Tax Implications of Business Entity Types

The most important decision a business owner can make is about the structure of their business. Sole proprietorships, partnerships, corporations, and LLCs have different tax treatments and legal consequences. There is no “correct” entity type. It all depends on a business’s goals.

Sole Proprietorship

Sole proprietorships are generally the cheapest and most simple businesses to run from an organizational standpoint. Income and expenses are reported as a part of the proprietor’s personal tax return with a Schedule C. With few legal filings required and no separate tax return, proprietors can save on legal and tax preparation fees. These benefits are countered by increased personal liability and the increased likelihood of an IRS audit.

Partnerships

When two or more people conduct a trade or business, it is called a partnership. Partnerships file an information return with Form 1065 and issue a Schedule K-1 that records each partner’s share of the expenses and income. Partnerships are relatively easy to form, organize, and dissolve. Audit risk for partnerships is generally much lower than sole proprietorships. One drawback is that each partner may be held liable for the actions of the other.

Corporations

Corporations are legal entities that have rights, privileges, and liabilities that are separate from its owners. Tax rates on corporations with low levels of income are relatively low, but taxes quickly rise along with income.

LLCs

LLCs may be considered less formal versions of corporations, because they also offer liability protection. All LLCs must have an operating agreement, and these can be difficult to change. LLCs provide owners with flexibility from a tax perspective. Depending on the number of owners, an LLC may be considered a sole proprietorship, a partnership, or a corporation. However, tax treatment for LLCs varies by state.

Changing from One Entity to Another

When business owners form as one entity and want to change it, several things must be taken into account. Sole proprietorships and partnerships are relatively easy to change into almost any other kind of entity. Changing a corporation into an LLC or partnership is more complicated and may have significant tax consequences. As we said, a business’s structure is incredibly important in determining its success or failure, and changes in entity type should be considered from both tax and legal perspectives.

Tax Preparation from Cohen & Burnett

Cohen & Burnett has served the Washington, D.C. area with tax preparation, estate planning and administration, and retirement planning for over 25 years. For more information on our services, please visit our homepage today.

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