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The decision as to which type of business organization to use when starting a business is a major one. And, it’s a decision to be revisited periodically as your business develops. While professional advice is critical in making this decision, it’s also important to have a general understanding of the options available.
Businesses fall under one of two federal tax systems:
1. Taxation of both the entity itself (on the income it earns) and the owners (on dividends or other profit participation the owners receive from the business). This system applies to the business called the “C-corporation” (C-corp) for reasons we’ll see shortly and the system of taxing first the corporation and then its owners is called the “corporate double tax.”
2. Pass-through taxation. This type of entity is in itself not taxed; however, each owner is each taxed on their proportionate shares of the entity’s income. The leading forms of pass-through entity (further explained below) are:
A Partnerships, of various types.
B S-corporations (S-corps), as distinguished from C-corps.
C Limited liability companies (LLCs).
A sole proprietorship such as John Wayne Plumbing or Marcus Garvey, M.D. is also considered a pass-through entity even though no “organization” may be involved.
The first major consideration (in this case, a tax consideration) in choosing the form of doing business is whether to choose an entity (such as a C-corp) that has two levels of tax on income or a pass-through entity that has only one level (directly on the owners).
Co-owners and investors in pass through entities may need to have their operating agreements require a certain level of cash distributions in profit years, so they will have funds from which to pay taxes.
Losses are directly deductible by pass-through owners while C-corp losses are deducted only against profits (past or future) and don’t pass through to owners.
Business and tax planners therefore typically advise new businesses-those expected to have startup losses-to begin as pass through entities, so the owners can deduct losses currently against their other income, from investments or another business.
The major business consideration (as opposed to tax consideration) in choosing the form of business is limitation of liability, that is, to protect your assets from the claims of business creditors. State law grants limitation of liability to corporations (C and S-corps), LLCs, and partners in certain forms of partnership. Liability for corporations and LLCs is generally limited to your actual or promised investment in the business.
User | 12/03/2021