MIARI TAX & ACCOUNTING 

Business Structure

Question:   Can a husband and wife operate a business as a sole proprietorship or do they need to be a partnership?
Answer:   Unless a business meets the requirements listed below to be a qualified joint venture, a sole proprietorship must be solely owned by one spouse, and the other spouse can work in the business as an employee. A business jointly owned and operated by a husband and wife is a partnership unless the spouses elect to be treated as a Qualified Joint Venture or, in a community property state, Rev. Proc. 2002-69 applies.

A married couple who jointly own and operate a trade or business may choose for each spouse to be treated as a sole proprietor by electing to file as a “qualified joint venture.” Requirements for a qualified joint venture:

  • The only members in the joint venture are a husband and wife who file a joint tax return,
  • The trade or business is owned and operated by the spouses as co-owners (and not in the name of a state law entity such as an LLC or LLP),
  • The husband and wife must each materially participate in the trade or business, and
  • Both spouses must elect qualified joint venture status on Form 1040 by dividing the items of income, gain, loss, deduction, credit and expenses in accordance with their respective interests in such venture and each spouse filing with the Form 1040 a separate Schedule C, C-EZ, or For Form 4835 accordingly, and, if required, a separate Schedule SE to pay self-employment tax.


Partnerships 

 

A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return.

Partners are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions


Corporations 


In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.

The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.


S Corporation


S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income.

To qualify for S corporation status, the corporation must meet the following requirements:

  • Be a domestic corporation
  • Have only allowable shareholders
    • including individuals, certain trust, and estates and
    • may not include partnerships, corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have one class of stock
  • Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.


In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation (PDF) signed by all the shareholders

Limited Liability Company (LLC) 


A Limited Liability Company (LLC) is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.

Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.

A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.


Classifications


The federal government does not recognize an LLC as a classification for federal tax purposes. An LLC business entity must file a corporation, partnership or sole proprietorship tax return.

An LLC that is not automatically classified as a corporation can file Form 8832 to elect their business entity classification. A business with at least 2 members can choose to be classified as an association taxable as a corporation or a partnership, and a business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a “disregarded entity.” Form 8832 is also filed to change the LLC’s classification.


Effective Date of Election


The election to be taxed as the new entity will be in effect on the date the LLC enters on line 8 of Form 8832.  However, if the LLC does not enter a date, the election will be in effect as of the form’s filing date.  The election cannot take place more than 75 days prior to the date that the LLC files Form 8832 and the LLC cannot make the election effective for a date that is more than 12 months after it files Form 8832. However, if the election is the “initial classification election,” and not a request to change the entity classification, there is relief available for a late election (more than 75 days before the filing of the Form 8832).


Single Member Limited Liability Companies 


Over the years, there has been confusion regarding Single Member Limited Liability Companies in general and specifically, how they can report and pay employment taxes.

An LLC is an entity created by state statute. The IRS uses tax entity classification, which allows the LLC to be taxed as a corporation, partnership, or sole proprietor, depending on elections made by the LLC and the number of members. An LLC is always classified under federal law as one of these types of taxable entities.

A multi-member LLC can be either a partnership or a corporation, including an S corporation. To be treated as a corporation, an LLC has to file Form Form 8832, Entity Classification Election (PDF), and elect to be taxed as a corporation. A multi-member LLC that does not so elect will be classified under federal law as a partnership.

A single member LLC (SMLLC) can be either a corporation or a single member “disregarded entity”. Again, to be treated under federal law as a corporation, the SMLLC has to file Form 8832 and elect to be classified as a corporation. An SMLLC that does not elect to be a corporation will be classified by the existing federal guidance as a “disregarded entity” which is taxed as a sole proprietor for income tax purposes.

Employment tax and certain excise tax requirements for an SMLLC that is a disregarded entity have changed over the past few years. In August, 2007, final regulations (T.D. 9356) (PDF) were issued requiring disregarded single member LLCs to be treated as the taxpayer for certain excise taxes accruing on or after January 1, 2008 and employment taxes accruing on or after January 1, 2009. SMLLC’s will continue to be disregarded for other federal tax purposes.

For employment taxes, prior to the regulation changes, the single member owner of a disregarded SMLLC was responsible for reporting and paying employment taxes. Before January 1, 2009 the single member owner could file using either the name and EIN assigned to the SMLLC, or the name and EIN of the single member owner. Even if the pre-January 1, 2009 employment tax obligations were reported using the disregarded SMLLC's name and employer identification number, the single member owner retains ultimate responsibility for collecting, reporting and paying over employment taxes for those periods.

