Part A: Overview
- What are the options? The main options for organization of small and medium sized businesses are sole proprietorship, general partnership, limited partnership, limited liability company ("LLC"), S corporation and C corporation. There are lesser used variations on the above but we shall stick to the main options in this article.
- Sole Proprietorship. This is the default business form for an individual. If you operate a business by yourself without taking formal steps to organize a separate business entity, you are operating as a sole proprietorship. Your income tax return for this business is filed on Schedule C of your individual form 1040. Self-employment taxes (i.e., the employer and employee's share of FICA taxes) are to be paid upon all earnings from a sole proprietorship in addition to standard income taxes. The operator of a business as a sole proprietorship is personally liable for any debts incurred by the proprietorship. If your business operates under a trade name (i.e., Joe's Fish Market), you must make a fictitious name registration with the state secretary of state's office but there will be no state franchise taxes due. Note: In California, the minimum annual franchise tax for corporations is $800 per year; however, most other states have annual franchise taxes under $100.
- General Partnership. A general partnership occurs whenever one or more personals or legal entities jointly operate a business together but fail to formally organize the business as a business entity. A general partnership may or may not have a written partnership agreement that spells out the rights and duties of the partners relative to partnership assets, liabilities, income (loss) and control of business operations. See General Partnership Agreement for more information. All general partners are jointly and severally liable for all partnership debts. "Jointly and severally" means that each partner can be held liable to 3rd parties for the entire partnership debt. Also, each partner has the potential to hold all partners liable for actions taken in connection with the business (note: there are limitations upon this hazard but one must be aware of the potential danger when operating as a partnership). Partnerships file a separate tax return (i.e., federal form 1041) and partners pay Social Security and Medicare on all partnership earnings.
- Limited Partnership. A limited partnership is formed through the filing of a certificate of limited partnership with the appropriate state office for corporate filings (usually the secretary of state). See the Missouri Certificate Limited Partnership for an example of this document. In sole proprietorships and partnerships, the owners are all active participants in the operation of the business. In a limited partnership, we have two groups of owners: (a) the general partners who operate the business and are personally liable for partnership debts and (b) limited partners who may not participate in the operation of the business but are NOT liable for partnership debts. Limited partners are, thus, passive investors in the business. The general partners pay Self-Employment tax on all partnership earnings whereas the limited partners do not. All limited partnerships are required by state law to have written partnership agreements.
- LLC. An LLC is also formed through the filing of articles of organization with the appropriate state office for corporate filings (usually the secretary of state). See the Missouri LLC Articles of Organization; see also LLC Formation for more information on this topic. An LLC is a hybrid between a partnership and corporation. Generally, LLCs are required by state law to have written operating agreements that set forth the rights and duties of the llc members much like a partnership agreement. See LLC Operating Agreement. Although an LLC can be organized with non-member managers operating the business, the IRS has ruled that in most cases LLC members shall be liable for self-employment taxes on their share of LLC earnings. An LLC reports its income (loss) on federal form 1041 and LLC members are not personally liable for the debt of an LLC.
- Corporations. A corporation is formed through the filing of articles of incorporation with the state. See Incorporation in all 50 States for more information on this topic. There is no distinction between an S and C corporation when the initial filing of articles of incorporation are made with the state. To become an S corporation, a corporation must file Form 2553 with the IRS within a certain deadline to qualify for S status. See Form SS-4 and instructions for filing Form SS-4. If you fail to make a timely S election, the corporation is automatically a C corporation. S corporations are taxed on income (and losses) like partnerships in that there is no entity level taxation whereas corporations have their income taxed at the corporate level. Please note that S corporations that formerly were C corporations can be taxed upon "built-in gains" that existed upon their conversion from C to S. Shareholders are not personally liable for the debts of either C nor S corporations. In regard to employment and unemployment taxes, S and C corporations are treated alike: employment taxes are only paid upon the designated salary of a shareholder and not upon dividends.
