Are you thinking about starting a small business? If so one of the first things you need to figure out is what kind of business you want to be. There are five basic entity types – sole proprietor, partnership, C Corporation, S Corporation, and Limited Liability Company (LLC). We’ll take a look at each of these but please talk with us and your lawyer before you decide which type of company you are going to start.

First is the sole proprietor. As the name implies there is just one owner. The upside of starting this type of business is that it’s the easiest to get started. You decide on a name, apply for the proper license from your county/state, and you’re ready to go. You can and probably should open a bank account for the business, even if it is in your name. It is helpful for bookkeeping and tax reasons to keep your personal money separate from business money.

The downside to a sole proprietorship is there is not a legal separation between you, the owner, and you, personally which means that if the company runs into problems of any sort you are responsible. If your business goes into debt and closes, you are responsible for paying off the debt even if the business no longer exists. If your business gets sued, it’s actually you who are being sued. There are ways to protect yourself (liability insurance) but you need to be aware of these issues and plan for them.

As a sole proprietor at tax time your business will fill out a Schedule C to report income/losses and expenses. Once the Schedule C is completed, the bottom line is transferred to your personal 1040 return and reported there. If you made a profit, this is where the company will be taxed; if you had a loss, you will be able to deduct the loss off any other income you had (for example if you have a “day job” and a “side business” you can take the loss from your side business against the income of your day job). You will also need to fill out a Schedule SE for self-employment tax if you have any employees.

The next type of business entity is a partnership. This is when two or more people come together to start a business. There are two types – a general partnership where the partners manage the company and assume responsibility for the debts and other obligations and a limited partnership where there are general and limited partners. The general partners own and operate the business and assume the liability of the company and the limited partners are investors only and have no control over the company and assume no liability for the company’s actions.

This is also an easy type of business to set up. It is very similar to a sole proprietorship except with more people. The main difference is that you should have a partnership agreement in place before you start operating. This should outline things like how much of the company does each partner own, how are business decisions made, how to dissolve the company, and how to buy out a partner. Be sure to consult a small business lawyer to help you draft your partnership documents.

For tax purposes a partnership is like a sole proprietor and the profits/losses pass through to your personal tax return, in this case by way of a K-1. The partnership files a tax return (Form 1065 which is due March 15) and generates the K-1s which are distributed to all partners for use in preparing their personal returns.

Choosing the correct entity type for your business is one of the most crucial decisions you can make when starting your business. It is the foundation of how you will be tax as well as how you will be compensated. Feel free to call us today if you would like to speak with someone who can help you identify the best choice for you and your company.

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The preceding article is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that LeMay & Company is not engaged in rendering legal, investment, insurance or other expert advice in these areas. If expert assistance is required, the services of a competent professional should be sought. The views and conclusions expressed herein are those of the writer and not necessarily those of LeMay & Company. Any tax advice contained herein is not intended to be used, nor may it be relied upon or used; by any taxpayer for the purpose of (1) the avoidance of any tax-related penalties under the Internal Revenue Code or applicable state or local tax law provisions, or (2) promoting, marketing or recommending another party any tax transaction or tax-related matters that may be addressed herein