Choosing which type of entity to use is among the most important decisions a business can make. Most clients wish to avoid personal liability for the obligations of the business (an attribute of corporations) but may wish to personally deduct the losses of the business and avoid double taxation.
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The limited liability company may offer the best of both worlds.
An LLC is generally treated as a partnership for tax purposes. At the same time, the LLC's members, like corporate shareholders, are not personally liable for the debts of the business.
However, LLCs are not always the best form of entity, even for a closely held business. There may be circumstances in which a corporation or limited partnership is a more appropriate form.
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Sole Proprietorship.
A sole proprietorship is nothing more than a business in which an individual engages in business personally rather than by means of a separate entity such as a corporation. The sole proprietorship avoids many of the formalities and reporting requirements associated with other forms of business organization. However, the proprietor is personally liable for the obligations of the business, thus making a limited liability entity such as a corporation or LLC an attractive alternative.
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Corporation (Including S Corporation).
A corporation is a limited liability entity, in that none of the owners (shareholders) are liable for the obligations of the corporation. The income of a corporation (other than an S corporation) is taxable, both by the federal government and California, at the corporate tax rate. Thus, a corporation and its shareholders are subject to "double taxation," because the corporation pays tax on its income and the shareholders pay tax on dividends received from the corporation, and the corporation is not allowed to deduct dividends as an expense. Double taxation may be minimized in certain cases by the payment of salaries to shareholders and by the use of shareholder loans. In addition, a corporation that retains most of its income may find the corporate tax structure beneficial because the marginal rates applicable to corporations are often lower than the marginal rates applicable to individuals.
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Making a "S" Election - IRS Form 2553 Application
Qualifying corporations can ameliorate the effect of double taxation by making an S corporation election. If a corporation makes a valid S corporation election, then, for federal tax purposes, the corporation's net profits, losses, and tax credits are passed through (and taxed) to the corporation's shareholders, without being taxed to the corporation. Thus, S corporations are treated similarly, but not identically, to partnerships. There are important restrictions on the ability to qualify as an S corporation.
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General Partnership.
A general partnership is an association of two or more persons to carry on as co-owners of a business for profit that is not a limited partnership. A joint venture is an entity formed for a limited or temporary business purpose. Joint ventures have generally been treated as general partnerships under California law. However, LLCs may become the entity of choice for many limited purpose business ventures. A general partnership is generally not subject to federal or California income or franchise tax. For federal tax purposes, a partnership is any joint enterprise other than a trust or estate that carries on a business and is not organized as a corporation under state law.
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