The form of business entity you choose will have legal and tax implications and affect your ability to grow, obtain outside investment, or even sell the business down the road. Entity selection will affect your personal liability, level of accounting and record keeping required and whether you take payroll or are subject to self-employment taxes. While it is generally possible to change entities later, getting it right the first time can save time and money down the road.
Businesses are organized or incorporated at the state level. Choices are governed by the entities your state recognizes. The most common types of business entities are Corporations, Partnerships, LLC’s and Sole Proprietorships. After setting up a business at the state level, a tax election with the IRS might be beneficial. As an example, a Partnership or LLC might want to be taxed as an S Corporation and would file paperwork to make that election with the IRS.
How Do I Choose an Entity?
Primary considerations when deciding on an entity type are 1) ownership, 2) earnings, 3) taxation and 4) liability. A new or prospective business owner should carefully consider how they anticipate the business will grow and what their long-term goals are. A business plan should address the following questions:
- Where will funding come from? Does the owner have the money it will take to build the business or will outside investment be necessary?
- What is the liability exposure from the product or service this business produces?
- Is it likely the business will generate large losses during start-up?
- Will you need employees?
- Is the goal to distribute earnings currently or reinvest earnings and sell for a profit down the road?
This is the simplest business structure and there is no legal distinction between the owner and the business. This type entity is inexpensive to create and maintain and is taxed on the owner’s personal tax return. Sole proprietors do not have to maintain a separate bank account (although this is a good idea). Owners receive profits of the company, not payroll, but can employ others.
Some of the disadvantages are that Sole Proprietorships pay both self-employment tax and regular income tax on business earnings. Owners have full liability for all debts of the business, and it is difficult to raise outside funds since the company cannot issue stocks. It is also hard to sell a Sole Proprietorship because it is indistinguishable from its owner.
Limited Liability Companies
LLC’s can be formed as single member or multi-member organizations. A single member LLC is typically taxed like a sole proprietorship. Multi-member LLCs are usually taxed as a partnership but could be treated like a Qualified Joint Venture or elect to be taxed as a Corporation. When operated properly, an LLC can protect owner(s) from personal liability and financial losses are limited to their investment in the company. Protection does not extend to criminal liability. An LLC can have an unlimited number of member/owners and allows flexibility in structuring member investment and profit or losses. LLC’s are not required to have a board of directors but should create an operating agreement specifying how disagreements and changes of members will be handled in the future. Limitation in raising outside funds can be a major disadvantage of an LLC.
Corporations function as separate entities from the shareholder-owners. They can own property, incur liabilities and be sued with no responsibility transferring to shareholders. Ownership of corporations can be transferred through sales of stock, ensuring the business continues to exist even if owners die or want out of their investment. Additional funds can be raised through sale of equity, which does not usually have to be repaid and is less costly than a loan.
Corporations are more expensive to form than other entities, require more accurate accounting and recordkeeping and if you incorporate, you’ll have to file two returns: one for the corporation and one for your personal income. If a corporation has insufficient assets to obtain loans, banks may require personal guarantees, which defeats the goal of limited liability. Shutting down a corporation can also be more difficult that closing other types of entities.
Corporations can save on taxes by planning how income is distributed and by paying dividends instead of wages. C Corporations pay tax at the corporate level as well as the individual level, but offer high income individuals the opportunity to defer taxes by planning for distributions. Corporations also have the ability to shift income to family members with lower incomes and reduce the tax paid.
Partnerships are one of the easiest entities to form and one of the most flexible. A partnership can be formed by verbal agreement and can allow any number of participants, making it easy to raise additional funds. Profits and losses can be allocated in whatever manner the partners agree on and partners can be actively involved in day-to-day management or merely passive investors.
Partnerships can be structured in a variety of ways, but partners who participate in management decisions may have unlimited liability for the actions of the other partners and the success or failure of the business. Death or insolvency of a partner can cause a partnership to fail as can disagreements between the individual partners. Individual partners are agents of the business and can create agreements that are binding on other partners. A partnership interest may also be hard to transfer to an outside party as a transfer or sale requires the consent of the other partners. Partnerships file their own tax return and partners receive K-1’s which they use to prepare their individual tax returns.
This information is provided for general information only and should not be construed as specific tax advice as your situation may vary.
Contact a CPA in Golden Today
Karen Schwimmer, CPA helps small business owners incorporate their business to reduce taxes, reduce cost and improve profits. Contact Karen Schwimmer, CPA today at 303-642-0628 or Karen@SchwimmerCPA.com