Be sure to make the best entity choice for your business.
One of the first major decisions you will have to make as you start your new business is to decide what form of business entity to adopt. Depending on how you have organized your business and whether you intend to work on your own or in conjunction with others will play a large role in determining the type of entity you select. The issues here can be complicated which is why it is so important to do some research and seek out the advice of a professional. Choosing the wrong business entity or not properly understanding all the filing and compliance issues can prove extremely costly in taxes.
The form of entity you choose will govern the liability protection of your company, as well as, have an impact on the way you are affected by income tax regulations and tax rates. The basic forms of business organizations can be broken down into five general types. Each type has both advantages and disadvantages with regard to both taxation and legal issues. The following is a brief overview of each.
Sole Proprietorship
A sole proprietorship is a business owned and operated by one individual, or by a husband and wife. A sole proprietorship is not actually a separate legal entity under the law, but is merely an extension of the individual who owns it. As the owner has possession of the business assets, he/she is personally liable for the debts and obligations incurred by the business as well. The income or loss of a sole proprietorship is reported on Schedule C and combined with any other earnings of the individual or spouse. Unlike a corporation, the net income is not potentially subject to double-taxation.
A distinct advantage of a sole proprietorship is that it is the easiest form of business to own and operate since it does not require any specific legal organization. Of course, the normal registration requirements for licenses, permits and payroll must still be satisfied. A sole proprietorship typically does not have rules or operating regulations it must adhere to. The business decisions are solely the result of the owner's abilities.
The disadvantage of a sole proprietorship is that, unlike a corporation, there is no limited liability protection to the owner.
Partnership
Partnerships can be of either two legal forms, general or limited. In a general partnership, two or more individuals join together to run the business enterprise which will operate under the partnership name. Each of the individual partners will have an ownership interest in the partnership assets and will also be personally responsible for partnership liabilities. The duties of the partners, as well as, the determination of how profits or losses are to be shared will typically be detailed in the partnership agreement. Generally, partnership creditors typically have recourse to the personal assets of each of the partners for settlement of partnership debts.
A limited partnership, on the other hand, is comprised of one or more general partners who are personally liable for partnership debts and one or more limited partners who contribute capital and share in the profits or losses of the business but do not play an active role in running the business and are not personally liable for the debts of the partnership. The rights, responsibilities and obligations of both the limited and general partners will typically be detailed in a partnership agreement.
A partnership is a legal entity recognized under the law and has rights and responsibilities as a separate entity. This means the partnership can sign contracts and borrow money. However, if the partnership is small, most creditors will require a personal guarantee of the general partners before extending credit.
A partnership is required to file a federal income tax return. In some states such a Pennsylvania, they must also file a state partnership return. However, a partnership typically does not pay income tax at the entity level. Rather, the profit or loss is passed through to the personal income tax returns of the partners to be combined with other components of income and deductions to determine the overall tax liability.
Corporation
A corporation is actually a separate legal entity created under the authority granted by state law. It has its own legal rights as well as liabilities. A corporation must file income tax returns and pay taxes on any income it derives through operations (unless an S-corporation election has been filed as discussed later). If the corporation wishes to do business under a fictitious name, it must first obtain permission from the Secretary of State in which it is to be incorporated. A corporation must also adopt and file articles of incorporation and by-laws which govern the rights and obligations of its shareholders, directors and officers.
One of the primary advantages of being a corporation is that its shareholders are protected from the liabilities of the business. However, in the case of a small corporation, creditors may still require the personal guarantees of the principal owners before extending credit. Depending on the type of business, the additional up front expense of incorporating and the ongoing cost to administer the corporation will usually pale in comparison to the benefit of the limited liability protection to the shareholders.
Another advantage of incorporating is that it can facilitate bringing in additional equity capital as well as allow efficient ownership transfer among shareholders of the business. This in turn allows for business continuity when shareholders retire or sell their ownership interest.
S Corporation
A variation to the above corporation is an S corporation. S status can be adopted by filing an election within the required time parameter. As an S corporation, the entity is taxed similar to that of a partnership in that there is no tax assessed at the entity level. Instead, the net income or losses flow through to the shareholders to be included with other components of income and expense on their individual income tax return. S-corporations are more restrictive in terms of the number and type of eligible shareholders and the fact that there can only be one class of stock.
Requirements for S-corporations vary from state to state. Therefore, you should contact your State Department of Revenue or your CPA to determine your state's specific requirements.
Limited Liability Company
A limited liability company (LLC) operates and is taxed as a partnership for federal tax purposes, but provides the liability protection of a corporation. An operating agreement determines how income or loss is allocated among owners as well as other operating matters.From this perspective, the ability to allocate components of income and expenses according to an agreement gives the LLC more flexibility than an S-corporation. Also, unlike the S-corporation, they can have an unlimited number of owners and any person, business or trust can own one. LLC's are often preferable over S-corporations when setting up highly leveraged ventures such as real estate since, unlike under an S-corporation, your share of the LLC debt owed to others counts as "basis" meaning you have a larger investment against which to deduct any LLC losses.
So, which entity should you choose?
Unfortunately, there is not one simple answer. It depends on the type of business you operate as well as other factors such as your aggregate tax situation. The place to start, however, is to discuss your objectives with your CPA and your attorney. You can save yourself a lot of grief and perhaps enough in tax savings alone to easily justify the cost of professional counsel at the very beginning. It's usually easier to set up your business correctly from the beginning rather than try to rectify the results of a poor decision later.
If you are interested in learning more about incorporation, we have placed a banner below link for you to click through to directly to MyCorporation - a QuickBooks affiliated site to learn more - or even incorporate right on line.
(The above discussion is intended to be only an overview of this topic. You should consult with your accountant and legal counsel before implementing any of the above concepts.)
Miller, Bahr & Wills, P.C.
