🧾Taxes and Business Strategy Unit 2 – Business Entity Types & Tax Implications

Key Business Entity Types

• Sole proprietorships are unincorporated businesses owned and operated by a single individual
  • Profits and losses flow through directly to the owner's personal tax return (Schedule C)
  • Unlimited personal liability for the owner
• Partnerships involve two or more owners conducting business together
  • General partnerships have unlimited liability for all partners
  • Limited partnerships have both general partners (unlimited liability) and limited partners (liability limited to investment)
• Corporations are separate legal entities owned by shareholders
  • C corporations are taxed separately from their owners (double taxation)
  • S corporations pass through income and losses to shareholders (avoids double taxation)
• Limited Liability Companies (LLCs) combine features of partnerships and corporations
  • Provides limited liability protection for owners (members)
  • Flexible tax treatment (can be taxed as partnership or corporation)

Legal Structures and Characteristics

• Sole proprietorships are the simplest and most common business structure
  • No formal registration required with the state
  • Owner has complete control over business decisions
• Partnerships are formed by agreement between two or more individuals or entities
  • Partnership agreement outlines roles, responsibilities, and profit-sharing arrangements
  • Partners are personally liable for business debts and obligations
• Corporations are more complex legal structures
  • Requires filing articles of incorporation with the state
  • Shareholders have limited personal liability (only risk investment)
  • Managed by a board of directors elected by shareholders
• LLCs offer flexibility in management and ownership structure
  • Can be managed by members or appointed managers
  • Operating agreement defines member roles, responsibilities, and profit distribution

Tax Treatment of Different Entities

• Sole proprietorships are not taxed separately from the owner
  • Business income and expenses reported on Schedule C of Form 1040
  • Self-employment tax (Social Security and Medicare) paid on net profits
• Partnerships file an informational tax return (Form 1065)
  • Each partner receives a Schedule K-1 showing their share of income, deductions, and credits
  • Partners pay self-employment tax on their share of partnership income
• C corporations pay corporate income tax on profits (Form 1120)
  • Shareholders pay personal income tax on dividends received
  • Leads to potential double taxation of corporate profits
• S corporations pass through income and losses to shareholders (Form 1120S)
  • Shareholders report their share of income on personal tax returns
  • Avoids double taxation, but subject to certain restrictions (e.g., limited to 100 shareholders)

Advantages and Disadvantages

• Sole proprietorships offer simplicity and full control, but unlimited personal liability
  • Easy to establish and dissolve
  • Difficult to raise capital and attract top talent
• Partnerships allow for pooling of resources and expertise
  • Shared decision-making and profits
  • Potential for conflicts between partners
• Corporations provide limited liability protection and easier access to capital
  • Perpetual existence (can outlive founders)
  • More complex and costly to establish and maintain
• LLCs combine limited liability with pass-through taxation
  • Flexible management and ownership structure
  • May have higher administrative costs compared to sole proprietorships

Formation and Compliance Requirements

• Sole proprietorships may require local business licenses and permits
  • No separate tax filing requirements (Schedule C on personal return)
  • Must keep accurate records of income and expenses
• Partnerships require a partnership agreement and federal tax ID number (EIN)
  • Must file annual partnership tax return (Form 1065) and provide K-1s to partners
  • State registration requirements vary
• Corporations must file articles of incorporation with the state
  • Requires bylaws, board meetings, and annual shareholder meetings
  • Must file annual corporate tax return (Form 1120 or 1120S)
• LLCs require articles of organization filed with the state
  • Operating agreement outlining management and member roles
  • Tax filing requirements depend on chosen tax treatment (partnership or corporation)

Impact on Business Operations

• Sole proprietorships allow for quick decision-making and flexibility
  • Limited ability to scale and raise capital
  • Owner's personal assets at risk in case of legal issues or debt
• Partnerships can leverage diverse skills and resources of partners
  • Potential for disagreements and deadlocks in decision-making
  • Partners personally liable for business obligations
• Corporations have a more formal management structure
  • Easier to raise capital through sale of stock
  • Shareholders not personally liable for corporate debts
• LLCs offer flexibility in management and ownership
  • Can be taxed as partnership or corporation
  • Members' personal assets protected from business liabilities

Strategic Considerations for Entity Selection

• Consider current and future business goals and growth plans
  • Sole proprietorships and partnerships may be suitable for small, local businesses
  • Corporations and LLCs better for businesses seeking outside investment and growth
• Evaluate tax implications and potential benefits of each entity type
  • Pass-through taxation (partnerships, S corps, LLCs) avoids double taxation
  • C corporations may offer tax advantages for businesses retaining earnings for growth
• Assess personal liability risk and asset protection needs
  • Corporations and LLCs provide limited liability protection for owners
  • Sole proprietorships and partnerships expose owners to personal liability
• Consider administrative costs and compliance requirements
  • Sole proprietorships have minimal formation and ongoing compliance costs
  • Corporations and LLCs have higher formation and maintenance costs (annual filings, meetings)

Case Studies and Real-World Examples

• Sole proprietorship: Freelance graphic designer operating under their own name
  • Reports income and expenses on Schedule C of personal tax return
  • Personally liable for any business debts or legal issues
• Partnership: Two friends start a local catering business
  • Draft partnership agreement outlining roles, profit-sharing, and decision-making process
  • Each partner reports their share of income and pays self-employment tax
• C corporation: Tech startup seeks venture capital funding
  • Files articles of incorporation and issues stock to founders and investors
  • Pays corporate income tax on profits, shareholders pay tax on dividends
• S corporation: Small manufacturing company with 20 employees
  • Elects S corp status to avoid double taxation
  • Shareholders report their share of income on personal tax returns
• LLC: Real estate investment group with multiple properties
  • Forms LLC to provide limited liability protection for members
  • Chooses partnership tax treatment to pass through income and losses to members