When starting a new business, there are literally hundreds of decisions to be made. One of the first, and most important, is the type of entity under which the business will operate. Whether your business employs only you, or a hundred other people, there are questions of liability and asset protection to address. Your choice of business entity will also have a profound impact on your tax obligations. In short, there’s a lot at stake, financially speaking, on which business entity you choose.
Therefore, it’s a wise investment to work with an experienced business planning and tax attorney who can explain the tax implications of your options, and help you select the business entity that is right for your needs. While this article is no substitute for such personalized guidance, it offers an introduction to some important considerations in business entity planning and selection.
Types of Business Entities and Their Tax Implications
The most common business entities are sole proprietorships, partnerships, limited liability companies, and corporations.
Sole Proprietorships
As the name suggests, a sole proprietorship is a business with a single owner. It is unincorporated, so the owner must report all of the business’s income and expenses on his or her individual income tax return. The business’s net income, taken together with the individual’s other net income, will determine the owner’s income tax liability.
In addition to income tax, a sole proprietor must pay self-employment tax. He or she also has personal liability for the business’s debts. This means, if the business owes money to a creditor, the sole proprietor’s personal assets can be reached to pay the debt.
Partnerships
Like a sole proprietorship, a partnership is unincorporated, but has two or more owners. Partnerships may be general or limited. A general partnership means that all partners share management of the business, and all share joint and several personal liability for partnership debts. In a limited partnership, the general partner has liability for the business’s financial obligations as well as being in control of the business’s management.
A partnership is not a separate entity for tax purposes. Income will be taxed directly to partners, regardless of whether they take distributions of income from the business. The partnership files a return with state and federal tax authorities to report each partner’s share of income and losses, and notifies each partner of that information through a Schedule K-1 form. For a general partner, partnership income constitutes self-employment income and is subject to self employment taxes. This is typically not the case with limited partners.
Limited Liability Companies (LLCs)
Limited liability companies, or LLCs, may have one, two, or multiple owners. Single-member LLCs are generally taxed like sole proprietorships, with income from the LLC being taxed to the owner as income from self-employment. If an LLC has more than one owners, for purposes of state and federal taxes it will be treated as a partnership, with income and deductible losses “flowing through” to the owners. With some limited exceptions, income from a multiple-owner LLC will be subject to self-employment taxes.
The primary difference between LLCs and sole proprietorships or partnerships is in the name: “limited liability.” In an LLC, owners are protected from personal liability for the debts of the company. For this reason, many business owners prefer to form an LLC.
Corporations
Tax treatment of a corporation varies depending on whether the entity is a “C” corporation or an “S” corporation, so named because of the Subchapters of the Internal Revenue Code under which they are described. “S” corporations are generally considered to be taxed more favorably than “C” corporations, but there are limitations on what businesses can qualify for “S” corporation status. For example, “S” corporations must be domestic (U.S.) corporations and must have fewer than 100 shareholders, among other requirements. In addition, an “S” corporation may not have any shareholders who are non-resident aliens.
Getting the Right Help for Washington Business Entity Planning
The Internal Revenue Code and Washington state tax laws, are constantly evolving. In order to insulate yourself and your business from needless tax liability, you should consult with an attorney with knowledge of how tax laws impact businesses of all sizes. The attorneys of Ortiz & Gosalia, PLLC have post-JD degrees in tax law and can help you to understand and manage your business’s potential tax obligations.
With offices in Redmond, Bellevue and Kirkland, we offer services throughout the Seattle area and Washington State. If you would like to learn more about the TFRP, including the assessment process, we invite you to contact us.