SP, LLC and Subchapter S - what does it all mean and why do you need to know? These are several of the different types of legal entities that businesses adopt, which allow the business to take on an existence apart from it's owners - though the owners still control the business.
The type of entity that you choose will affect your personal responsibility for the liabilities of the business. A lawyer can best advise you as to which entity would be the optimum solution for your personal situation.
But the choice of legal entity also affects your personal income tax liability. In order to best utilize the tax advantages of each type of entity, you need to understand how the incomes goes from your business cash register through your tax return and into your pocket.
Flow through entity types: An entity is considered a "Flow through" type because the income of the entity is treated as the income of the owners. For Federal tax purposes, a flow through entity avoids double taxation because only owners themselves are taxed on the revenue. Net Income is divided among the owners and each owner pays taxes on that income as part of their personal income tax return. Generally, losses from the business can be applied against income from other sources (investment income, salary of spouse, etc), which will decrease the individual tax liability. Whether these losses can be applied against other income is subject to regulations on hobby loss, tax shelters and material participation, among others.
Types of flow through entities include:
1. Sole Proprietorship: This is the simplest form of doing business for tax purposes. a business operated by one individual owner (or married couple who jointly own and operate a business may elect for each spouse to be treated as a sole proprietor) is a sole proprietorship. You file a Schedule C or F (Farm income) as a schedule of your personal Form 1040 and the business is not required to file a separate tax return.
2. Partnership: When a business is operated by two or more owners (in this type of entity, owners are known as "partners"), with each owner contributing to the business and each sharing in the profits and losses of the business, the owners may elect the partnership as the legal form of entity for that business. The partnership is required to file a tax return (Form 1065) but the form is informational only. There is no tax liability for the business itself.
3. Subchapter S Corporation: A business with 100 or fewer ownrs (in this type of entity, owners are known as "Shareholders") may elect to be a Subchapter S Corporation. As a type of flow through entity, income or loss of the business is included as part of the personal income of each shareholder and except for under very limited circumstances, the business has no income tax liability. The corporation is required to file a tax return (Form 1120S) but the form is for informational purposes only.
4. LLC: The LLC (Limited Liability Company) is a legal entity but is not recognized by the IRS for tax purposes. So a business organized as an LLC would be required to elet to be taxed otherwise - as a Sole Proprietorship, Partnership or C Corporation. Owners in an LLC are known as "Members".
Non flow through entity type:
C Corporation: This probably the most complex form of doing business. A C Corporation is a separate taxable entity from its owners. It not only files a separate tax return but has its own tax liability. Profits by the business are taxed on a corporate level and if distributed to the owners, taxed again on an individual level.
Some important considerations when determining the best type of entity for your business would be the extent to which you need to limit legal liability and the future plans for your business in years and generations to come. In some cases, relief from personal legal liability has more value to the owner than simplicity of operation or tax benefits. Seek the advice of an attorney when making this important decision. Be sure you understand not only the benefits but the future responsibilities involved in your choice.