How to determine which type of business to use

When starting a business, you need to choose which type of business to use. Some of these types need to be formally filed or incorporated. The type of business you use has important implications for both tax and legal purposes. This guide focuses on its implications for filing taxes properly.

First, what are the types of businesses?

Sole Proprietorship:

A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and
maintain. The business has no existence apart from you, the owner. Its liabilities are your personal liabilities. You undertake the risks of the business for all assets owned, whether or not they are used in the business. You include the income and expenses of the business on your personal tax return.

More information on sole proprietorships is available in IRS Pub. 334

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 items on his or her tax return.

More information on partnerships is available in IRS Pub. 541

- Business owned and operated by spouses:

If you and your spouse jointly own and operate an unincorporated
business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. Do not use Schedule C. Instead, file Form 1065, U.S. Return of Partnership Income.

- Community property

If you and your spouse wholly own an unincorporated business as community property under the community property laws of a state, foreign country, or U.S. possession, you can treat the business either as a sole proprietorship or a partnership. States with community property laws include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

See IRS Pub. 555 for more information about community property laws.

- Qualified joint venture

If you and your spouse each materially participate as the only members of
an unincorporated, jointly owned and operated business, and you file a joint return for the tax year, you can make a joint election to be treated as a qualified joint venture instead of a partnership for the tax year. Making this election will allow you to avoid the complexity of Form 1065 but still give each spouse credit for social security earnings on which retirement benefits are based.

For an explanation of "material participation," see here

To make this election, you must divide all items of in-
come, gain, loss, deduction, and credit attributable to the
business between you and your spouse in accordance
with your respective interests in the venture. Each of you
must file a separate Schedule C and a separate Sched-
ule SE. For more information, see here

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.

- C corporation

The profit of a C corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. However, shareholders cannot deduct any loss of the corporation.

- S corporation

An eligible domestic corporation (or a domestic entity eligible to elect to be treated as a corporation) can avoid double taxation (once to the corporation and again to the shareholders) as long as it meets certain tests and elects to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their
share of nonseparately stated income or loss.

Limited Liability Company:

A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. The members of an LLC are
not personally liable for its debts.

An LLC may be classified for federal income tax purposes as either a partner-
ship, a corporation, or an entity disregarded as separate from its owner by applying the rules in Regulations section 301.7701-3.