Entity Choices for Starting a New Business
There are many benefits to being your own boss, but the first step in starting a new business is picking the right entity in which to operate that business. As discussed below, there are many types of structures available for a new business, and the best one usually depends on the type of business you will be operating. Here are six options to consider:
Sole proprietorship
A sole proprietorship is one of the simplest forms to use for operating a business. No legal documents are required, and the income and deductions are reported directly on your personal income tax return. The downside is that a sole proprietorship provides no legal liability protection against claims on your personal assets.
Partnership
If you are going into business with others and you don’t want to incorporate the business, then you’ll generally be operating as a partnership, which requires the filing of a Form 1065 (U.S. Return of Partnership Income) with the IRS. However, just sharing expenses, such as co-owning rental property, does not count as a partnership unless the co-owners provide services to the tenant.
There are several types of partnerships, including:
- General partnership (all partners are personally liable for debts)
- Limited partnership (has at least one general partner and one limited partner)
- Limited liability partnership (all owners have limited liability)
A smoothly functioning partnership requires having a well-drafted partnership agreement that spells out how income, expenses, etc., are allocated among the partners. You’ll want to talk with a financial or tax adviser to help you determine the best way to set up such an agreement.
Businesses owned and operated by spouses
If you and your spouse jointly own and operate an unincorporated business and share in the profits and losses, you are partners in a partnership and must file a partnership return. However, there are a couple of exceptions to this rule.
First, if you each materially participate in the business and you file a joint tax return, you can elect to have the business treated as a qualified joint venture instead of a partnership. Making this election will allow you to avoid the complexity of a partnership tax return.
Second, if you and your spouse wholly own an unincorporated business as community property under the community property laws of a state, foreign country or U.S. territory, you can treat the business either as a sole proprietorship or a partnership. States with community property laws are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Because this can get complicated, it’s best to discuss your various options with a tax professional who is familiar with the community property laws in your state.
Limited liability company
A limited liability company is an entity formed under state law, and it may be classified as a partnership, a corporation or an entity disregarded as separate from its owner. Because the members of an LLC are not personally liable for its debts, LLCs have become very popular. However, some of the drawbacks of an LLC include difficulties in transferring ownership and members being liable for self-employment taxes.
C corporation
Another option for operating your business is incorporating it as a C corporation. However, a downside to operating as a C corporation is that its profits are subject to corporate tax, and when those profits are distributed to you as a dividend, they are taxed again. Also, unlike a sole proprietorship, if the corporation loses money, you cannot deduct the loss. One of the benefits of a C corporation is that your personal assets are protected from liabilities of the corporation, unlike with a sole proprietorship.
S corporation
You can avoid the double taxation of a C corporation by instead electing to be an S corporation, if certain tests are met. Generally, an S corporation is exempt from federal income tax except on certain capital gains and passive income. Instead, the S corporation’s shareholders include their share of the corporation’s separately stated items of income, deduction, loss and credit, and their share of non-separately stated income or loss on their income tax returns.
Setting up a new business can be complicated. To avoid problems down the road, it’s important to get things structured correctly from the beginning. In this case, obtaining assistance from a professional qualified in this area can make all the difference.
