Overview.
The choices for organization of small and medium sized businesses are sole proprietorship, general partnership, limited partnership, limited liability company ("LLC"), S corporation and C corporation. Below are some commonly used entities. Please note that this is not an exhaustive overview and a consultation is needed to fully begin to understand the intricate nuances of the listed entities.
Sole Proprietorship.
- This is the default business form for an individual. If you operate a business by yourself without taking formal steps to organize a separate business entity, you are operating as a sole proprietorship. Your income tax return for this business is filed on Schedule C of your individual form 1040. Self-employment taxes (i.e., the employer and employee's share of FICA taxes) are to be paid upon all earnings from a sole proprietorship in addition to standard income taxes. The operator of a business as a sole proprietorship is personally liable for any debts incurred by the proprietorship. If your business operates under a trade name (i.e., Joe's Fish Market), you must make a fictitious name registration with the state secretary of state's office but there will be no state franchise taxes due. Note: In California, the minimum annual franchise tax for corporations is $800 per year; however, most other states have annual franchise taxes under $100.
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 (note: there are limitations upon this hazard but one must be aware of the potential danger when operating as a partnership). Partnerships file a separate tax return (i.e., federal form 1041) 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 (usually the secretary of state). 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.
Limited Liability Company.
- 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. 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.
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A corporation is formed through the filing of
articles of incorporation with the state. 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-corporation 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 or 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.
