When you decide to start a new business, the first decision you must make is what type of business entity works best for you and your situation.
The Internal Revenue Service explains that while numerous types of business entities exist, you have only three basic initial options as discussed below.
- Sole proprietorship
A sole proprietorship is the simplest and easiest business entity you can establish. All you need do is decide on a business name and start selling whatever products and/or services your company offers. For federal income tax purposes, you and your new company represent the same entity. You pay the company’s income taxes via attaching a Schedule C to your individual tax return.
If people in addition to you will have ownership interests in your business, you may wish to form a partnership. Again, the resulting company pays no income tax itself, but it must file an annual informational tax return. You and the other partners pay your respective shares of the tax via attaching Schedule Cs to your respective individual tax returns.
A corporation is its own legal entity. As such, it pays its own income taxes. You and the other shareholders, however, likewise pay income taxes based on the amount of dividends the corporation pays each of you. This double taxation structure is a major drawback to corporations, even though they protect their shareholders’ personal assets in the event the business fails.
An S Corporation is one corporate offshoot you can choose. An S Corporation represents a corporation/partnership hybrid entity. You and the other shareholders preserve your personal asset protection, but you also avoid double taxation since you each pay your respective share of the S Corporation’s taxes.
A Limited Liability Company offers you another corporate option. LLCs work like regular corporations in terms of double taxation, but they give you more flexibility in the types of shareholders you can have. For instance, you can include other corporations, other LLCs and even foreign entities among your shareholders.