Determining legal organization structure is one of the most important decisions when establishing a business structure because; it will affect transferability, operational efficiency, financial reporting, personal liability, and taxation. Making the choice of the business structure may be complicated and the errors can be costly because the current tax laws make it hard to change the tax laws after the business starts operating. Two most common legal organization structures are corporation and partnerships. Comparing and contrasting applicable tax rules and treatment to partnership and corporation is crucial in ensuring that the investors make the correct investing decisions.
Comparison of Tax rules applicable to corporation and partnership
A corporation is a legal business entity that has its own identity separate from the owners or the shareholders. In partnership, on the other hand, there is no legal separation from its shareholders (Nonprofit Business Advisor, 2016).A corporation is considered as a tax payer according to IRS (Internal revenue Service and is required to file its annual income tax return under its own name and the identification number of the employer; partnership on, the, another hand, is not a taxpayer according to IRS, and it operates personal responsibility and legal name of the partners. Another difference is that corporations are required to pay taxes at the established corporation tax rate unless it meets IRS requirements of S-Corporation; however, a partnership does not pay its taxes as a business entity, but the profits and losses on the individual income are reported and tax payments are made based on individual tax rates.
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How the tax treatment affects the partners and the shareholders
Corporations are required to distribute the surplus to shareholders as dividends after the payment of corporate tax. The dividends paid are determined by the number of shares held by each shareholder (Rupert, Pope, Anderson & Bandy 2017).Rupert, et, al further narrates that after receiving the dividends, the shareholders are required to file the payments individually and then pay the individual tax rate on the distribution, which causes the double taxation of the profits. The double taxation affects the shareholders because the shareholders pay taxes on both the individual level and the corporate level.
IRS considers the partners as being in self-employment, not a business; thus any payment or compensation that the partner receives is advancement against the profits; therefore, they are required to pay self-employment taxes. In corporations, the shareholders who are employed are the considered as employees of the corporation, and while paying the employer share from the wages, the employer deducts the staff share of payment withholdings.
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Reasons the business owners may opt a partnership with a corporation
Partnerships have tax advantages over the corporation because they do not pay income tax. Loss or profits of the partnerships are passed to their owners, whereby they pay the income tax based on the individual income tax rates, which eliminates the burden of double taxation(Masters, n.d.).Corporation has a disadvantage of double taxation, whereby the shareholders pay taxes on both the individual and the shareholders level.
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Another reason for choosing a partnership over a corporation is the by-pass taxation. The profits and losses are passed to the partners on the proportional levels, where the share of each partner are reported as the individual income for the purposes of taxation(Masters, n.d.).In an event that the partnership makes the loss, the owners of the partnership receive tax relief which is not available for corporations.
Why C Corporation is the most suitable business entity compared to a partnership.
Internal Revenue Service defines C Corporation as an ‘entity which has a separate tax life and ownership from the shareholders’. Tax paid by the corporate is determined by the corporate tax rates and the profits. At the end of the financial year, the corporations are required by the IRS to file IRS Form 1120(Corporate tax forms). The boards of the directors are elected by the shareholders. The role of the board is to control and manage the business undertakings of the corporation’s(Rupert, et.al.2017).Additionally, the directors make major decision and policies, but they are not responsible when dealing with the third persons, rather undertakings are made by the employees or officers whom duties are delegated by the board.
The corporations have various advantages when compared to the partnership. One of the major advantages is that the shareholders are not liable for the losses unless the shareholders personally guarantee the debt; on the other hand, partners are liable for the losses made by the partnership. Another advantage is that the corporations have a continuous life, unlike the partnerships where the business depends on the life and health of the partners (Griffin, Ebert, Starke Dracopoulos, & Lang, 2014). Furthermore, transferring the ownership of the corporation is easier without disrupting the business activities. Some of the tax rules that are enjoyed by the corporation include.
- When the corporation makes losses, they are fully deductible, while in partnership, before deducting the losses, they must prove that they had a profit motive.
- In a corporation, it is possible to come up with plans to “avoid” tax by engaging in retirement schemes, which can be set as fringe benefits which are tax deductible.
- Profits of the corporation can be used for the expansion of business activities, which has tax advantages.
Furthermore, the tax liability of the corporation can be reduced by leasing your own assets to the corporation. After leasing the assets, the business is required to pay lease income. Adapting this strategy enables the lessor to deduct certain costs such as repairs and maintenance on the taxes.
Factors to consider when determining the type of the business entity
There are various things to consider when determining the most appropriate business entity that will suit the vision and goals. For instance, the level of control that the goals and vision dictate should be analyzed. If the owners desire to control the business, the sole trader or partnership is the most appropriate; if the owners are not concerned with the control, then the corporation is appropriate. Additionally, if the owners have a vision of expanding the business activities locally or globally, establishing corporation is the best option because corporations have legal, operational and financial advantages when venturing into new activities or penetrating new markets (Besley, 2016).
Furthermore, considering the flexibility and the future needs of the corporation is crucial because a corporation has well-defined expansion goals, also the goals are flexible, on the other hand, partnerships goals or flexible, but does not provide for the expansion undertakings. Besides, the tax consideration is critical because partnerships enjoy tax benefits, while the corporations have disadvantages of double taxation. Additional continuity of the business should be considered; if the business is temporal, sole proprietorship or partnerships are appropriate; if the vision favors continuity, the corporation is appropriate. In conclusion, before determining the business entity to form, researching on capitalization and government programs is crucial. Capitalization is the amount that the owners the amount assets that the owners want to invest in the business. Owners may contribute or borrow the capital required to establish the business entity. Capitalization rules depend on the type of the entity, hence the owners must research on the financing options. Besides, researching on the on government support initiative is crucial because the choice of the entity may affect the payments limit or eligibility associated with such initiatives.
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