One of the big decisions we must make when starting our business is which form of business best fits our needs. The simplest business structure is the sole proprietorship, which usually involves just one individual who owns and operates the business. A big plus in the sole-proprietorship is that you have complete control of your business-you make all the decisions. If we intend to include others in our business, perhaps a partnership or some type of corporation would be the best fit.
The tax aspects of a sole proprietorship are especially appealing because income and expenses from the business are reported on your personal income tax return (Form 1040) at the end of the calendar year. Your profits and losses are first recorded on a tax form called Schedule C, which is filed along with your 1040. Then the “bottom-line amount” from Schedule C is transferred to your personal tax return as profit or loss on your normal income. This is especially attractive because business losses you suffer may offset earned income and reduce the amount of tax owed. As a sole proprietor, you must also file a Schedule SE with Form 1040 to calculate how much self-employment tax you owe.
In addition to paying annual self-employment taxes, you will be required to also make quarterly estimated tax payments on your income. Currently, self-employed individuals with net earnings of $400 or more must make estimated tax payments to cover their tax liability. If your prior year’s adjusted gross income is less than $150,000, your estimated tax payments will be at least 90 percent of your current year’s tax liability or 100 percent of the prior year’s liability, whichever is less. The federal government permits you to pay estimated taxes in four equal amounts throughout the year on the 15th of April, June, September and January. With a sole proprietorship, your business earnings are taxed only once, unlike other business structures.
Those are all pluses for sole proprietorship. But. There are a few disadvantages to consider, too, before deciding which structure is right for you. Selecting the sole proprietorship business structure means your personal assets are at risk to cover your company’s liabilities. As a result, your assets could be seized to satisfy a business debt or legal claim filed against you.
Raising money for a sole proprietorship can also be difficult. You will find that banks and other financing sources are reluctant to make business loans to sole proprietorships, in general, and startups in particular. In most cases, you’ll have to depend on your own financing sources, such as savings, home equity or family loans until you have a proven track record to demonstrate to a potential investor or lending officer.
If your business will be owned and operated by several individuals, you should investigate whether a partnership is right for you. Partnerships are more expensive to establish than sole proprietorships due to more extensive legal and accounting services, but they come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners.
The general partners own and operate the business and assume liability for the partnership, while the limited partners serve only as investors only and are not subject to the same liabilities as the general partners. Limited partnerships usually are not the best choice for a new business because of the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form. One of the major advantages of a partnership is the tax treatment it enjoys. A partnership doesn’t pay tax on its income but “passes through” any profits or losses to the individual partners. At tax time, each partner files a Schedule K-1 form, which indicates his or her share of partnership income, deductions and tax credits, and report profits from the partnership on his or her individual tax return.
Even though the partnership pays no income tax, it must compute its income and report it on a separate informational return, Form 1065. Similar to a sole proprietorship, general partners are personally liable for the partnership’s obligations and debt, so if personal liability is a major concern in your business, you may be better off selecting some form of corporate entity.
Limited Liability Company
The Limited Liability Company (LLC) has been around since 1977, bringing together some of the best features of partnerships and the corporation, offering what is arguably the best setting for tax purposes. LLCs were created to provide small business owners with the liability protection that corporations enjoy without the double taxation. Profit and loss passes through to the owners and reported on their personal tax returns, just as in a partnership or sole proprietorship. Like partnerships, LLCs do not have perpetual life, in that the company dissolves when a member dies, quits or retires. And, some states require a partnership to dissolve after 30 or 40 years.
These considerations have often led small businesses to incorporate as an S Corporation. Today however, the LLC offers small-business owners another option. For example, there’s no limitation on the number of shareholders an LLC can have, unlike an S corporation, which has a limit of 75. In addition, every member or owner of the LLC is allowed a full participatory role in the business’s operation. To set up an LLC, you simply file Articles of Organization with the Secretary of State in the state where you intend to do business. Some states also require you to file an Operating Agreement, which is similar to a partnership agreement.
