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FAQ: Tax Law

What is the Best Business Entity for Income Tax Purposes?

When starting a new business, you can pick from a number of different types of business entities. Each entity is taxed differently and each has its own pros and cons. There is not necessarily an objective “best” entity for tax purposes. Rather, you should select an entity that best fits the needs of your new business. The most common types of domestic business entities are sole proprietorships, partnerships, corporations and limited liability companies.

Sole Proprietorship

A sole proprietorship is an unincorporated business owned by one person. Setting up a sole proprietorship is easy — there are no special state formation requirements and the owner does not have to file any paperwork with the government. While the owner has complete control over the management of the business, he or she does not have personal liability protection, which means that creditors can reach the personal assets of the proprietor to satisfy claims

For tax purposes, all tax information is disclosed on the proprietor's tax return. Income, losses, deductions and credits pass through to the individual owner. There is no additional business tax filing required. The owner of a sole proprietorship is subject to self-employment taxes. A sole proprietorship will generally use the calendar year for its tax year. If the sole proprietorship does business in more than one state, the business' income will be divided up among those states to determine how much tax the business must pay in each one.

Partnership

A partnership is generally defined as an association of two or more people to carry on a business for profit. There are general partnerships, limited partnerships and limited liability partnerships. General partners share management responsibility and profits and can be held personally liable for all debts and obligations of the partnership. Limited partners do not typically share management duties and enjoy limited liability in that they are only liable for partnership debts and obligations to the extent of their contributions to the partnership.

A partnership is not treated as a separate entity for tax purposes and there is no double taxation. Under subchapter K of the Internal Revenue Code (IRC), partnership income, gains, losses, deductions and credits pass through the partnership and are accounted for by the partners on their individual tax returns. While the partnership is not taxed, it still must file an informational tax return. Partnerships generally use the same tax year as the majority of the partners. Partnerships that do business in more than one state will divide up the income among those states and pay a proportional amount of tax in each one.

Corporations

The traditional or regular corporation is known as a C corporation, so named because it is subject to taxation under subchapter C of the IRC. The C corporation is subject to two levels of taxation. The corporation itself pays taxes on any gains, and then the stockholders personally pay taxes on the income that the corporation passes on to them. A C corporation can adopt any tax year, it does not need to use the calendar year as its tax year.

The rate of taxation for the corporation depends on the amount of income the company realizes; the top federal rate is about 35%, while the top state tax rate is about 10%. If a corporation does business in more than one state, it will divide up its business income among those states and pay the appropriate amount of tax in each state.

An S corporation is a regular corporation that qualifies and elects to be taxed under subchapter S of the IRC. While a C corporation is subject to double taxation, an S corporation is not. The S corporation is basically treated as a partnership and is not taxed at the corporate level. Shareholders account for all income, gains, losses, deductions and credits on their individual tax returns.

In order to be classified as an S corporation, all shareholders must elect to have the business taxed as an S corporation. The corporation also must meet the definition of a "small business corporation," which is defined as a corporation with fewer than 75 shareholders who are US residents and citizens. In addition, the shareholders must be individuals, estates or certain qualifying trusts.

Limited Liability Company

A limited liability company (LLC) is a relatively new business form. State statutes provide for the formation of an LLC. LLCs are separate legal entities like corporations, but are treated as partnerships for tax purposes. As such, there is no double taxation. The earnings of the LLC are not taxed at the corporate level; rather each individual owner is personally responsible for the LLC's taxes and must report any gains or losses on their individual tax returns. While there is no federal income tax on LLCs, they may be subject to state income tax depending on the state.

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