When you decide to become an entrepreneur, you must choose the type of business structure that best fits your needs. If you are going into business with at least one other person, you can form a partnership or a corporation. Partnerships have the virtue of simplicity. Another option is a subchapter S corporation. There’s more paperwork involved, but S corporations have some definite advantages.
Creating the Business
Forming a partnership can be as simple as a verbal agreement and a handshake over dinner. You and your partners should draw up a formal partnership agreement, of course. You will have to obtain a business license and any permits that are required, but that’s about it. A subchapter S corporation is a full-fledged corporation. To create an S corporation, you must file articles of incorporation with your state government. To obtain subchapter S status, you also have to file Form 2553 with the Internal Revenue Service within 75 days of the date you file articles of incorporation.
Profit and Basis
In a partnership, each owner shares in the profits based on mutual agreement. Typically the proportion of profits for each partner is defined in the partnership agreement. The shareholders of an S corporation receive their share of profit, or assume their share of any losses, in proportion to their shareholder basis. Suppose you invest $10,000 in an S corporation. That is your shareholder basis. If the total of all shareholder investment is $200,000, you own 5 percent of the company and your share of the profit or loss will be 5 percent. At the end of the company’s tax year, you will receive an updated statement of your shareholder basis adjusted for distributions, losses and reinvestment.
In a partnership, the business is not liable for income taxes. The partners are responsible for reporting their profit or loss on their individual tax returns. Each partner must be provided with an IRS Schedule K-1 (Form 1065) that states her profit or loss by the filing deadline for Form 1065. Like a partnership, an S corporation is not responsible for income taxes. Tax liability “flows through” to the shareholders. Each shareholder reports her share of profit or loss on her tax return. If profits are reinvested, this increases the shareholder basis. Distributions that decrease the shareholder basis are not taxable unless they exceed the shareholder basis. In that case, the excess is subject to capital gains taxes. Shareholder profits are not subject to Social Security or Medicare taxes.
One advantage of an S corporation is that the shareholders have limited liability. With a partnership, each partner’s liability is unlimited. Thus, in the event of a lawsuit or business failure, a partner’s other assets may be at risk. The liability for a shareholder in an S corporation is limited to the shareholder basis. A shareholder’s other assets (his home, for example) are not at risk.
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