Business Organization and Tax Implication
One of the first and most important decisions that any business owner will make is what structure or type of business organization to form. The Internal Revenue Service (IRS) and the Small Business Administration (SBA) agree that the type of structure will have operational, legal, and tax implications for both the business owner and the business operation. Business owners and consultants recommend that new business owners consult with both an attorney and an accountant before making the final decision as to which business structure to use.
This is a discussion of the five common types of business organizations and the tax implications of each. The general types of business organizations are sole proprietorships, partnerships, corporations (c-corp), Subchapter S-corporations (s-corp), and limited liability companies (LLC). Businesses, like individuals, must pay federal, state, and local income taxes. Additionally businesses are subject to self-employment, payroll, withholding, and unemployment taxes. The type of taxes, tax forms, and reporting requirements vary according to the type of business organization.
How would you define each of the five business organizations? Sole Proprietorship A sole proprietorship is the easiest type of business to organize. If any individual decides to begin operating a business, a sole proprietorship has been formed. Simply put, the individual and the business are one and the same. Most small businesses begin as sole proprietorships with the vision, labor, and investment of the business owner. Many professionals including accountants or attorneys may begin operating as sole proprietors using their personal names, such as B. L. Smith Accounting, as opposed to a trade name, such as BLS Accounting Services.
A sole proprietorship requires no legal forms or registration. Although, many states require that trade names be reserved or registered with the state. Some localities may requiring registration or licensing to conduct certain activities such as plumbing or electrical contractors, or rental property managers. Sole proprietorships cannot be bought or sold. If the owner retires or closes the business, it is simply dissolved upon cessation of business activities. All rights to income and responsibilities for debts belong to the owner, and are considered part or their personal income and debt.
The sole proprietorship pays income taxes as an individual. The owners files IRS for Schedule C or C-EZ to report profit or loss from business activities. The profit is reported on the 1040 series and taxed at the corresponding rate. Also, sole proprietors must pay Self-employment taxes on Schedule SE, which covers social security and medicare taxes. If the sole proprietor has employees, then they will also file Form 940, Federal unemployment taxes (FUTA) and must set up a withholding account for their employees federal, state, and local tax withholdings and payments, and must match social security and medicare taxes.
Partnership A partnership is similar to a sole proprietorship except that two or more individuals own and or operate the business. The partners may, like the proprietor, simply begin operations with a verbal agreement, such as a husband and wife team. However, most partnerships create a legal partnership agreement spelling out the terms of ownership, outlining the duties of each partner, and outlining provisions for sale or transfer of ownership. Partnerships generally operate under a trade name, although the partners names may be used as the trade name, for example, Smith and Smith Accountants.
Partnerships must also comply with state and local laws for registering business activities. Partnership agreements may be filed with the state or locality for legal protection and identification. Additionally, a partnership will file for an Employer Identification Number (EIN) with the IRS to distinguish it from the individual partners. There are three types of partnerships that can be utilized, determined largely by the type and expected duration of business activities.
A general partnership is one in which equal ownership, management, legal, and financial responsibilities are shared between the owners. General partnerships are usually intended to be ongoing business operations. A limited partnership is when one or more owners have unequal ownership, management, legal, or financial responsibilities. Many limited partnerships have a managing partner who is solely responsible for day-to-day operations, and several limited partners who may only have a personal financial investment in the business.
A limited partnership agreement may state that limited partners have limited legal liabilities as investors. Many companies attract private investors with this form of organization, especially companies that do not wish to trade on public stock markets. A joint venture can combine elements of a general and a limited partnership. What is unique about the joint venture is that the business activities are usually for a limited or definite period of operation. Real estate developments and feature film movies are often joint ventures.
A real estate developer may establish separate joint ventures for building a strip mall, an apartment complex, and a single family home site. A movie studio may establish a joint venture for a single movie production. Investors know the duration of their investment and have an expected date to receive the return on their investments. Partnerships must file IRS form 1065, which is a declaration of partnership income, but the business itself pays no taxes. Each partners’ share of income is then reported on Schedule E and transferred to their 1040 series as taxable income.
Partners must also file Schedule SE for self employment taxes. They then pay taxes at the corresponding individual tax rates. Partnerships with employees are subject to the same withholding and social security matching requirements as sole proprietors with employees. Corporation ©-corp) A corporation takes the general partnership concept and turns the business into a legal entity separate from its owners, investors, and managers. A corporation technically has a life of it’s own. A corporation is formed by a statutory agent and group of operating officers.