Chart from Washington University comparing partnerships, S Corporations, C corporations
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Part B: Taxes
- Introduction. There are several layers of tax issues to be found in choosing a business entity; for example, employment taxes, unemployment taxes, state franchise taxes, double taxation of income at the entity and owner level, taxation and deductibility of fringe benefits, and the ability to specially allocate elements of an entities income or losses to specific owners. We shall try to point out the most important implications for each entity type but a thorough discussion of the topic is beyond the scope of this article.
- Entity level taxation--double taxation. Double taxation of business profits refers to taxation at the level of the business entity and a second taxation upon the same earnings at the owner level when they are distributed. The classic example of this is C corporations wherein the corporation pays federal and state income taxes upon all earnings and, then, the shareholders are also taxed when earnings are distributed to them in the form of dividends. Sole proprietorships, general and limited partnerships, and S corporations all do NOT pay income tax at the entity level but, rather, pass it along to the owners who pay the tax personally. Please note, however, that the taxation of entity profits to the owners of sole proprietorships, general and limited partnerships, and S corporations is made when the earnings are recognized regardless of whether the earnings are actually paid out or withdrawn by the owners. For instance, an S corporation may earn $100,000 in 2003 with each of its 50% shareholders reporting $50,000 in income upon their individual returns from the S corporation. The shareholders are each still required to report $50,000 in income from the S corporation even though the S corporation held the earnings for its own uses and failed to pay make dividend payments. This is especially an important factor to keep in mind when one is to be a minority shareholder in an S corporation with no control over the payment of the dividends.
- Employment and unemployment taxes. An employee only has the employee's share of FICA taxes withheld from his or her paycheck (currently 7.65 %) while the employer is responsible for an additional 7.65% tax. A self-employed individual faces the possibility of paying both the employer and employee's share of FICA (currently 15.3 %) as well as unemployment taxes which vary by state and business type. General partners, a most LLC members have all of their income from a partnership or LLC treated as self-employment income. Click for additional information on this issue. Unemployment taxes typically are capped at lower levels of income (i.e., $7000 in the State of Missouri) whereas Medicare (2.9 %) is unlimited and Social Security (12.4 %) was capped at $87,000.00 for 2003. When one creates a business entity, S corporations are liable for unemployment taxes, Social Security and Medicare only upon the those amounts deemed "wages" to the owners whereas partnerships and LLCs pay Social Security and Medicare upon all earnings (although they pay no unemployment taxes as he or she is treated as a self-employed individual). This issue especially comes into play when deciding between S corporations, on the one hand, and LLCs or partnerships on the other. They are taxed the same way for income tax purposes (with a few exceptions noted below); however, S corporations have the ability to cap employment taxes at a lower level. In order to substantiate to the IRS having an S corporation pay substantial dividends (as opposed to salary) to a shareholder who is also an employee (and thereby limit employment and employment taxes), the corporation should be able to demonstrate that it generates income through methods other than the personal services of said shareholder / employee.
- Sale of Assets. Upon the sale of the assets of a business, a C corporation shall be liable for capital gain tax at the corporate level and again at the shareholder level when either the company is liquidated or the shareholders are paid dividends. When we are talking about substantially appreciated assets, this can be a significant issue for the owners.
- Fringe Benefits / Charitable Deductions. Accountants often tout the use of C corporations for small businesses due to the more favorable deductibility of fringe benefits and allowance of charitable deductions by C Corporations. One who owns more 2% or more of the stock of an S corporation as well as all LLC members and partners are taxed upon the value of fringe benefits provided to them by the business. An S Corporation, as opposed to C corporations, has no life and disability insurance deduction, and lesser deductibility of retirement plan contributions. See Additional information regarding fringe benefits and S corporations.
We are merely pointing out issues in this article. One would need to sit down with a tax accountant to arrive at hard estimates of the tax pros / cons for the choice of each business entity as applied to your particular situation.
Comparison of S and C corporation taxes
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