When starting a business, one of the first things that people need to worry
about is the formation. Anderson et al. (2023) explain the differences between
the most popular ways to form a business. A sole proprietorship is essentially
the easiest business to start because it only involves one owner and it has
simple rules. This business entity is not subject to double taxation, and the
owner will pay their marginal rate on income after potentially qualifying for a
20% business deduction. On top of these advantages, it is easy to contribute
and withdraw cash and property. On the flip side, the full tax amount must be
paid on earnings whether they come out of the business or not. On top of that,
owner-employees are unable to deduct compensation and there are limitations
on social security tax cuts and using the fiscal calendar. Moving on,
partnerships have a similar tax treatment as sole proprietorships, there can just
be multiple owners. Double taxation is avoided, and partners simply pay taxes
on their shares of earnings based on their individual rate, less a potential 20%
business income deduction. The disadvantages also closely mirror the last
option, and partners are not considered employees of the business, so there
isn’t a lot of preferentially tax treatment for work done within the business by
owners. Finally, corporations offer a quite different approach because they are
an entity separate from their owners. The big difference is that in this case,
there are more deductions available and owner-employees can be considered
separate employees. That results in preferential tax treatment and benefits. On
the negative end, double taxation typically results in a higher tax bill.
Furthermore, money withdrawn or deposited has to be recognized and many
losses can’t be transferred to owners until they are realized.
Many times, the simpler solution is often the easiest. As an example, imagine
four investors that want to open a gas station together. If I was guiding their
decision, I would advise them to set the business up as a partnership formation
within an llc. According to the IRS (2022), an LLC set up as a partnership can
avoid a lot of the upfront paperwork that you would get when forming a
corporation. Despite this, it offers limited liability and avoids double taxation.
There is also a ton of freedom when it comes to depositing and withdrawing
within the business, and should things not work out, it can easily be dissolved.
Unfortunately, there could be some hang ups if the investors want to spend a
significant amount of time working in the business as employees. If that is the
case, a corporation may be favorable due to the separation.
Citation:
Anderson, K., Hulse, D., and Rupert, T.,. Prentice Hall’s Federal Taxation
2023 Corporations, Partnerships, Estates & Trusts. 2023.