The owners are called shareholders, and their evidence of ownership is called stock, or common stock. The shareholders vote for a board of directors who oversee the day-to-day operations. In smaller private corporations an individual may be an officer, shareholder, and manager of operations. What is unique about a corporation is that ownership can be transferred by a simple sale of stock either to existing owners or to anyone who is willing to buy at the set price. Corporations can also sell stock on the stock markets.
A corporation must pay taxes on the income it earns since it is a legal entity. The corporation will file IRS form 1120, and pay taxes on the profits that the company earns. Most states and localities also require corporations to file income tax returns. Shareholders are also taxed as individuals on capital gains, if they sell their ownership stocks, and on dividend, which are profits passed on to shareholders. Unlike a proprietorship or partnership, and owner/manager of a corporation will pay taxes twice. Subchapter S Corporation (S-corp)
A subchapter S corporation is no different than a c-corporation in organization or operation. The primary difference, or in some cases advantage, is the income tax status and treatment of the s-corporation. S-corporations generally never sell stock on the public stock markets, and are usually private family owned businesses. S-corps allow owner/managers to avoid paying taxes twice. When the owners pay themselves what is considered reasonable compensation for their job classifications, the corporate income will be reported on for 1120-S, and then passed through to the shareholders on Schedule E.
The owner, like the partner, then reports that share on the 1040 series and pays taxes at the individual rate. Limited Liability Company (LLC) The limited liability company is a combination of a corporation and a limited partnership. A joint venture, when incorporated, becomes a limited liability company. The owners are called members instead of shareholders. Ownership is defined in the LLC charter, not by stock ownership. The members may be only financial investors, only managers, or both. What is unique about the LLC is its ability to choose whether to be taxed as a partnership or as a corporation.
The LLC, may file any of the IRS forms, Schedule C, 1120 series, or 1065 series depending on the number of members. The benefit is that taxes are passed on to the members and taxed at the corresponding individual rate. How would you analyze the tax implications of each organization? All businesses with employees, regardless of type of structure and organization, will pay FUTA, federal unemployment taxes, state unemployment insurance, and workers compensation insurance. Workers compensation may vary from state to state and by job classification.
They must also match their employees social security and medicare taxes, and withhold and deposit the employees federal, state, and local tax liabilities. The most important tax implications for business is level or amount of taxation and complexity of paperwork. The sole proprietorship has the least amount of paperwork required for income tax reporting, and depending on the actual profit may pay at the lowest income tax rate or have no tax liability at all, if the business incurs a loss. Partnerships, corporations, and LLCs will file two tax returns, one for the business and one for the individual.
1120s and 1065s also require additional record keeping and reporting of business assets and liabilities in addition to income and expenses. Finally the traditional C-corp must pays double taxes along with the additional record keeping and filing requirements. Conclusion An individual owner may be overwhelmed by the filing requirements of a corporation. A group of owners may reduce the overall tax burden by filing a partnership or s-corp return and paying at the individuals’ tax rates. Business owners must weigh several factors when deciding what legal form of organization to use.
Tax implications should play a major role in this decision. Tax implications are not only limited to how much tax will be paid, but also include the amount of record keeping required to file certain types of tax returns. References Business Startup Where to Begin & How to Grow. Tax Information. (pp. 23-25). Retrieved August 5, 2008, from http://www. businessfinance. com/books/S tart-A-Business. pdf Business Startup Where to Begin & How to Grow. Types of Business Organizations. (pp. 12-14).
Retrieved August 5, 2008, from http://www.businessfinance. com/books/S tart-A-Business. pdf www. irs. gov. Business Structures. Retrieved August 5, 2008, from http://www. irs. gov/businesses/small/ar ticle/0, id=98359,00. html www. sb a. gov. Choose a Structure, Forms of Ownership. Retrieved August 5, 2008, from http://www. sba. gov/smallbusinessplanne r/start/chooseastructure/START_FORMS_OW NERSHIP. html www. sba. gov. Choose a Sturcture, Basic Structures. Retrieved August 5, 2008, from http://www. sba. gov/smallbusinessplanne r/start/chooseastructure/START_BASIC_ST RUCTURE. html
