In tax planning, you have to start somewhere. For business owners, the first (and most important) step is choosing the business tax entity that best meets your needs.
Your four primary choices for tax purposes will be:
You may be asking, what about LLCs, LLPs, LLLPs, and all of the other business entities that are out there?
Federal tax law does not have separate categories for those business entities. For federal tax purposes, these alternative business forms are taxed under the old categories listed above (C corporations, partnerships, etc.)
This is good news for you. In most cases, you get to choose the federal tax treatment you want for your business, which gives you a lot of flexibility in designing your business entity to meet your specific needs.
What if you have already picked your business form? It may be wise to reevaluate your decision from time to time. As your business develops and changes, you may find you should change business form as well.
Also, to make things more complicated, Congress tends to change rates, laws, and the availability of tax benefits, so it is always worth checking to see if your circumstances have changed.
A little research and planning could save you a lot of money.
The topic of business entities is too complex to discuss completely in this article, but what follows is an overview that should help you get started.1
States Make Entities
Every state establishes its own laws for business entities. Your state will decide the types of entities that are available to you, as well as the fees and the laws that govern the entities.
Thus, when you look to form a particular business entity, such as a corporation or a limited liability company (LLC), the first thing you need to do is determine which types are available in your state.
Consider state law first. You have a lot of issues to weigh at the state level, such as liability protection, fees, transferability of ownership, and state regulation of your industry.
Consider these state level issues before you think about federal tax law. For the most part, you can usually still choose the federal tax treatment you want.
Federal Tax Law Categories
Federal tax law reduces all of the different state level business entities into four main categories:2
C corporations (which include personal service corporations)
C Corporations and S Corporations
Federal tax law requires some business to pay taxes as corporations. Other businesses get to choose.
Under the mandatory rule, if state law refers to your business as a “corporation,” then you have to use corporate taxation.3
Under the optional rule, if you set up a business entity (such as an LLC) in your state, you can choose to use federal corporate taxation.4
C corporations. If you have a C corporation (the default choice), you pay tax twice. Technically, the corporation pays tax, and then you pay another tax when you receive distributions like dividends. (See more about this in .)
S corporations. If you meet certain requirements, you can elect to make your corporation an “S corporation.”5 This means your corporation does not pay tax. Only you, the shareholder, pay tax. (See more about this in .)
Sole Proprietorships and Partnerships
If you don’t choose to be a corporation, you will have a sole proprietorship or a partnership.
Which one do you have? The answer depends on how many people share in the ownership of your business:
More than one owner. You have a . The partnership does not pay taxes as an entity, but the partnership files a Schedule K-1 to tell the IRS how the partners divide income and losses for that year. As one of the partners, you will use that information to file your individual return.
Husband-and-wife businesses. In most states, your spouse counts as a separate owner. So if you co-own a business with your spouse, the two of you have a partnership, not a sole proprietorship.6
Even better, if you happen to live in one of the community property states, then you and your spouse also have the option to classify your business as a sole proprietorship.8
1 At the Tax Reduction Letter, we have detailed articles and tools that can guide you further down this path.
2 Reg. Section 301.7701-2(a) and (b). The regulation refers to “sole proprietorships” as “disregarded entities.”
3 Reg. Section 301.7701-2(b)(1). You also have a “per se corporation” if the statute under which you organized your business refers to the entity as “incorporated,” “body corporate,” or “body politic.”
4 Reg. Section 301.7701-2(b)(2).
5 See IRC Section 1361.
6 IRS Pub. 541, Partnerships, posted March 9, 2011, p. 3.
7 IRC Section 761(f).
8 The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. See IRS Pub. 555, Community Property.