLC
• Default Taxation: Treated as a partnership for tax purposes. The LLC files an informational return on Form 1065, and each member receives a Schedule K-1 showing their share of the profit and loss, which they then report on their personal tax returns. Members are taxed at their individual income tax rates for their share of the earnings.
• Self-Employment Tax: Like Single Member LLCs, the income that flows through to the members is typically subject to self-employment taxes, unless the LLC elects to be taxed as an S corporation. Members need to pay self-employment tax on their distributive share of the LLC’s profits.
• Corporate Tax Option: A Multi-Member LLC can also elect to be taxed as an S corporation or C corporation, which can offer tax benefits similar to those described for Single Member LLCs, such as potentially lower taxes on distributions compared to ordinary income and a split between salary and dividends.
Partnership
-
A Partnership is a type of business entity in which two or more people share ownership and the responsibilities of running a business. Partnerships are relatively simple to establish and operate, with the owners (partners) actively involved in the management of the business. A partnership may be established for a limited duration or specific project, or it can be a long-term business arrangement. The partnership generally dissolves when a partner withdraws, unless the partnership agreement provides for the continuation of the partnership or the addition of new partners.
-
A General Partnership (GP) is one of the most basic forms of partnership where all partners share in the management and responsibilities of the business. In a general partnership, each partner has equal rights to manage the business and shares in the profits and losses.
Forming a General Partnership is relatively straightforward and does not require as many formalities as corporations or limited liability companies (LLCs). In many places, a general partnership can be formed based on an oral agreement, though it is highly advisable to have a formal, written partnership agreement to outline terms clearly.
-
A Limited Partnership (LP) is a more structured variation of a partnership that differentiates between two types of partners: general partners and limited partners. This setup allows for investment into the business without requiring all partners to take part in day-to-day management or have full liability for the business’s obligations.
Limited Partnerships are commonly used in real estate investments, film production, and certain types of family businesses where it is advantageous to have passive investors contribute capital while a smaller group or single individual takes on the responsibility for managing the business operations. They are also prevalent in private equity and venture capital firms, where the fund managers act as general partners, and the investors as limited partners. This structure allows investors to benefit from the potential profits and tax advantages of a partnership while limiting their exposure to liability.
-
A Limited Liability Partnership (LLP) is a form of partnership that provides each partner with limited liability, similar to what shareholders in a corporation enjoy. This means that partners in an LLP are not personally liable for the business debts or the negligent actions of other partners. LLPs are especially popular among professional groups such as lawyers, accountants, and consultants.
In an LLP, all partners can participate in the management of the business, unlike in a limited partnership (LP), where limited partners must refrain from management to maintain their liability protection. This makes LLPs attractive to professionals who wish to be involved in business decisions.
-
Partnerships themselves do not pay income taxes directly to the IRS. Instead, they are treated as “pass-through” entities, where the profits and losses of the business pass through to the partners who then report these amounts on their personal tax returns.
Corporation
-
A Corporation is a type of business entity that is legally separate from its owners. It is recognized as an independent legal entity, which means it has rights and responsibilities separate from those of its shareholders. Corporations can enter into contracts, sue and be sued, own assets, and are responsible for their own debts and liabilities. This structure is particularly noted for its ability to raise capital through the sale of shares and its extensive legal protections for its owners.
-
S Corporation is a special type of corporation created through an IRS tax election. It avoids double taxation by allowing profits (and losses) to be passed through directly to the owner’s personal income without being subject to corporate tax rates.
S Corporations are restricted to no more than 100 shareholders, and shareholders must be U.S. citizens or permanent residents. S Corporations cannot be owned by C Corporations, other S Corporations, LLCs, partnerships, or many trusts.
-
The standard form of corporation which is taxed as a separate entity and faces the possibility of double taxation on profits and dividends.
C Corporations are taxed as separate entities under the Internal Revenue Code. They pay corporate income tax on their profits before distributing dividends to shareholders, who then pay taxes on these dividends at their individual tax rates. This results in double taxation (at the corporate level and then at the shareholder level on dividends).
-
Tax-exempt corporations are special types of organizations that qualify for a tax exemption from federal and state income taxes on their earnings related to their exempt purposes. These organizations are typically formed for charitable, religious, educational, scientific, or other purposes that benefit the public.
-
Federal Corporate Income Tax Rate:
Flat Rate: A flat federal corporate income tax rate of 21%. This rate applies to the taxable income of the corporation, which is the net income after allowable business deductions.
State Corporate Income Tax Rates:
Varies by State: Corporate tax rates vary widely by state. Some states, like Nevada, South Dakota, and Wyoming, do not impose any corporate income tax at all. Other states have rates that can range from around 3% to 12%.
Sole Proprietorship
-
A Sole Proprietorship is the simplest and most straightforward form of business ownership, where there is no legal distinction between the business and the owner. It is owned and run by one individual, and there’s no legal separation between the owner and the business entity.
Sole proprietorships are commonly used by individuals starting out in business, freelancers, consultants, and other service providers who want to maintain full control over their operations with minimal regulatory paperwork and cost. Despite the risks associated with personal liability, many find the sole proprietorship an attractive option due to its simplicity and tax advantages.
-
Income Tax:
• Personal Income Tax Rates: Income from a sole proprietorship is reported on the owner’s personal tax return and is taxed at the individual’s personal income tax rates. In the U.S., these rates are progressive and can range from 10% to 37%, depending on the total amount of taxable income the individual has for the year.
Self-Employment Tax:
• Social Security and Medicare: Besides regular income tax, sole proprietors must also pay self-employment taxes, which cover Social Security and Medicare. The self-employment tax rate is 15.3%, which consists of 12.4% for Social Security (up to an income ceiling which is adjusted annually for inflation) and 2.9% for Medicare (with no income ceiling).
• Additional Medicare Tax: There is an additional 0.9% Medicare tax that applies to income above a certain threshold ($200,000 for single filers, $250,000 for married filing jointly, and $125,000 for married filing separately).
