Choosing a business entity can seem like a daunting task. But when you are familiar with your options, and the benefits of each type of business, the choice is easier to make. For example, different business formations come with different tax consequences, both good and bad. The basic business entities include sole proprietorships, partnerships, limited liability companies and corporations. If you know how to save on taxes when choosing your business entity, you will be well on your way to cultivating a successful business.
How does a Sole Proprietorships work?
For those solo business owners, the IRS will automatically consider your business entity to be a sole proprietorship, unless you either register as a corporation or elect to be treated as an LLC. A “sole proprietorship” is effectively a “pass through” entity, for tax purposes. This means, as the owner, you will pay personal income taxes on all earnings from the business, along with self-employment taxes. The benefit is that you can deduct all qualified business expenses on your personal income tax returns, as well. Another tax advantage is that the owner of a sole proprietorship is only taxed once on all business income. Also, your net business losses can be carried over to subsequent tax years. This helps to offset future tax liability.
Partnerships are also “pass through” entities
Similar to a sole proprietorship, a partnership is the default business entity when there is more than one owner, and they have not registered as a corporation. Just as with a sole proprietorship, capital gains and income are taxed to the business owners. Partners are only taxed once and can “assign” property, income and debts to other partners. Another benefit is that partners can avoid property disbursement taxes, when assets are transferred from the business.
IRS designations of Corporations
The IRS recognizes two specific corporate entities for tax purposes: S-Corporations and C-Corporations. A S-Corporation operates much like a sole proprietorship or partnership. The income is passed through to the owners, and all profits and losses are allocated proportionally. The difference in a C-Corporation is that the income is taxed twice. In other words, the C-Corporation pays taxes on its net income, and the shareholders also pay taxes on the distributions they receive.
Limited Liability business entities
Limited Liability Companies (LLCs) and Limited Liability Partnerships (LLPs) are business entities that have been established solely by state statute. Either of these limited liability entities can elect to be taxed as “passes through” entities, such as S-Corporations or general partnerships. Most business owners elect to do so because it allows them to avoid double taxation. The flexibility of a limited liability entity also allows business owners to assign income and losses in a way that will save the most in taxes.
If you have questions regarding taxes and business entities, or any other business planning issues, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.