Each type of business entity has pros and cons as well as tax consequences. Here we offer some basics about two of the most popular business formats: sole proprietorships and partnerships.
Businesses often start out as sole proprietorships simply because it is easier at the beginning. Unlike other business structures, no formal set up is involved. Sole proprietorships are viewed as pass-through entities because all business income and losses are reported on the business owner’s personal tax return rather than on a separate business return. Profits and losses are reported on Schedule C, which is submitted with Form 1040. Following are specific rules that affect the taxation of sole proprietorships:
- All business profits are taxed, even if they are not withdrawn.
- There is no distinction between the personal assets of the owner and the business, so the business owner is personally liable for all business debts and liabilities.
- Subject to certain income and other restrictions, sole proprietors may be able to qualify for the 20% pass-through tax deduction mandated by the Tax Cut and Jobs Act of 2017 (the TCJA). This deduction is set to expire in 2025, however, unless it is extended by Congress.
- Unlike other business models, which are taxed at the company rate, sole proprietors are taxed at their individual rate.
- Business records must be kept separately from personal expenses.
- Quarterly estimated taxes must be paid in lieu of income tax withholding.
- Self-employment taxes must be reported on Schedule SE, which is submitted with Form 1040 and paid when income taxes are paid.
- Sole proprietorships may hire employees, but the sole proprietor is responsible for filing taxes and properly administering those employees.
- Sole proprietors may use independent contractors.
Once the business reaches a certain level of profitability, the business owner may choose to restructure the business. Doing so allows the owner to protect his or her personal assets. Usually, it also results in lower taxes.
Forms of Partnerships
A business owner’s options also include partnerships. Partnerships are similar to sole proprietorships in that both business structures are pass-through entities. Partnerships report their income and expenses on a partnership tax return, and each partner reports his or her share of the profits or losses on their personal return. Partners may be general partners — that is, partners whose liability for the business is not limited — or limited partners. The liability of limited partners toward the business’s debts is legally limited to the extent of his or her investment.
There are three common types of partnerships:
- General partnerships: the association of two or more persons as co-owners of a business. The partners are considered to be equal partners unless a written partnership agreement states otherwise. No state filing is required for a general partnership. The partnership is created when the business begins.
- Limited partnerships: a partnership of two or more people in which one is the general partner and the others are limited partners. A limited partner invests money but has no involvement in company operations. A Certificate of Limited Partnership must be filed with the office of the Secretary of State or similar department. This document provides certain basic information about the limited partnership.
- Limited liability partnerships (LLPs): LLPs are available only to certain types of professional service businesses, depending on state law. The LLP needs to register with the office of the Secretary of State or a similar department. It is advisable for the LLP to have a formal partnership agreement outlining how the business will operate. With an LLP, each partners’ personal assets generally are protected from being used to satisfy business debts and liabilities. This is not true, however, in the event of a partner’s personal misdeeds.
Sometimes, businesses opt to maintain their sole proprietor or partnership structure throughout the business’s life cycle. Other times, the business chooses to restructure to a corporate business model. Contact an MCB Advisor at 703-218-3600 or click here to determine whether it is time for your business to restructure. To review our business planning articles, click here. To learn more about MCB’s tax practice and our tax experts, click here.