Choosing a Legal Structure for Your New Business

We have a great article today from guest writer James Kim. Take a look at the pros and cons of your legal structure. If you do not feel you have the correct structure for your business, contact a lawyer who can help with either implementing a legal structure changing an existing structure. Thanks James for this great article.

Ron Finklestein
Business Growth Facilitator

Choosing a Legal Structure for Your New Business

One of the first things that an entrepreneur has to do when
starting a business is decide on a business ownership structure. Here, we
outline the different structures, helping you find the business solutions
that best suit your startup and understand its tax implications.

1.  Sole  Proprietorship

A sole proprietor is someone who owns an incorporated business
on their own. In this structure there is no legal distinction between owner and
business and, therefore, the owner has complete control over and liability for
the business, including the debts and legal actions against the business. In
sole proprietorships the profit is “passed through” to the owner and the business
profits will be documented on the individual tax return, Form 1040.

Many people consider the sole proprietorship to be the most
simple and straightforward business organization because you don’t have to file
any specific forms (like income tax forms) or pay massive startup fees.
However, on the downside a sole proprietor is fully responsible for all debts, making it
difficult or impossible to raise capital from investors.

The taxable year is the same as the owner’s: a calendar year. As
mentioned above, a sole proprietor must fill out a Form 1040-ES (Estimated Tax
for Individuals). The profits or losses are calculated on Schedule C. Earnings
from the sole proprietorship are subject to the self-employment tax, Schedule
SE, Form 1040, which is a contribution to Social Security and Medicare. You can
calculate the self-employment by multiplying net earnings from self-employment
by the self-employment tax rate. The self-employment tax rate for 2011 is 13.3%
(10.4% for Social Security and 2.9 for Medicare). However, you can deduct half
of your self-employment tax contribution in figuring your gross income by
filing a Form 1040 Schedule C (line 27). You can visit,,id=130102,00.html
to determine eligibility for the Earned Income Tax Credit (EITC). Other forms
include the Form 941 (Employer’s Quarterly Federal Tax Return) and Form 940
(Employer’s Annual Federal Unemployment Tax Return).

To find these forms see,,id=98202,00.html

2.  Partnership

A partnership involves two or more people who carry on a trade
or business together. This structure of business, like a sole proprietorship,
“passes through” profits or losses to its partners and these partners pay taxes
on their share of the profits in their individual income tax returns.

Instead of the Form W-2, the partnership must turn in a Schedule
K-1 and the Return of Partnership Income (Form 1065).Then, each partner reports
their profit and losses with the individual tax return (Form 1040) and Schedule


3.  C Corporation

In a corporation, shareholders exchange money or property for
the corporation’s capital stock and usually take the same deductions as a sole
proprietorship for its taxable income. C corporation refers to any corporation
that is taxed both in corporate income and shareholder income (as opposed to
passing through the income to the owners like a sole-proprietorship or
partnership). This process is sometimes referred to as the “double tax.”

In a c corp you can implement “income splitting.” If the owners
keep some income within the corporation (“retained earnings”), it will be taxed
at lower corporate income tax rate, not at the individual tax rates of
the shareholders. These retained earnings are reported on Form 1120. C corps
also have to file the Estimated Tax for Corporations, 1120-W, quarterly.


4.  S Corporation

In an S corporation you have both limited liability while paying
income taxes like a sole proprietor or partner. S corps are essentially
corporations that have chosen to pass corporate income, losses, deductions, and
credit through to their shareholders; they are not subject to Self-Employment

The IRS defines an S corporation as one that is 1) a domestic
corporation, 2) has only allowable shareholders, 3) has no more than 100
shareholders, 4) has one class of stock, and 5) is not an ineligible corporation
(like an insurance company or domestic international sales corporation).

To become an S corp the corporation must first turn in Form 2553
Election by a Small Business Corporation. An S corp “passes through” its net
income to its shareholders via a Schedule K-1 in Form 1040 (Federal Income
Tax). The salary paid to the employee-owner is subject to employment taxes
(940), but the remaining income, the distribution from the S corp, is not subject
to employment tax. The IRS requires, however, that the salary allotted is
“reasonable,” to prevent shareholders from giving themselves extremely low
salaries, attributing the rest of their earnings to distributions, and thereby
avoiding high employment tax.

5.  Limited Liability Company

If your business will most likely engage in some sort of riskier activity (the use of hazardous
materials, selling of edible goods, caring for children or animals, requiring
injury-prone actions), you should opt for the LLC, which protects your personal
assets from business debts and claims. There are no tax advantages (or disadvantages) to forming
an LLC: LLCs with one owner file for taxes as a sole-proprietor, while LLCs
with multiple owners file taxes as partnerships.

This is because the federal government does not identify LLC as
a classification, so a member (and owner of an LLC) must file as a corporation,
partnership, or sole proprietorship tax return. A Form 8832 is filed to
establish a business classification. Owners of an LLC may also have to pay
additional state taxes, or “franchise taxes,” in addition to the income

While understanding the legal side of business can be
complicated and, well, “taxing,” hopefully this summary of the basics has clarified
it a little!

James Kim is a writer for ChooseWhat is a company that provides
product reviews and test data for business services and products.  Their
goal is to help small companies make informed buying decisions on business
solutions that help their business.


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