Which State or States to Form a Business Entity?Generally speaking, entrepreneurs incorporate their business in the state where they conduct their business. If you live and work in New Hampshire, for example, you would incorporate your business in New Hampshire. If your business conducts business throughout the United States, you need to incorporate in the state where your headquarters will be. If you have a substantial business presence in another state, you may need to let that state know and file state tax returns or sales tax returns based on your business earnings in that other state. Businesses with substantial nationwide activity sometimes choose to be incorporated in Delaware or Nevada because of the business-friendly laws in those states. Even if you incorporate in Delaware or Nevada, you will still need to register your business in those states where you have an actual business location.
Types of Business Entities for Tax PurposesWhile there are a variety of designations at the state level, for federal tax purposes there are only 6 forms of business organizations:
- Sole Proprietor (Form 1040 Schedule C or Schedule F),
- C-Corporation (Form 1120),
- S-Corporation (Form 1120S),
- Partnership (Form 1065),
- Trust (Form 1041), and
- Non-profit organization (Form 990)
You may notice that the limited liability company (LLC) is not listed above. That's because an LLC can be treated (for tax purposes) as a sole proprietor, as a partnership, as a C-corporation, or as an S-corporation. The owners of the limited liability company (LLC) can pick which tax treatment will apply. By default, an LLC with just one owner is considered a disregarded entity, with the result that the LLC is treated for tax purposes in the same way that the owner of the LLC is taxed. By default, an LLC with two or more owners is considered a partnership. An LLC can opt out of the default treatment by electing to be treated as a Corporation. After electing to be treated as a corporation, owners of an LLC can further elect to be treated as an S-corporation. (For further details, see Publication 3402, Taxation of Limited Liability Companies.)
Overview of Each Type of Business OrganizationSole proprietors are unincorporated businesses. They are also called independent contractors, consultants, or freelancers. There are no forms you need to fill out to start this type of business. The only thing you need to do is report your business income and expenses on your Form 1040 Schedule C. This is the easiest form of business to set up, and the easiest to dissolve. (An LLC with only a single shareholder, a so-called single-member LLC, is taxed as a sole proprietor on a Schedule C.)
C-Corporations are incorporated businesses. The shareholders of C-corporations have limited liability protection, and corporations have full discretion over the amount of profits they can distribute or retain. Corporations are presumed to be for-profit entities. Corporations must have at least one shareholder.
S-Corporations are a type of corporation. The shareholders of S-corporations have limited liability protection, and the corporations has full discretion over the amount of profits they can distribute or retain. An S-corporation must have at least one shareholder, and cannot have more than 100 shareholders. The net income of the S-corporation is imputed as income to the shareholder, even if the S-corporation decides to retain some or all of the net income.
Partnerships are unincorporated businesses. Like corporations, partnerships are separate entities from the shareholders. Unlike corporations, partnerships must have at lease one General Partner who assumes unlimited liability for the business. Partnerships must have at least two partners. The net income of the partnership is imputed as income to the partners, even if the partnership decides to retain some or all of the net income.
Trusts are usually formed upon the death of an individual and are designed to provide continuity of the investments and business activities of the deceased individual. We will not discuss trusts further.
Nonprofits are corporations formed for a charitable, civic, or artistic purpose. Nonprofits are generally exempt from federal and state taxation on their income, and so they are often called "exempt organizations." Nonprofits reporting their activities, income, and assets to ensure that they are in compliance with federal and state laws governing charities. For additional information on starting, managing, and developing a not-for-profit organization, see the About.com Guide to Nonprofits.
As mentioned above, sole proprietors, S-corporations, and partnerships are taxed at the shareholder level. Corporations, however, are taxed at the corporate level.