If you’re thinking of starting a business, kudos to you! Starting a business can be an overwhelming experience in the beginning, but well worth it in the end.
Of all the decisions you’re going to make, one of the most important decisions that should not be taken lightly, will be the type of legal structure you will choose for your company, whether it may be a sole proprietorship, partnership, or corporate entity. This decision will definitely have an impact on your tax obligations, it will affect the amount of paperwork your business will be required to complete and process. It also has ramifications for your personal liability.
Before we get into the various business types, there are some considerations which lead to one business form over another regardless of tax advantages. For example, do you have foreign partners or investors, will you operate in various states, will you seek venture capital (if so, how soon)? These are but a handful of considerations that need to be considered. Let’s now look at the various business forms.
Types of business entities
Sole proprietorship is the most common form of business organization and easiest to operate. It is very simple to form often requiring only registering a Doing Business As (DBA) with the county courthouse. A mistake many owners make since this form of business is so easy to form and operate is they are lax in maintaining adequate books and records and frequently commingle business and personal expenses in the checkbook.
Tip – Open a separate checking account and pay yourself a draw. Pay business expenses from the business account and personal expenses from your personal checkbook.
Another consideration is this type of entity makes the owner personally liable for any and all financial obligations pertaining to the business. Think bankruptcy or liability from acts of your employees, such as an auto accident. I’m not referring to professional liability such as doctors, professionals are always held personally liable. Thought must be given to the nature of your business and potential for liability before selecting this form of entity.
Finally, adequate and accurate books and records are required, but the owner does not take a salary. The owner takes a draw and pays the federal, social security and state taxes assuming no employees via quarterly estimated tax payments. Keep in mind your draw is your “gross” pay check. This means you’ll need to estimate a reserve for income and social security taxes from each draw, no different than you would withhold taxes for an employee.
Tip –Establish a separate bank account for your tax liability and transfer the estimated amount for taxes to this account to establish a delineation between funds available for operations versus those earmarked for taxes.
A partnership consists of two or more people who agree to share in the profits and losses of a business. Similar to a sole proprietor, partners do not take salaries, but rather take guaranteed payments. The guaranteed payments are deducted from the net income, but included as partner’s compensation and subject to income and social security taxes.
Depending on whether a partner is a general partner or a limited partner, they may be held personally liable for the financial obligations of the business, absent personal guarantees. Many individuals form partnerships to avoid double taxation such as is the case with C-Corporations. Partnership tax law is one of the most complex areas of the tax code due to the flow-through nature of income, expenses, gains and losses. However, it’s useful when partners want flexibility in partner sharing percentages for income and losses.
Tip –Make sure you have a partnership agreement in place from the start. This can help you avoid heartache and expensive litigation if the partnership ever goes sour.
A corporation is a legal entity incorporated within a state. Many corporations are formed in Delaware, since most attorneys are trained in Delaware law and the law of their home state. The corporation is a separate entity, subject to federal and state taxation. Like a person, the corporation can be taxed and can be held legally liable for its actions.
Most venture capitalists require a corporate structure to facilitate investment and eventual sale, or public offering. In addition, there is the possibility certain officer fringe benefits and those of other shareholders will not be subject to tax as is the case with partnerships or S-corporations.
Tip –The key benefit of corporate status is the avoidance of personal liability, so long as the corporate veil is not pierced. Bes sure to work with a knowledgeable advisor to make sure you have the right documents and processes in place to take full advantage of corporate status.
The primary disadvantage is the cost to form a corporation and the extensive record-keeping (minutes, resolutions, etc). While double taxation is sometimes mentioned as a drawback to incorporation, the S corporation (or Subchapter S-corporation, a popular variation of the regular C-corporation) avoids this situation by allowing income or losses to be passed through on individual tax returns, similar to a partnership. Similar to the partnership tax laws, those applying to the Subchapter S-corporation are often quite complicated due to the flow-through nature of the income and expenses.
A hybrid form of partnership, the limited liability company (LLC), is very popular among new business owners and the legal community. LLCs offer personal liability protection for the owners, but for income tax purposes they are treated as a sole proprietorship if there is one owner or a partnership if more than one.
Tip –An LLC can elect to be treated as a corporation, but this is seldom done unless there are extenuating circumstances, for example foreign owners.
The foregoing is meant to provide a broad overview of the types of business entities a new business owner may choose. Each choice carries with it its own advantages and disadvantages based on your goals, so be sure to consult your CPA or other trusted business advisor before making any decisions.
Need help talking through your options? Magone & Co. CPAs can help you make the decision that’s right for your needs and goals.