Entity Formation Fundamentals by hkksew3563rd

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									?One of the most important steps in any tax strategy is determining what entity should
be formed to hold your businesses and investments. For legal purposes, there are four
basic types of entities: sole proprietorship, partnership, corporation and limited
liability company. The entity you choose should take into account both the tax effects
of the entity and the legal aspects of the entity.

-Sole Proprietorship-
Let's examine the tax and legal aspects of each entity, beginning with the sole
proprietorship. A sole proprietorship is not really an entity. It's what happens when
you don't have an entity and you don't have any partners. Sole proprietorship is the
simplest form of business. You simply report your income on Schedule C of your
personal income tax return. You don't have to keep a balance sheet and only a limited
income statement. Sounds good, right? Wrong! This is one of the worst forms of
business both from a tax and a legal standpoint.

From a tax standpoint, not only will you pay income taxes at your highest marginal
tax rate on all of your income, you will also pay self-employment taxes on 100% of
your income. And you will be at least 4 times more likely to be audited by the IRS
than any other business structure. So unless you have a loss in your business, you will
pay the highest rate of tax in a sole proprietorship.

If that's not bad enough, the legal side of a sole proprietorship is even worse. Not only
are you liable for all of your actions, you are personally liable for all of the actions of
your employees. Don't take our word for it; ask your attorney. They will confirm that
a sole proprietorship provides absolutely NO asset protection.

So when would you use a sole proprietorship? ALMOST NEVER. About the only
time you might want to use a sole proprietorship is for a side business where you are
the only owner, the only employee and there is very little taxable income or even a
loss. However, if you do use a sole proprietorship because your business will have
little taxable income or even a loss, consider using an LLC for legal purposes - it can
still be a sole proprietorship for tax purposes. LLCs are discussed in more detail
below.

-Partnerships-
For tax purposes, there are two types of partnerships: general partnerships and limited
partnerships. General partnerships are the simplest form of partnership. In a general
partnership, two or more people share all of the management and operating
responsibilities of the partnership. In a limited partnership, only the general partners
share the management and operating responsibilities. The limited partners are passive
investors.

For tax purposes, income and deductions of the partnership are reported on Form
1065, which is a separate tax return just for partnerships. The partners each receive a
form K-1 that shows their share of each item of income or loss. The income or loss
from their K-1 is reported on their personal income tax return. The partnership does
not normally pay any income taxes. Distributions from a partnership are not normally
taxed to the partners.

General partners are typically liable for all of the debts of the partnership. This means
that they can lose more than the amount they have invested. If there is a lawsuit
against the partnership, the general partners normally are "on the hook" for any
judgments that are more than the partnership itself can pay. Limited partners typically
are only liable for the amount of their actual investment.

General partners must pay social security taxes on their share of all of the ordinary
earnings from the partnership. Limited partners normally are not subject to social
security taxes on any of their share of income from the partnership.

-Corporations-
For tax purposes, there are two types of corporations: S corporations and C
corporations. S corporations are taxed a lot like partnerships. The income is reported
on a separate tax return, an 1120S and the shareholders all receive a K-1 that shows
their share of each item of income or loss. The income or loss from their K-1 is
reported on their personal income tax return. The S corporation does not normally pay
any income taxes. Distributions from an S corporation are not normally taxed to the
shareholder. In addition, they are not normally subject to social security taxes.

C corporations are different. C corporations have their own set of tax laws, tax rates
and they pay their own taxes. They report their income on a form 1120 and pay tax
directly to the IRS. Shareholders of a C corporation are only subject to tax on
distributions from the corporation. These distributions are referred to as dividends and
they are often taxed at lower rates than other income.

Shareholders of corporations are not normally liable for the debts of the corporation
unless they personally guaranteed the debt. This means that shareholders normally can
only lose the amount they have invested in the corporation

-Limited Liability Companies-
For tax purposes, limited liability companies can be taxed as whatever tax entity the
owners want them to be. The IRS allows a limited liability company to decide how it
wants to be taxed. There are some fundamental principals that apply to how LLC's are
taxed.

Single-member LLC's, those with only one owner, are normally taxed as sole
proprietorships. The IRS calls this a "disregarded entity." So, for tax purposes, the
LLC is ignored. However, the owner of an LLC can elect to have the LLC taxed as a
C corporation or an S corporation (subject to the rules of ownership for S
corporations).

Multi-member LLCs, those with two or more owners, are normally taxed as
partnerships. They can be taxed either as a general partnership or a limited partnership,
depending on the responsibilities of the various members (owners). However, the
owners of an LLC can elect to have the LLC taxed as a C corporation or an S
corporation (subject to the rules of ownership for S corporations). Whether and how
distributions from an LLC are taxed depends entirely on how the members have
elected to tax the LLC, i.e., as a partnership, S corporation or C corporation, and
follow the distribution rules for the respective tax entity.

Like a corporation, owners of an LLC generally are not liable for the debts of the
company unless they personally guarantee the debt. This means that LLC members
normally can only lose the amount they have invested in the corporation.


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Tom Wheelwright is not only the founder and CEO of Provision, but he is the creative
force behind Provision Wealth Strategists. In addition to his management
responsibilities, Tom likes to coach clients on wealth, business, and tax strategies.
Along with his frequent seminars on these strategies, Tom is an adjunct professor in
the Masters of Tax program at Arizona State University. For more information please
visit

								
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