The most commonly used business entities
A sole proprietorship or sole ownership is the simplest version of doing business. This is an individual conducting business without being a legal entity such as corporation. If the individual wants to use a name other than her or his name, she or he may select a fictitious name also know Doing Business As (DBA), which is generally registered with the County where the business is operated. For liability purposes, a sole proprietor has unlimited personal liability to business creditors. Therefore, this type of entity may not be the best choice for that matter.
For income tax purposes, a sole proprietor is considered an individual taxpayer and files the IRS form schedule C along with his or her income tax return, and is subject to quarterly estimated tax payments and is held liable for his or her taxes and the employees’ payroll taxes (trust fund recover penalty). A sole member of a limited liability company (LLC) is considered an individual for income tax purposes, unless elected to be treated as a corporation.
Tax Tip: Based tax practitioners’ experience Schedule C s with revenue in excess of $100,000 may be more susceptible to an IRS audit, and may be advisable to be incorporated.
A corporation is a legal entity established under the state law for conducting business. Provided that a corporation is incorporated properly and maintained according to the law, the stockholders or owners of the stock of a corporation may not be held personally liable to the business creditors. The corporate officers may be held personally liable under the “duty of care” and other statutory responsibility to the stockholders. They may also be held liable for the employment tax purposes (trust fund recovery penalty).
For federal income tax purposes, a C corporation is recognized as a separate legal and taxpaying entity. A corporation conducts business with the public, realizes revenue, deductions and net income or losses, pays taxes and distributes profits to shareholders also known as dividends. The shareholders in turn pay income tax on the dividends. Because the dividends are not tax deductible at the corporate level, the stockholder may be paying income tax twice (once at the corporation and once in their own individual tax return) and this is the theory of the double taxation. In addition, shareholders cannot deduct any losses of the corporation in their individual tax returns.
Tax Tip: To mitigate double taxation, it may be advisable to consider an S corporation or a Limited Liability Company (LLC).
S corporations enjoy the same legal protection as C corporations. For federal tax purposes, S corporations elect to pass each individual stockholder’s share of the corporate profit, loss or credit through K-1 to the shareholders. Shareholders of S corporations flow-through their share of the corporate income, losses or credits on their individual income tax returns and pay tax at their individual income tax rates. Therefore, S corporations avoid double taxation on the corporate income. In addition, Stockholders of S corporation may deduct their losses up to the amount of their capital in the corporation known as “stock basis”.
In order to qualify for S corporation status, the corporation must meet the following IRS requirements:
a) Be a domestic corporation
b) Have only allowable shareholders:
i) including individuals, certain trusts, and estates and
ii) may not include partnerships, corporations or non-resident alien shareholders
c) Have no more than 100 shareholders
d) Have only one class of stock
e) Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a legal business entity created under state statute. States use different regulations, and you should check with your state to ensure that your desired entity is allowed. Some types of businesses cannot be LLCs, such as banks and insurance companies. In California professional services such as engineering, accounting, medicine or law cannot be LLCs. According to knowledge authors, there is no legal reasoning for this restriction and it is purely politics. Owners of an LLC are called LLC members. Generally states do not limit ownership of an LLC and members may be individuals, corporations and other LLCs. Most states such as California permit one member LLC or “single-member” LLCs (SMLLCs).
For federal income tax purposes, depending on election made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”). Most lawyers elect domestic LLCs with at least two members to be taxed as partnerships and file the partnership tax returns. Share of income, losses and credits of each member is reported under K-1 and each member includes it in their respective personal income tax returns.
An LLCs may elect to be treated as a corporation for federal income tax purposes by filing the Form 8832 and affirmatively electing to be taxed as a corporation. And a Single Member LLC with only one member is considered as disregarded entity for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless elects to be treated as a corporation.
Tax Tip: Members’ of an LLC may deduct their losses up to the amount of their capital in the LLC. According to the IRS, since each member of an LLC has limited liability, investors are analogous to limited partners under IRC § 469. For purposes of passive loss rules, LLC members are treated as limited partners, even if the taxpayer is a member-manager.
Zaher Fallahi, Attorney At Law, CPA is a California Attorney, and practices as Los Angeles Business Attorney and Orange County Business Attorney. Telephones: LA (310) 719-1040 and Orange County (714) 546-4272, e-mail: firstname.lastname@example.org