Trying to decide what “type” of company you want your business to be is one of the most important tax decisions you will make.
A company is much like an individual person. It has certain legal rights and the IRS recognizes this individual as an entity. Just as with any individual, a company can grow and with that growth be forced to change from one type of entity to another. A company that starts as an S-corporation may have an investor who is actually another corporation which will force it out of that S-corp status to a C-corp. What would be the difference? A huge tax change would be incurred.
So understanding the different entity types is very important to a business owner. Each type of company has different legal rights and liability affecting those individuals who own the corporation. An example, a Sole proprietor company has no separate existence from its owner. Income and losses are taxed on the individual’s personal income tax return. In layman term’s the company’s income is seen the same as the owner’s usual income. Even if you leave the money in the business and don’t use it for personal expenses, you are still taxed on that income at the end of the year. You will also incur the self-employment tax, which is 15.3% of the business income which goes to Medicare and Social Security.
Incorporating is a way of getting protection in the case a business is sued for negligence created by employees of the company, the owners of the company are not directly liable. This is why a Limited Liability Company or LLC is used when owners want to be insulated from the company’s issues. An LLC can be either a single member or have multiple owners; depending on the number of owners, you will be taxed the same as a Sole proprietor or a partnership as the IRS does not recognize LLC as an actual tax entity.
A partnership has more than own owner, and the corporation (or partnership) is not taxed at the corporate level, any income is passed through to the individual owner’s based offset percentages set by the members, due to this, it also creates the dreaded self-employment tax mentioned above. And as above, whether the money is left in the business or not, the total income is taxed to the individual members. Also, any money that is “borrowed” from the partnership during the year may also cause a capital gains tax on the individual returns. That is because money borrowed from the company cannot exceed the owners’ contribution to the company. This type of business does require a Partnership Tax Return and then each member would have their personal tax returns.
A business that has multiple owners or even one owner, can choose to set the business up as an actual corporation, called a C-Corporation, this makes it so that income made in the company is taxed to the corporation and not passed through to the owners. Owners are only taxed on any money they receive from the corporation. However, this creates a situation in that if the corporation issues a dividend, an owner could be taxed at the corporate level, then taxed again on their dividend payment, or double taxation. To help this situation the IRS allows an S-Corporation designation as a way to avoid being double taxed.
S-Corporations have very strict guidelines as to what type of businesses qualify and the number of owners among other things. However, S-Corp designation allows owners to get money from the business tax-free and lowers the taxable income from the business. However, in order to do this, business owners must pay themselves like an employee and have taxes come out of their paychecks.
So in every designation there are advantages and disadvantages, here is a link for more details.
Making the decision of what type of corporation you need to designate your business as is something a professional tax and legal person must investigate for you.