By Maurice L. Smith CPA, JD
You are very good at what you do, and to top that off you have the personality and networking skills to market that ability. In fact, you are so proficient that you have decided to start your own business; but be careful in choosing the legal structure for that business because what you don’t know can hurt you.
There are many types of structures to choose from and they all have their benefits and pitfalls. The basic structures are Sole Proprietor, Partnership, LLC, LLP, Corporation and S-Corporation. What I am proposing to do today is briefly explain the basic characteristics of these entities to assist you in making the right choice. Please be aware that this article is not all encompassing and you should still seek the help of a competent professional. I seek only to open your eyes; the rest is up to you.
For many new business owners, the sole proprietorship will be very attractive. It is simple and inexpensive to set up. This satisfies the budget as going into business usually demands that every penny is pinched and squeezed. In addition, because this entity is not recognized for tax purposes, you will save money by not having to file a separate business tax return. The activities of the business goes directly onto your personal tax return as a Schedule C business activity. But be careful, this could be the worse choice that you can make. The Sole Proprietorship will not protect you from liability and so in the unfortunate event of a lawsuit you could lose both your business and personal properties. All the other entities that we will discuss will protect you from personal liability except in the case of a general partnership. In addition to leaving you totally open to liabilities, a sole proprietorship will also subject the entire net profit to Self-Employment Taxes which is 15% of the net income (sales minus expenses). This comes right off the top; half the amount is deducted and then income tax is accessed on the balance.
The next type of business structure is a partnership. This is very much like a sole proprietorship except that there are more than one owners in the business. The partnership files its own return and issues the partners a Form K-1 showing their share of the profits (or Loss) which is then reported on their individual returns. The partners are jointly and severally liable for the liabilities of the partnership and are held accountable for the actions of the other partners. This liability extends to the personal assets of the partners except in the case of a limited partner, where the liability is limited to the amount invested. The net profit of the partnership is also subject to Self-Employment Taxes on the individual partner’s tax return (except in the case of a limited partner). Please note that all partnership must have at least one General Partner. The partnership can choose to share different streams of income or losses differently, and unlike a Corporation or S-Corp does not have to allocate income according to owner’s percentage. For example, three persons can be equal owners of a partnership but agree to share profit 40%, 15% and 45%, but share losses equally or in any other proportions that they want.
Corporations are probably the business form that is most readily recognized by the public; but be aware, this is not the structure for you except in very specialized circumstances. For example, if you are not planning on going public (traded on the stock exchange), nor have foreign investors, a corporation is probably not the structure for you. Corporations will protect their owners from personal liability, but will also subject them to double taxation. The corporation must file its own tax return and pay its own taxes. There are only four ways to get money out of a corporation, salary, loan, dividends and sale of stock. If a dividend is paid, then the owner will pay taxes on that dividend, which was already taxed at the corporate level.
An S-Corporation is a corporation that have elected to be treated as a pass-through entity. This means that although the S-Corp files a tax return, it does not pay any taxes, but instead “pass through” the profit to its owner who reports it and pays taxes at the individual level only. Even though the owners of an S-Corp reports and pay income taxes on their personal tax returns, the income is not subject to Self-Employment Tax as are the profits of a sole proprietor. Note that the law has recently changed and in the case of professionals such as lawyers, doctors and accountants where the income of the S-Corp is directly connected to the reputation of that professional, the income of the S-Corp is treated as Self Employment Income.
The Limited Liability Corporation (LLC) and Limited Liability Partnership (LLP) entities are very similar and so we will discuss them as one. The LLC is the most flexible of all the entities. It has the liability protection of a corporation with the flexibility of a partnership. The LLC is not recognized by the IRS as a taxable entity, and so if it has only one owner, it is deemed a disregarded entity, does not file a tax return, and the profits are directly reported on its owner’s individual tax return. However, this individual will pay Self Employment Income on the Net Income of the business (except for real estate entities). The LLC can also choose to be taxed as a Corporation or a partnership. In the case where there is more than one member, the entity will file its own tax return (no tax is paid) and issue a Form K-1 to the members for them to report on their personal tax return.
Please remember that this is a simple and broad overview of the choices that are available to business and that a knowledgeable tax professional should be consulted before making a final decision.