Question

What Business Entity would you choose for a starting company that included 4 people each investing in the company?

Include your interpretation of the tax law pertaining to the form of business entity you recommended and how the law helps that helps maximize tax outcomes. Reference appropriate tax code and regulations

Answer 1

What is LLC?

Limited Liability Companies

Limited liability companies, often referred to as "LLCs," have been around since 1977, but their popularity among small-business owners is a relatively recent phenomenon.

An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations. "An LLC is a much better entity for tax purposes than any other entity," says Ralph Anderson,

Why LLC?

• Limited liability. Your only risk is capital paid into the business. Business debts and other liabilities can't be squeezed out of your personal assets. Caution: If you personally guarantee a debt, you've forfeited your "limited liability."
• Tax simplicity. Profits and losses are reported and taxed on owners' individual returns. There's no separate business tax return, unless you have more than one member and choose to be taxed as a partnership, in which case you file Form 1065. And there's no corporate "double taxation," in which both the business and the shareholders are taxed.
• Flexible management. A "member" (shareholder equivalent) can be a person, partnership or corporation. Members get a percentage of ownership. If your idea people can't manage their way out of a paper bag, you can hire management help. Smaller LLCs are usually member-managed, but not always.
• Flexible distribution. Profits and losses don't have to be distributed in proportion to the money each person puts in. A regular C corporation can't allocate profits and losses. And in a subchapter S corporation (taxed as a partnership), profits and losses are in proportion to shares held l

How Does an LLC Pay Income Taxes?

Because an LLC is fairly new, the IRS does not have a specific tax category for this business type, so they use the tax categories of other business types.

The default tax status of an LLC with one owner (called a member) to be taxed as a sole proprietorship. The default tax status of an LLC with more than one owner (member) is to betaxed as a partnership.

In either case, the LLC doesn't pay taxes directly, but the business net income is taxed through the personal tax return of the owner or owners--as a sole proprietorship, for a one-member LLC or as a partnership for a multiple-member LLC. This is called "pass-through taxation."

For a sole proprietor/single member LLC, the tax for the business is calculated using Schedule C as part of the tax return, then the business net income is added to the owner's other income on the tax return. For a partner/multiple-member LLC owner, the partnership tax return is prepared on Form 1065, and the individual owner's part of the tax is calculated on Schedule K-1, and it's included on the owner's individual tax return.

A corporation pays corporate taxes, and the owners of the corporation are considered to be employees if they work in the business (otherwise, they are considered shareholders). There are tax advantages and disadvantages of the LLC vs. a Corporation

Tax Advantages of the LLC

• Tax rates: The tax rate for an LLC depends on the total income of the owner. At higher levels of net income, the LLC may be paying taxes at a lower tax rate than a corporation. For example, the corporate tax rate for $75,000 in taxable income is 34%, while the personal tax rate for this same taxable income is 25%. (Other factors and other income may be included in the personal income of a business owner.)
• Double taxation: Corporate owners may be subject to double taxation, while an LLC owner is not. Corporate owners have double taxation. The corporation pays taxes on corporate net income, and the corporate owners must pay tax on any dividend income they receive.

• Franchise taxes: In some states, corporations must pay state corporate franchise taxes, but some states do not require LLC's to pay this tax. (This varies greatly state to state, so check with your state tax department to see its requirements.)