Choice of Entity Tax Considerations for Startups

Choice of Entity Tax Considerations for Startups
06 Mar 2017

The legal form that a startup business takes is an important decision for many reasons, not the least of which are the tax considerations that are inherent in the choice made by the owners of the business. A brief description of the major choices available and some of their tax attributes follows:

Sole proprietorship

In a sole proprietorship, the owner and the business are legally the same. The business itself is not a taxable entity. The owner is responsible for the tax reporting activities of the business on his or her individual federal and state tax returns (generally Schedule C of Form 1040 on the federal tax return). A sole proprietorship does not provide limited liability for the owner.

General partnership

In a general partnership, all partners are jointly and severally liable for all debts and obligations. This means that a creditor may pursue any one or more of the partners for the satisfaction of partnership debts and obligations. In Colorado, a general partnership is not required to register with the Office of the Secretary of State, but should file a Statement of Trade Name. The income and losses of the partnership are the reporting responsibility of the individual partners who will be taxed based on their individual returns. The tax information of the partnership is made available to the partners on Schedule K-1 of the informational tax return that the partnership files in Form 1065. The partnership itself does not pay tax.

Limited Liability Company (LLC)

An LLC is a separate legal entity under a state law filing (Articles of Organization) under which owners are accorded limited liability protection that owners of a corporation (shareholders) had under state law. Most LLCs are taxed as partnerships for federal and state purposes. Thus the LLC is a “pass-through” entity and the LLC does not pay taxes on its income. The tax attributes of an LLC are represented on the personal returns of its members on the basis of Schedule K-1 of the LLC’s informational tax returns. LLCs may elect to be treated as a corporation or an S corporation by filing form 8832, Entity Corporation Election.

C Corporation

A C corporation is a separate entity incorporated by the filing of Articles of Incorporation with the state. As such it is subject to federal and state income tax using corporate tax rates. A C corporation is subject to “double taxation” on its income when it distributes such income to its shareholders in the form of dividends and the shareholders must pay the tax on the dividends plus any salary paid to the shareholders including employment taxes.

S Corporation

An S Corporation is a state corporate entity that has filed an election with the Internal Revenue Service to be treated somewhat similar to a partnership or an LLC for tax purposes when the income or loss is “passed-through” the company to the shareholders and reported on their individual tax returns based on Schedule K-1 of Form 1120 S, the informational federal tax returns.

The foregoing is a simplified description of the major tax attributions of the choices of business forms available to startups. As a business grows and matures the topic of exit strategies may arise. The subject of taxation differences among the entity choices will become important and a fresh examination of such alternatives will be warranted.

William H. Parsons, Jr., is a tax attorney who advises corporations, general and limited partnerships, limited liability companies and trusts on federal and state tax planning strategies to accomplish business transactions, tax planning, tax-free reorganizations, and both taxable and non-taxable liquidations.

If you have questions about these or other tax related questions for your business, contact William Parsons at 303-628-3604 or wparsons@irelandstapleton.com.

What is written here is intended as general information, and is not to be construed as legal advice. If legal advice is needed, you should consult an attorney.