As of January 1, 2009, Notice 99-6 is obsolete and the SMLLC will be responsible for collecting, reporting and paying over employment tax and excise tax obligations using the name and EIN assigned to the LLC.

An LLC applies for an EIN by filing Form SS-4, Application for Employer Identification Number, and completing lines 8 a, b, and c. An SMLLC that is a disregarded entity that does not have employees and does not have an excise tax liability does not need an EIN. It should use the name and TIN of the single member owner for federal tax purposes. However, if a SMLLC, whose taxable income and loss will be reported by the single member owner, nevertheless needs an EIN to open a bank account or if state tax law requires the SMLLC to have a federal EIN, then the SMLLC can apply for and obtain an EIN.


LLC Filing as a Corporation or Partnership 


The LLC structure is not recognized by federal law and therefore their filing status is determined by the Entity Classification Rules.  Form 8832 is used for this purpose.  Pursuant to the entity classification rules, LLCs with multiple owners that do not elect to be taxed as a corporation are taxed as a partnership.


Classification


The Entity Classification rules classify certain LLC business entities as Corporations:

  • A business entity formed under a Federal or State statute or under a statute of a federally recognized Indian tribe if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic.
  • An Association under Regulations section 301.7701-3.
  • A business entity formed under a Federal or State statute if the statute describes or refers to the entity as a joint stock association.
  • A state chartered business entity conducting banking activities if any of its deposits are insured by the FDIC.
  • A business entity wholly owned by a state of political subdivision thereof, or a business entity wholly owned by a foreign government or other entity described in Regulations section 1.892.2-T.
  • A business entity taxable as a corporation under a provision of the code other than section 7701.(a)(3).
  • Certain foreign entities (see Form 8832 instructions).
  • Insurance Company


An LLC that is not automatically classified as a corporation can file Form 8832 to elect their business entity classification. A business with at least 2 members can choose to be classified as an association taxable as a corporation or a partnership, and a business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a “disregarded entity.” The Form 8832 is also filed to change the LLC’s classification.


When beginning a business, you must decide what form of business entity to establish. Your form of business determines which income tax return form you have to file. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute. Legal and tax considerations enter into selecting a business structure.


   1. Sole Proprietorships

   2. Partnerships

   3. Corporations
   4. S Corporations
   5. Limited Liability Company (LLC)
   6. Single Member Limited Liability Companies 
   7. LLC Filing as a Corporation or Partnership 


Sole Proprietorships

A sole proprietorship can be defined as any unincorporated business with a single owner. It's the most commonly used form for new small businesses. If your business has only one owner, the IRS will presume that it's a sole proprietorship unless you incorporate under state law.

From the IRS's perspective, the business is not a taxable entity. Instead, all of the business's assets and liabilities are treated as belonging directly to the business owner. When tax time rolls around, all income and expenses generated by the business are reflected on either Schedule C, Profit or Loss from Business, or Schedule C-EZ, Net Profit from Business. Whichever of these forms you use, it must be included as part of your annual individual tax return (Form 1040).

To give you a handle on how this form works, your gross revenue from sales and other business income items are reported on the top of the Schedule C or C-EZ. Expenses of the business are subtracted from income to arrive at the net profit (or loss) figure at the bottom of the form.

The net profit or loss is then carried over from the Schedule C or C-EZ and reported on page 1 of the owner's 1040. This means that there is no separate tax rate schedule that applies to a sole proprietorship — the business owner's individual tax rate will determine the amount of tax paid on the earnings of the sole proprietorship.

The main advantage of a sole proprietorship is simplicity. Because there is only one owner, the accounting rules are much easier to understand and to use. Also, a business owner may transfer money in or out of the business with no tax effects to keep track of.

Sole proprietors are generally required to pay self-employment taxes on all of the business's net profits, as computed on Schedule C or C-EZ. You must use Schedule SE of the annual income tax return to compute and report these taxes.

For each quarter, a sole proprietor generally needs to make an estimated tax payment that includes income tax and self-employment taxes.

A sole proprietor who sells a business asset or even the business itself is treated as if he or she sold each individual item that was included in the sale, and gain or loss on each item must be computed separately. Intangible assets such as patents and copyrights are considered assets of the business, and separate gain or loss is computed on them as well.
Beyond these basic issues, sole proprietors may face some notable distinctions in their tax situations.

For example: when you pay yourself as a sole proprietor, you simply withdraw money from your business checking account — you don't have to issue yourself a paycheck and make payroll tax deductions.

Similarly, if you decide to contribute some personal money to the business, you can simply add it to your checking account — you don't have to formally make (and keep track of) your capital contribution as you would with a partnership or a corporation, at least as far as the IRS is concerned
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