LLCs also have disadvantages. Since LLCs are created first at the state level, legislation in each state dictates the abilities and limitations of the LLC. If you decide on an LLC structure, be sure to obtain the services of an experienced accountant or small business attorney who is familiar with the various rules and regulations of LLCs. If you plan to operate in several states, you must determine how each of those states will treat an LLC formed in another state. Another excellent resource is the Internet. Simply go to your state’s website, find the Secretary of State’s office, and do a search for “Business” or “Companies” until you find the links to Corporations or LLCs. You can learn a lot very quickly about these entities in your state from these websites.
Using the corporate structure is more complex and expensive than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires compliance with more regulations and tax requirements than any other entity.
The biggest benefit the corporation offers is the liability protection provided the owner(s). A corporation’s debt is not considered that of its owners, so you’re not putting your personal assets at risk. A corporation also can retain some of its profits, without the owner(s) paying tax on them, and can also sell stock to raise money. The corporate structure, however, comes with a number of downsides, including higher costs.
Corporations are formed under the laws of each state with their own set of regulations. Because a corporation must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax preparation services. For these reasons you’ll probably need the assistance of an attorney to guide you through the maze. I have also found it a good practice to have an accountant to help with timely tax filing and reporting.
Another drawback of standard corporations is that owners of the corporation pay a double tax on the business’s earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.
To avoid double taxation, you can pay the money out as salaries to yourself and other corporate shareholders. A corporation is not required to pay tax on earnings paid out as reasonable compensation, and it can deduct the payments as a business expense. The IRS, however, has strict limits on what it believes to be reasonable compensation, and varying the amount of compensation each year to reflect what would have otherwise been profit for the corporation can amount to waving a yellow flag in the face of the IRS.
It is possible to file for incorporation without the help of an attorney, saving $500-$1,000 in start up costs, but the process is likely to take some time to accomplish, and there is also the risk that you might miss some small but important detail in your state’s law. Generally, you must prepare a certificate or articles of incorporation with the proposed name of the corporation, the purpose of the corporation, the names and addresses of the parties incorporating, and the location of the principal office of the corporation.
The corporation will also need a set of bylaws that describe in greater detail than the articles how the corporation will run, including the responsibilities of the shareholders, directors and officers. You also need to state when annual stockholder meetings will be held; and other details important to running the company. When your articles of incorporation are accepted, the secretary of state’s office will send you a certificate of incorporation.
Once you’re incorporated, be sure to follow the rules of incorporation required by state law, and to follow your own articles and bylaws. If you don’t conduct business according to these strict rules, a court can pierce the Corporate Veil of Protection, and hold you and the other owners personally liable for the business’s debts. Be sure to keep accurate financial records for the corporation, showing a separation between the corporation’s income and expenses and that of the owner(s).
The corporation should also issue stock to its shareholders, hold annual meetings to elect officers and directors, and file annual reports. Be sure to keep minutes of these annual meetings, and any interim meetings of the Board of Directors, and get them typed and entered into the official records of the corporation.
The IRS subchapter S corporation is more attractive to small-business owners than a standard corporation because of some appealing tax benefits while still providing the liability protection of a standard corporation. With an S Corporation, income and losses are passed through to the shareholders and reported on their individual tax returns. As a result, there’s just one level of federal tax to pay.
Owners of S corporations who don’t carry inventory can use the cash method of accounting, which is much simpler than the accrual method. Under this method, income is taxable when received and expenses are deductible when paid. Tax law changes brought about by the Small Business Job Protection Act of 1996 have made S corporations even more attractive for small-business owners. In the past, S corporations were limited to 35 shareholders of common stock, but in 1996 the new law increased the number of shareholders to 75, making it possible to have more investors and thus attract more capital.
S corporations do come with some downsides. For example, they’re subject to many of the same requirements corporations must follow, which in my experience means higher legal and tax service costs. These corporations also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. These costs, legal and accounting expenses are similar to those of a standard corporation.
Even after you settle on a business structure, remember that the laws that make one type of business organization favorable are always subject to change. Reassess your form of business from time to time to make sure you’re using the one that provides the most benefits, and in all cases, get outside advice from a specialist about the ideal form to take.
I recommend your Secretary of State’s website, and Entrepreneur.com’s Tax Center as excellent resources for preliminary research into these complex topics. You may also visit the Internal Revenue Service website to download information on this topic. Download forms 17, 334, and 583.