Question

Why is it important for entrepreneur to determine the legal form of business ownership? When choosing the legal form, what kind of tax considerations to make?

Answer 1

Of all the choices you make when starting a business, one of the most important is the type of legal structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, it will affect the amount of paperwork your business is required to do, the personal liability you face and your ability to raise money.

Here's a quick look at the differences between the most common forms of business entities:

• A sole proprietorship is the most common form of business organization. It's easy to form and offers complete managerial control to the owner. However, the owner is also personally liable for all financial obligations of the business.
• A partnership involves two or more people who agree to share in the profits or losses of a business. A primary advantage is that the partnership does not bear the tax burden of profits. A primary disadvantage is liability-each partner is personally liable for the financial obligations of the business.
• A corporation is a legal entity that is created to conduct business. The corporation becomes an entity-separate from those who founded it-that handles the responsibilities of the organization. Like a person, the corporation can be taxed and can be held legally liable for its actions. The corporation can also make a profit. The key benefit of corporate status is the avoidance of personal liability.
• A hybrid form of partnership, the limited liability company (LLC) , is gaining in popularity because it allows owners to take advantage of the benefits of both the corporation and partnership forms of business. The advantages of this business format are that profits and losses can be passed through to owners without taxation of the business itself while owners are shielded from personal liability.

Selecting a Business Entity:

When making a decision about the type of business to form, there are several criteria you need to evaluate.

1. Legal liability. To what extent does the owner need to be insulated from legal liability? They didn't want to take on personal liability for potential losses associated with the business. You need to consider whether your business lends itself to potential liability and, if so, if you can personally afford the risk of that liability. If you can't, a sole proprietorship or partnership may not be the best way to go.

2. Tax implications. Based on the individual situation and goals of the business owner, what are the opportunities to minimize taxation? There are many more tax options available to corporations than to proprietorships or partnerships. As mentioned before, double taxation, a common disadvantage often associated with incorporation. Business losses can help reduce personal tax liability, particularly in the early years of a company's existence.

3. Cost of formation and ongoing administration. Tax advantages, however, may not offer enough benefits to offset other costs of conducting business as a corporation. High cost of record-keeping and paperwork, as well as the costs associated with incorporation are reasons that business owners may decide to choose another option--such as a sole proprietorship or partnership.

4. Flexibility. Your goal is to maximize the flexibility of the ownership structure by considering the unique needs of the business as well as the personal needs of the owner or owners. Individual needs are a critical consideration. No two business situations will be the same, particularly when multiple owners are involved. No two people will have the same goals, concerns or personal financial situations.

Tax Implications:

Some of the tax considerations to make while determining the legal form of business ownership are:

Sole proprietorship. The business and the owner are legally the same. From the IRS's perspective, the business is not a taxable entity. Instead, all of the business assets and liabilities and income are treated as belonging directly to the business owner.

General partnership. As with sole proprietorships, the business and the owners (two or more) are legally the same. A partnership is not a taxable entity under federal law. There is no separate partnership income tax, as there is a corporate income tax. Instead, income from the partnership is taxed to the individual partners, at their own individual tax rates. For tax purposes, all of the income of the partnership must be reported as distributed or “passed-through” to the partners, who will then be taxed on it through their individual returns.

Limited liability company (LLC). A separate legal entity created by a state filing. Under state laws, LLC owners are given the liability protection that was previously afforded only to owners of a corporation (shareholders). Now, LLCs are treated like partnerships for federal tax purposes (unless they elect to be treated like a corporation, which most don’t). LLCs have “pass-through” taxation, which means that no tax on the LLC’s income is paid at the business level. Income/loss is instead reported on the personal tax returns of the owners, and any tax due is paid at the individual level. Keep in mind, even though LLCs are treated as partnerships for federal tax purposes, the same is not always true for state tax purposes.

Corporation. A separate legal entity created by a state filing. The corporation, also called the "regular" corporation, is subject to corporate income tax. Income earned by a corporation is normally taxed at the corporate level using the corporate income tax rates. Corporation income is also subject to what is called “double taxation,” when the income of the business is distributed to the owners in the form of dividends, because dividends are taxable. Tax is paid first by the corporation on its income and then again by the owners on the dividends received. If the owner draws a salary from the corporation, that salary is also subject to income tax (and FICA).