How choosing the right entity can save you

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How choosing the right entity can save you

Published By Janet Gershen-Siegel at September 16, 2017

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Business entities can seem confusing. Choose the right business entity from the very beginning and save on taxes and company liability.

First, here are the more common business entities.

Types of business entities

Sole Proprietorship

The SBA says a sole proprietorship is an unincorporated business owned and run by just one person. There is no difference between the owner and the business. That means you, the owner, get all of profits, but you are also responsible for all your business’s losses, debts, and liabilities.

Partnership

The SBA defines a partnership as a single business with two or more owners. Partnerships then divide into three types.

General Partnership

General partnerships assume the partners equally divide up all of the, liability, profits, and management duties. However, when selecting an unequal distribution, the percentages assigned to each partner must be documented in the partnership agreement.

Limited Partnership

Also called a partnership with limited liability, these are more complex than general partnerships. A limited partnership means the partners have limited liability but also limited input in management decisions. What a limit will be will depend on each partner’s investment percentage. Therefore, limited partnerships can be attractive to investors in short-term projects.

Joint Venture

Joint ventures work like a general partnership, but only a limited period of time or for a single project. Partners in a joint venture can convert it to an ongoing partnership if they continue the venture. However, they must file that way (usually with the IRS and the applicable Secretary of State).

Corporation

A corporation (also called a C corporation) exists as an independent legal entity owned by its shareholders. So the corporation itself, and not the shareholders who own it, can be held legally liable for actions and debts incurred by the business.

S Corporation (sometimes called a Subchapter S Corporation)

An S corporation works as a special type of corporation created by an IRS tax election (the IRS’s Subchapter S designation). An eligible domestic corporations can avoid double taxes (once to the corporation and again to the shareholders) if they opt to be treated as S corporations.

In an S Corporation, profits and losses can pass through to your personal tax return. The business itself is not taxed. Only shareholders are taxed. However, any shareholder employees must pay themselves reasonable compensation. The shareholder has to get fair market value, or the IRS could reclassify additional corporate earnings as wages.

Limited Liability Company

A limited liability company is as a type of hybrid legal structure. It has the limited liability features of a corporation with tax efficiencies and operational flexibility enjoyed by partnerships. The owners of an LLC are called members. Depending on the state, members can be one person (one owner), two or more people, corporations, or even other LLCs.

Unlike corporate shareholders, LLCs are not taxed as a separate business entity. Instead, all profits and losses pass through the business to each member of the LLC. Then LLC members report all the profits and losses on their personal federal tax returns, just like the owners of a partnership would.

There are two great reasons why it matters which business entity you choose.

Taxes

Here are the specifics:

  • Sole proprietorship – since the single owner and the sole proprietorship are the same; the owner pays taxes on the sole proprietorship’s profits.
  • Partnerships – The partnership does not pay income tax. Instead, the business passes its profits or losses to its partners. Then the partners include their respective share of partnership income or loss on their personal tax returns.
  • Corporation – Corporations pay state and federal taxes, and sometimes also local taxes. This includes income taxes on profits. A corporation can be taxed twice: first when a profit is made, and second when dividends go to the shareholders.
  • S Corporation – an S corporation is often a smart choice for tax savings purposes. LLC members must pay an employment tax on the whole net income of the business, but only the wages of an S corporation shareholder who is an employee are subject to employment tax. Any other income goes to the owner as a distribution. Distributions are taxed at a lower rate, if at all.
  • LLC – an LLC isn’t a separate entity according to the IRS, so it does not pay taxes. Instead, the members are individually taxed.

Legal Liability

Legal liability varies:

  • Sole proprietorship – there are no limits on personal liability. If the sole proprietorship did it, then so did its owner. You are responsible for all debts and obligations, and including any risks from actions of employees.
  • Partnerships – Partnership owners have full, shared liability. Hence partners are liable for their own actions and for any business debts and decisions made by the other partners. Furthermore, the partnership’s debts can be satisfied via all of the partners’ personal assets.
  • Corporation – In a corporation, shareholders’ personal assets have protection. Shareholders are usually just held accountable for their investment in company stock.
  • S Corporation – An S corporation shareholder’s personal assets, like their personal bank accounts, cannot be used to satisfy any business liabilities, like verdicts against the company.
  • LLC – LLC members are protected from personal liability for business decisions or actions of the LLC. If the LLC incurs debt or it is sued, members’’ personal assets are usually exempt. But not always, hence the term ‘’limited liability’.

Which business entity should you go for?

It’s your decision to make. Pay close attention to the tax burden and personal liability as they can affect you, particularly if you have a business with known hazards, like carpentry or exterminating. You might also want to consider how much control you want to have over your small business. A sole proprietorship means you call all the shots, but it also means you’re responsible for everything. That can be too much to handle. If it is, then consider one of the other common business entities for a small business.

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