Small Business Tax Tip – Corporation, LLC, Partnership or Proprietorship?

Sometimes it’s the small decisions — or lack of a decision — that have the greatest effect on your business.

Take the choice of what type of legal structure you use to operate your business. Many small business owners are so excited about starting their businesses that they give little or no thought to this very important decision. Should you incorporate? Form an LLC? A partnership? Would you be better off just doing nothing and running your business as a sole proprietorship?

Before you take the advice of the first person you ask or the first book you read, consider all of the legal, tax, financial and operational effects of your choice. Let’s look at your choices one by one.

Sole Proprietorship

When you open your business without a partner (a spouse does not usually count as a partner for this purpose) and without filing any paperwork to choose one of the other business types, you are automatically a sole proprietorship. You are doing business with your customers directly as yourself, an individual. This is true even if you have a name for your business and file “fictitious name” or “doing business as” papers with your state or local government.

For income tax purposes, there are no separate forms to file for the business. You simply attach Schedule C to your Form 1040. Schedule C is where you summarize your business revenues and expenses. You pay tax on any profit at the regular individual tax rates. If you have a loss, you can usually deduct the loss against your other income.

In addition to income tax, you must pay self employment tax on your business profit. The self employment tax rate is 15.3% on the first $94,200 (for 2006) of profit, and 2.9% on any amount over $94,200. The tax is designed to replace the social security and medicare taxes you and your employer pay when you have a regular job. Since you’re both “employer” and “employee,” you pay twice as much as you would if you worked for someone else.

The biggest pitfall of being a sole proprietor is your legal liability. If someone is injured, whether physically, financially, emotionally, etc. as a result of your business activities, you can be sued personally. In today’s litigious environment where people are sued at the drop of a hat, this is a risk no serious business owner should take lightly. While insurance may offer some protection, you still run the risk of losing your personal assets, and/or of having to file bankruptcy, due to a lawsuit.

While this form of business may be fine for some part-time or “sideline” businesses, most small business owners should choose a different option.

Partnership

When you co-own a business with one or more other people and don’t choose one of the other business types, you are automatically a partnership. (Technically, a “general partnership.”) While a sole proprietorship is low on the list of desirable business structures for a small business, a partnership is even lower.

Like a sole proprietorship, you can be sued personally for any harm you cause as a result of your business activities. Even worse, you can be sued for any harm caused by your partner! Not only that, if your partner signs a contract or takes out a loan on behalf of the business, you are automatically bound by the terms of that contract, whether you agree with it or not. This is scary stuff, and I simply never recommend this structure. This is an example where “doing nothing” can be a big mistake.

Income tax wise, a partnership must file a Form 1065, U.S. Return of Partnership Income, to report its revenues and expenses. The partnership itself does not pay income taxes. Rather, each partner reports his share of the profit or loss from the business on his individual tax return. As with a sole proprietorship, an active partner must pay the 15.3% self employment tax on his first $94,200 (for 2006) of the partnership income, and 2.9% on any amount above that.

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