Choosing which entity to operate your business involves two fundamental choices: 1) will you remain personally liable for business debts; 2) how will you and your business pay tax? There’s no “pat” answer, and in many cases you’ll want more than one entity. Consider these options as starting points:

• Proprietorship: This is a business you operate yourself, in your own name or trade name, with no partners or formal entity. You remain personally liable for business debts. You report income and expenses on your personal return and pay income and self-employment tax on your profits. These are best for startups and small businesses with no employees in industries with little legal liability.
• Partnership: This is an association of two or more partners. General partners (“GPs”) run the business and remain liable for partnership debts. Limited partners (“LPs”) invest capital, but don’t actively manage the business and aren’t liable for debts. The partnership files an informational return and passes income and expenses to partners. GP distributions are taxed as ordinary income and subject to self-employment tax; LP distributions are taxed as passive income.
• “C” Corporation: This is a separate legal person organized under state law. Your liability for business debts is generally limited to your investment in the corporation. The corporation files its own return, pays tax on profits, and chooses whether or not to pay dividends. Your salary is subject to income and employment tax; dividends are taxed at preferential rates. These are best for owners who need limited liability and want the broadest range of benefits.
• “S” Corporation: This is a corporation that elects not to pay tax itself. Instead, it files an informational return and passes income and losses through to shareholders according to their ownership. Your salary is subject to income and employment tax; pass-through profits are subject to ordinary income but not employment tax. These are best for businesses whose owners are active in the business and don’t need to accumulate capital for day-to-day operations.
• Limited Liability Company (“LLC”): This is an association of one or more “members” organized under state law. Your liability for business debts is limited to your investment in the company, and LLCs offer the strongest asset protection of any entity. Single-member LLCs are taxed as proprietors; multi-member LLCs choose to be taxed as partnerships or corporations. This flexibility and asset-protection strength makes LLCs the entity of choice for many new businesses.

Limited liability companies (“LLCs”) are associations of one or more members operating the business themselves or through appointed managers. Your liability for business obligations is limited to your investment in the business. LLCs offer the limited liability of a corporation and flexibility to allocate income and losses of a partnership, without the ownership limits of an S corporation or double taxation of a C corporation. This versatility is making the LLC the entity of choice for most new businesses.

• Single-member LLCs are disregarded for federal and most state taxes.1 You’ll file Schedule C or Schedule E:

• Income and loss from trade or business activities is treated as self-employment income and subject to self-employment tax.2
• Income and loss from rental real estate is passive income and loss. Income is subject to ordinary income but not self-employment tax. Losses can offset passive income and may be available to offset ordinary income if you qualify for the rental real estate loss allowance or as a “real estate professional.”

• If you’re actively involved in managing the LLC’s trade or business, you’re treated as a “general” partner:

• The IRS has issued proposed regulations treating income from trade or business activities as ordinary income, subject to income and self-employment tax.3
• Income and losses from rental real estate activities is “passive” income and loss. Income is subject to ordinary income tax, but not self-employment tax. Losses can offset passive income and may be available to offset ordinary income if you qualify for the rental real estate loss allowance or as a “real estate professional.” Losses you can’t currently use are “suspended” until you have passive income to offset or you dispose of the activity.

• If you work less than 500 hours per year, you’re not personally liable for any LLC debt, and you play no role in managing the business, you’re treated as a “limited” partner. Your income from both trade or business and real estate activities is passive income, subject to ordinary income but not self-employment tax. Losses can offset passive income, but not ordinary income. Losses you can’t currently use are “suspended” until you have passive income to offset or you dispose of the passive activity.

“S” corporations are corporations that elect not to pay tax themselves, but to pass income and expenses directly through to shareholders. S corporations can have up to 100 shareholders, all of whom must be individuals (no nonresident aliens), estates, or certain trusts. S corporations can have just one class of shares; however, they can own taxable or “qualified subchapter S” subsidiaries.1 S corporations offer these advantages:

• Avoid Self-Employment Tax. Shareholder-employees draw salaries, reported on Form W-2 and subject to FICA tax. Corporate profits are passed through to their personal returns on Form K1, taxed as ordinary income, but not subject to FICA or self-employment tax.2 (For 2007, this is 15.3% of W-2 compensation or net self-employment income up to $97,500 plus 2.9% above that.3) You still have to pay yourself a reasonable salary.4 Otherwise, the IRS can recharacterize your dividend as wages and impose employment tax.5 “Reasonable compensation” varies from industry to industry, so be sure you can justify the salary you choose.
• Shift Income. You can use an S corporation to shift income to lower-bracket shareholders. You can give shares in the corporation to children or other lower-bracket beneficiaries so that their share of profits is taxed at their lower rate.
• Avoid Audits. S corporations can cut audit risk substantially. For FY 2005, the IRS audited 3.68% of Schedule Cs reporting incomes up to $25,000, 2.21% of Schedule Cs reporting incomes from $25,000 to $99,999, and 3.65% of Schedule Cs reporting income of $100,000 or more — but just 0.30% of all S corporations.7

“C” corporations pay tax on their income at corporate rates.1 They can retain after-tax profits or pay them to shareholders as dividends. Dividends are taxed again as personal income at preferential rates up to 15%. This “double taxation” is more bark than bite if you “zero out” profits by paying them as salary or bonus. This avoids corporate tax as long as your salary is “reasonable compensation” for the services you provide.2

C corporations have none of the ownership limitations that apply to S corporations. And C corporations offer you the widest range of deductible benefits. In fact, many businesses include C corporations in their entity structure specifically to pay benefits.

• If your personal tax rate is 28% or more, you can keep up to $50,000 in profit to be taxed at 15%, then distribute the remaining after-tax net as a “qualified corporate dividend” to be taxed at 15%. This yields an effective tax of just 27.75%.
• If your corporation pays for your life insurance (other than group term coverage up to $50,000), the corporation pays tax on the premium and you pay tax on the value of the coverage (valued at the “PS 58” rates used to value group term life or the insurer’s annual renewable term rate, whichever is less). Those combined taxes may be less than you’d pay for insurance personally with after-tax dollars.
• Your corporation can deduct employee disability insurance premiums; however, benefits are then taxable. If you pay premiums yourself (and forego the deduction) benefits are tax-free. This sounds like a hard choice—but the IRS has ruled that you can deduct premiums until the year in which you become disabled, then forego that year’s deduction and take benefits tax-free.3
• You can borrow up to $10,000 tax-free from the corporation4 so long as you show a business purpose other than avoiding tax.5 If you borrow more than $10,000, you need to pay interest at least equal to the applicable federal rate (“AFR”) or pay tax on the difference between your rate and the AFR.6
• If you own up to 50% of a partnership, LLC, or corporation, you’d like to deduct benefits for yourself, but you can’t afford to include rank-and-file employees, consider establishing a C corporation to deduct benefits for yourself without including parent entity employees. (If you own more than 50% of the parent, your corporation is part of a “controlled group” and you’ll have to offer equal benefits for both businesses.) (Your spouse can establish or use a separate business to offer deductible benefits, so long as they don’t own an interest in your parent entity or serve as director, fiduciary, or employee of that entity.7)

Prepared using the templates at Tax Coach Software