Forms of Business Entities

Forms of Business Entities

Business people can chose from several different types of legal entities when establishing a business. Each type of entity has advantages and disadvantages with regards to convenience, taxation and liability. In determining which type of entity to use, business people must evaluate these advantages and disadvantages, and chose the type of entity that best fits needs.

The simplest business form is a sole proprietorship. In essence, a sole proprietorship is a single individual operating a business as herself. There are no requirements for organizing an entity, conducting meetings, having officers, etc. However, a sole proprietor is personally liable for all of the business' obligations.

A partnership is the second simplest business entity. If you have more than one person jointly operating a business, and sharing the profits, you generally have a partnership. While it is a good idea to have a formal partnership agreement, a partnership agreement is not required to form a partnership. Each partner in a partnership is personally liable for all of the obligations of the partnership.

In recent years, most states have enacted legislation creating a new type of legal entity, the Limited Liability Company (LLC). In general terms, these are entities that operate like partnerships, but limit the liability of its owners (members) to the assets of the LLC. While more formalities are required of an LLC than a partnership, the formalities for establishing and carrying on an LLC are less than those required of a corporation.

A corporation is a separate legal entity. It is considered to be a "legal person," and the corporation is solely liable for its obligations. The shareholders are not part of the corporation, and normally cannot be held liable for the corporation's liabilities. By law, corporations must follow certain formalities to be created, and to remain as valid corporations. There must be officers and directors. The corporation must conduct regular meetings of it officers, directors and shareholders. The corporation must file required documents with the state, and pay required fees. If any of these formalities are not followed, the corporation will become defunct.

U.S. Taxation of Business Entities

Sole Proprietorship

A sole proprietor reports all of her business income and expenses directly on his individual income tax return. This is done by filling out a Schedule C and attaching it to Form 1040, Individual Income Tax Return.

Partnership

A partnership files a Form 1065, Partnership Income Tax Return. The income and expenses of the partnership are all reported on this return. However, no tax is calculated on the return.

Instead the income is divided among the partners, and the income attributed to each partner is written on Form K-1. A copy of the Forms K-1 are attached to the partnership return, and a copy of each K-1 is supplied to each partner, who then reports the income on her individual income tax return.

LLC

An LLC is generally taxed like a partnership. However, if desired an LLC can elect to be taxed like a corporation. This ability of an LLC to chose its method of taxation is based on the "Check the Box" regulations adopted by the I.R.S.

Corporations

S Corporation

Small corporations can elect to be taxed as an S Corporation, which will allow the income of the corporation to be taxed at the individual shareholder level. Like a partnership return, a Form 1120S does not report a tax liability. Rather, the S Corporation's income is calculated, and Forms K-1 divide the income among the shareholders, to be included on their individual income tax returns. This method is used to avoid the "double taxation" explained below.

C Corporation

Corporations that either do not qualify for, or that do not elect, S Corporation status are taxed as C Corporations. For tax purposes a C Corporation is treated as its own separate person. The corporation files a Form 1120, Corporate Income tax Return, and calculates its corporate income tax on the return. The corporation itself is liable to pay the tax.

However, when a corporation pays dividends, those funds come from after-tax profits, and must be reported on the shareholder's individual income tax return. Thus, the corporation has paid corporate income tax on the money, and the shareholder again pays tax on these same funds. Theoretically, this makes sense, because the corporation is a separate person from its shareholders. However, the legal fiction aside, the same money is taxed at two different levels.


	Forms of Business Entities Business people can chose from several different types of legal entities when establishing a business. Each type of entity has advantages and disadvantages with regards to convenience, taxation and liability. In determining which type of entity to use, business people must evaluate these advantages and disadvantages, and chose the type of entity that best fits needs. The simplest business form is a sole proprietorship. In essence, a sole proprietorship is a single individual operating a business as herself. There are no requirements for organizing an entity, conducting meetings, having officers, etc. However, a sole proprietor is personally liable for all of the business' obligations. A partnership is the second simplest business entity. If you have more than one person jointly operating a business, and sharing the profits, you generally have a partnership. While it is a good idea to have a formal partnership agreement, a partnership agreement is not required to form a partnership. Each partner in a partnership is personally liable for all of the obligations of the partnership. In recent years, most states have enacted legislation creating a new type of legal entity, the Limited Liability Company (LLC). In general terms, these are entities that operate like partnerships, but limit the liability of its owners (members) to the assets of the LLC. While more formalities are required of an LLC than a partnership, the formalities for establishing and carrying on an LLC are less than those required of a corporation. A corporation is a separate legal entity. It is considered to be a "legal person," and the corporation is solely liable for its obligations. The shareholders are not part of the corporation, and normally cannot be held liable for the corporation's liabilities. By law, corporations must follow certain formalities to be created, and to remain as valid corporations. There must be officers and directors. The corporation must conduct regular meetings of it officers, directors and shareholders. The corporation must file required documents with the state, and pay required fees. If any of these formalities are not followed, the corporation will become defunct. U.S. Taxation of Business Entities Sole Proprietorship A sole proprietor reports all of her business income and expenses directly on his individual income tax return. This is done by filling out a Schedule C and attaching it to Form 1040, Individual Income Tax Return. Partnership A partnership files a Form 1065, Partnership Income Tax Return. The income and expenses of the partnership are all reported on this return. However, no tax is calculated on the return. Instead the income is divided among the partners, and the income attributed to each partner is written on Form K-1. A copy of the Forms K-1 are attached to the partnership return, and a copy of each K-1 is supplied to each partner, who then reports the income on her individual income tax return. LLC An LLC is generally taxed like a partnership. However, if desired an LLC can elect to be taxed like a corporation. This ability of an LLC to chose its method of taxation is based on the "Check the Box" regulations adopted by the I.R.S. Corporations *S Corporation* Small corporations can elect to be taxed as an S Corporation, which will allow the income of the corporation to be taxed at the individual shareholder level. Like a partnership return, a Form 1120S does not report a tax liability. Rather, the S Corporation's income is calculated, and Forms K-1 divide the income among the shareholders, to be included on their individual income tax returns. This method is used to avoid the "double taxation" explained below. C Corporation Corporations that either do not qualify for, or that do not elect, S Corporation status are taxed as C Corporations. For tax purposes a C Corporation is treated as its own separate person. The corporation files a Form 1120, Corporate Income tax Return, and calculates its corporate income tax on the return. The corporation itself is liable to pay the tax. However, when a corporation pays dividends, those funds come from after-tax profits, and must be reported on the shareholder's individual income tax return. Thus, the corporation has paid corporate income tax on the money, and the shareholder again pays tax on these same funds. Theoretically, this makes sense, because the corporation is a separate person from its shareholders. However, the legal fiction aside, the same money is taxed at two different levels.