A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain. The business has no existence apart from you, the owner. Its liabilities are your personal liabilities. You undertake the risks of the business for all assets owned, whether or not used in the business. You include the income and expenses of the business on your personal tax return.
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business.
A partnership must file an annual tax return to report the income, deductions, gains, and losses from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership’s items on his or her tax return.
If you and your spouse jointly own and operate an unincorporated business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. You should not report the income and expenses, and the loss or gain on your individual tax return. You will need to file a separate tax return for the partnership.
There is an exception to this rule if there are no other owners and both spouses “materially participate” in the business. Under this exception, and after meeting certain other conditions, the spouses may report this business on their individual tax returns by filing two separate Schedule C’s. You may also use this exception to allow both spouses to count these earnings toward social security tax and therefore toward retirement benefits.
In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. However, shareholders cannot deduct any loss of the corporation.
An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation. An S Corporation is formed as a corporation and a separate application is made to IRS to be taxed as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. The net profit or loss of the S corporation is passed through to the shareholders who report their share on their individual tax returns.
Limited Liability Company (LLC)
A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the operational flexibility of a partnership.
A limited liability company is an entity formed under state law by filing articles of organization as an LLC. The members of an LLC are not personally liable for its debts. An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or as a “disregarded entity,” meaning that the income or loss from the business is reported directly on the individual tax return.
You should make the determination of how an LLC is to be taxed at the beginning of the business. This decision should be based on various factors such as your expected net profit or loss, the identity of the members of the LLC, and your long term financial objectives. As such, it can be helpful to seek professional advice.