CHOICE OF A BUSINESS ENTITY
FOR TAX PURPOSES
For tax purposes there are three main business entity
choices: sole proprietorship, partnership, and corporation.
Do not confuse a State entity with a Federal Tax entity. A
“Limited Liability Company” (LLC) is a State entity that
may be taxed as either a Partnership, a Corporation, or
even as a single person Sole Proprietorship.
There are advantages and disadvantages to each. For most
entrepreneurs, the easiest and usually most recommended
form to begin with is that of a sole proprietorship.
The sole proprietorship simply means one owner, and is
the "default" form. If you do nothing else, you will be a
sole proprietorship. The main feature of this form is that it
is identified with and intertwined with you. If the business
makes a profit, it automatically is income for you. If the
business incurs a debt, it is your personal debt as well. If
the business gets sued, you will be sued personally as well.
This is both the strength and weakness of the sole
proprietorship. You have complete flexibility, and can
instantly shift the direction, policies and focus of your
company. Yet, if there is a problem, the potential for the
damage extending throughout your personal life is ever
present.
Next up is the Partnership. It is often likened to being
married without being in love! It can destroy friendships,
and you are completely liable for whatever your partner
does. If he or she orders 5 thousand pet rocks, and then
skips town with the money in your account, not only will
you be out the money, but also you will be liable for paying
for the pet rocks when they arrive.
In spite of the above, Partnerships can work, when there is
a clear division of responsibilities and abilities. If you are a
good negotiator, salesperson and "people person," but your
paperwork is usually a shambles, and your potential
partner is meticulous and detail oriented, but fears selling
and meeting strangers, the two of you might be a natural
match.
One other way partnerships benefit is to raise more capital.
Your partner's contribution may be what you need to
launch your business. The thing to do, if you do
contemplate a partnership, is to have a clearly defined
partnership agreement drawn up. Have it checked by a
lawyer. The agreement should specify what happens if one
of you decides to quit. What if either of you dies? Who will
do what functions? How will decisions be made? What if
you can't agree? Who will pay for what? These things all
should be settled beforehand, before they have a chance to
cause disruption in the business. Nothing kills a business
faster than feuding partners do.
The third form of business entity is the corporation. There
are two main advantages to incorporating:
1. You can have people invest in your company and raise
money.
2. Because the corporation exists legally as a
separate entity, there is a liability shield between you and
your assets and the business. If the company gets sued,
you may not be. Company debts are separate from your
own financial situation.
There are two main types of corporation, the subchapter C
and subchapter S. (They refer to subchapters of the tax
code). The C Corporation is your "standard" corporation. All
the companies listed on the stock exchange are C
corporations. You can have unlimited shareholders. If you
sell 100,000 shares at $10 each, you've got a million
dollars in capital to work with. The investors can be people,
mutual funds, companies, and foreigners. The
disadvantage to the C Corporation is that of double
taxation. If your business earns $100,000, the first thing
that happens is that a corporate tax is paid. Then if you
want to draw a salary (for in a corporation you are in fact
an employee), you must declare that salary and pay
personal income tax. The same money gets taxed twice
before you get to spend any of it. Recognizing the
unfairness of this to the small business, the S Corporation
was formed.
A very popular choice for a business entity is the SCorporation. S-Corporation income “flows through” similar
to the Partnership and the net income is simply reported
on the personal income tax returns of the shareholders. In
exchange for this benefit, there are limits put on S
corporation formation and ownership.
Why should or shouldn't you incorporate? You should
incorporate if you need the extra trademark and/or
protection of your business name, if you have significant
assets to protect, or if you are in a litigious type of
business. Keep in mind that incorporating complicates your
business operation as the corporation has much more
formality to it then do partnerships or sole-proprietorships.
It is suggested that you have a consultation with both an
accountant and an attorney before making this decision.
They will help you to understand all the ramifications of
this decision, both operational and legal.
The liability shield is particularly important when you have
a lot of assets that would be vulnerable to business loss or
lawsuit or if your business tends to be litigious in nature. If
these situations do not exist for you, or not judged to be
significant then you might be fine to cover your liability
with business insurance. As is all matters regarding asset
protection, be sure to seek competent advice.
A popular form of business incorporation is the LLC, or
Limited Liability Company. It combines many of the features
of a partnership with those of a Corporation. It allows the
reporting on personal income tax returns of the "members,"
but with the liability protection (generally speaking) of a
corporation. It lacks many of the restrictions that apply to
Corporations and has the much desired flexibility of the
partnership. LLC’s with more than one member can choose
to be taxed as either a partnership or an S Corporation.
There is also an LLC for sole-proprietors know as the single
member LLC.
See articles on:
S-Corp Insurance Deductions
Officers of S-Corps wage compensation
Health insurance for the self-employed
For further information: Richard Garner 623-500-2654