Business Entities


The most common type of business is a sole proprietor. This means that you and the business are the same. You are personally responsible for the business. The income from the business is treated the same as if you got a check from an employer.


The income is reported on Schedule C of the 1040 tax return. The schedule C is pretty straight forward. It starts with the total income at the top. If income is reported on a 1099-Misc, that is included in the first line. You then have the opportunity to deduct all qualified expenses associated with that income. The IRS assumes that you will have expenses and may be more suspicious if there are not reasonable expenses deducted.


In some situations it may be advantageous to incorporate. This means that you register your business with a state and become a separate entity. You and the business are now separated and each must file income tax returns. Individuals file on Form 1040 and corporations file a Form 1120. The corporate 1120 is not significantly different than the 1040 Schedule C, especially for small businesses and the same basic business rules apply.


A corporation can sell pieces of itself, called stock or shares, and pay the owner wages, interest, director’s fees or whatever. This gives a lot of opportunity for financial planning and succession. A corporation must pay corporate income tax and then the owners must also pay tax on the income they receive from the corporation which may lead to double taxation if there is not careful planning.


 A corporation can file a Form 2553 with the IRS asking to be considered a Small Business Corporation. This limits some of the things it can do, for example the maximum number of shareholders is limited to one hundred, but it also causes all of the income from the corporation to pass through to the owners. This is called a S-Corp and as such does not pay income tax directly, instead the income shows up on the owners' returns and is reported on K-1 forms.


One argument for incorporating is that the owners are no longer directly responsible for liabilities. This is true in theory, but seldom true in practice except in large publicly held corporations. A new corporation will generally not be able to borrow money, sign a lease, or establish credit without a personal guarantee from the owners or stockholders, thus transferring liabilities back to the owners.


There are other forms of ownership or business entities such as partnerships and limited liability companies of various kinds. They can get complicated and require more diligence than many people apply when they get involved.


For most small businesses, there is little reason to incorporate, partnerships are a mine field, and LLCs are of limited value in real life. A sole proprietorship requires nothing to set-up or dissolve and offers plenty of flexibility.