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Forms of Business Entities

Starting up a Small Business from a Legal, Accounting, and Tax Standpoint

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There are a number of forms, or types, of business entities that you can choose when you set up a small business. If a business starts as the simplest form, the sole proprietorship, you may need to change as it grows to one of the more complex forms of business entities, like the corporation.

There are a number of ways you can look at which type of business entity you should use when setting up a business. If you are starting a business by yourself and it's small and, for example, based out of your home, you may want to start a sole proprietorship, unless you feel like you need the protection of the corporate form of organization. If you and another person or persons are starting a business together, then you can't be a sole proprietorship. You will have to start the business as a partnership. If you take on investors, you will have to start the business as a corporation.

As you can see, there are a lot of considerations concerning the type of business entity you should use when starting a business and all of them have legal, accounting, and tax implications.

Sole Proprietorship

A sole proprietorship form of business entity is the simplest type of business. It is owned by one person and has the accounting advantages of simplicity of record-keeping and organizational costs and the management advantage of ease of decision-making. Usually, a sole proprietorship has no more than 1 - 10 employees.

There is a disadvantage to the sole proprietorship from a legal standpoint. This disadvantage is called unlimited liability. This means that if the business fails, the owner is solely responsible for all debts of the business from his/her personal assets and wealth. The owner can lose not only the capital invested in the business but any assets that the owner has personally. This is a significant disadvantage to the sole proprietorship form of business organization.

From a tax standpoint, the profits of the sole proprietorship are taxed as income to the individual owner. This means that the owner simply files a personal tax return and shows the profits on his Federal Tax Form 1040. Usually, business income and expenses are shown on Federal Tax Schedule C or Federal Tax Schedule C-EZ. Look at the top of Schedule C-EZ to determine if you are eligible to use this Schedule instead of Schedule C. Whichever one you use, transfer the bottom line to Line 12 of Form 1040. It's important to understand the categories of expenses you can deduct.

An interesting fact is that more than 70 percent of the businesses in the United States are sole proprietorships. However, they only generate about 20 percent of the profit in the U.S.

Partnership

Partnerships are actually similar to sole proprietorships except they have more than one owner. From a legal standpoint, articles of partnership are usually drawn up to spell out the details of the partnership, such as the percentage of ownership interest for each partner and the means for distributing profits, among other legal issues. For purposes of taxation, profits or losses are allocated directly to each partner.

Partnerships may have a general partner who, like in the sole proprietorship, has unlimited liability for the liabilities (debts) of the partnerships. The other partners, called limited partners, are liable only for the amount of their investment in the firm. Sometimes, this type of partnership will have trouble securing funds from a bank if it is not incorporated.

Partnerships are usually incorporated. When a business is incorporated, it means that it is considered a separate legal entity just like a person. A business that is incorporated can engage in legal transactions; it can sue or be sued; it can acquire property; and it can engage in contracts. The profits from partnerships are taxed at the level of the owner, just like sole proprietorships. The partners claim profits or losses on the Federal Form 1040.

From a tax perspective, a partnership reports income on Federal tax form 1065. Partnership employers also file quarterly federal tax returns on employees on Form 941.

C-Corporations

Partnerships are usually incorporated. Sole proprietorships can be incorporated if owners feel they want or need the benefits of incorporation. Only about 20% of U.S. businesses are corporations, but they generate 85% of sales and over 60% of profits.

As stated above in the partnership section of material, a corporation is a legal entity apart from a person, but like a person. It is formed through the filing of articles of incorporation. A corporation is owned by investors or shareholders. You can think of a corporation as a large pie and each investor or shareholder owns a piece of that pie. Here is a table of the federal corporate tax rates that have been in effect 2007 through 2011. Corporate tax rates are different than those for sole proprietorships or other unincorporated businesses due to double taxation.

From a legal perspective, one of the benefits of the corporate form of organization is that it has continuous life. It does not die if one of the owners dies. The ownership interest of that owner simply transfers to someone else. Another benefit of this form of organization is the easy divisibility of ownership interests by issuing shares of stock. The interests of the shareholders are managed by a board of directors.

From a tax perspective, corporations file taxes at the corporate level. Their shareholders file taxes on the income they earn from corporations, either dividend or capital gain income. Corporations use Federal Form 1120 to file their tax returns. Shareholders of corporations use Schedule B for dividend income and Schedule E for capital gain (or loss) income.

Subchapter S Corporations

From an accounting perspective, S Corporations are formed to circumvent the double taxation problem of the C-Corporation. Shareholders of a C-Corporation have to endure taxation of the income of the corporation at the corporate level and then again at the shareholder level as dividends or capital gains.

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