One of the first decisions a new business owner must make is an entity selection. While the decision can be changed within the first year, or even years down the road, that change may be costly, so it's better to make the right decision the first time.

There are a number of basic options available to businesses:

Sole proprietorship.

General partnership.

Limited partnership.

Limited liability company ("LLC").

S corporation.

C corporation.

Other variations on these basic are available, but are generally only used in specific situations. The following is a basic summary of each option:

Sole Proprietorship.

If you run a business by yourself without organizing a separate business entity, you are operating as a sole proprietorship. Your income tax return for this business is filed on Schedule C; self-employment taxes are to be paid upon all earnings from a sole proprietorship, as well as individual income taxes. A sole proprietorship is personally liable for any debts incurred by the proprietorship. If your business operates under a trade name, individuals must register the fictitious name with the local County records office in the county they do business, but there are no state franchise taxes due.

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. 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. Partnerships file a separate tax return 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. 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). 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. 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.

These articles are intended to provide resources for the tax and accounting needs of small businesses and individuals. The information contained in this Website is intended to provide general information on matters of interest in the areas of tax and accounting. Users are encouraged to contact us regarding specific situations.