The decision to start your own business comes with many important considerations. One of the first tasks you will encounter is choosing the legal form of your new business. There are quite a few choices of legal entities, each with their own advantages and disadvantages that must be taken into consideration in light of your own personal and business tax situation.
The following offers a very general overview of some of the legal forms of operation available. However, the practical, legal and tax considerations need to be explored before choosing any of these vehicles for the operation of your business.
For more on the legal, financial and non-tax considerations review Choice of Business Entity: Legal, Financial and Other Non-Tax Concerns.
By far the simplest and least expensive business form to set up, a sole proprietorship can be maintained with few formalities. However, this type of entity offers no personal liability protection and doesn’t allow you to take advantage of many of the tax benefits that are available if you operate under a corporate format, especially a regular C corporation.
Income and expenses from the business are reported on Schedule C of the owner’s individual income tax return.
Net income is subject to both social security and income taxes.
Similar to a sole proprietorship, a partnership is owned and operated by more than one person. All partners can be jointly and severally liable for partnership debt. So partnerships offer no personal liability protection for its partners for partnership debt.
A partnership can somewhat limit the personal liability issue to a certain extent by operating as a limited partnership, but partners whose liability is limited cannot be involved in actively managing the business. The individual partner named as general partner in a limited partnership has unlimited liability. This is why in certain cases the general partner is a corporation. Note that in such case, the corporation must meet certain tests for it to be respected and to prevent any partner from becoming liable for partnership debt.
Partners receive a Schedule K-1 with their share of the partnership’s income or loss, which is then reported on the partner’s individual income tax return.
In addition, the passive activity loss rules, the “at risk rules,” and other limitations may apply that can limit the pass through of losses that can be currently deductible by partners from these partnerships.
This type of legal entity is somewhat of a hybrid between a partnership and a C corporation. Owners of an S corporation have the same liability protection that is available from a C corporation but business income and expenses are passed through to the owner’s (as with a partnership).
Like partners and sole proprietors, however, more-than 2% S corporation shareholders are ineligible for certain tax-favored fringe benefits.
Another disadvantage of S corporations is the limitations on the number and kind of permissible shareholders, which can limit an S corporation’s growth potential and access to capital.
As with a partnership, shareholders receive a Schedule K-1 with their share of the S corporation’s income or loss, which is then reported on the shareholder’s individual income tax return. Once again, the passive activity loss rules, the “at risk rules,” and other limitations may apply that can limit the pass through of losses that can be currently deductible by shareholders that receive K-1s from these S corporations.
Although they do not have the shareholder restrictions that apply to S corporations, the biggest disadvantage of a C corporation is double taxation. Double taxation means that the profits are subject to income tax at the corporate level, and are also taxed to the shareholders when distributed as dividends. This negative tax effect can be minimized, however, by not paying dividends, thus avoiding double taxation and by investing the profits back into the business to support the company’s growth. To minimize double taxation, profits are paid to shareholder-employees by the payment of salary or wages. However, the overall salary paid to shareholder-employees must meet the “reasonable compensation” test. For more on reasonable compensation please read “Reasonable” Compensation: IRS Auditors Favorite Issue
An advantage to this form of operation is that shareholder-employees are entitled to tax-advantaged corporate-type fringe benefits that are deductible at the corporate level, such as medical insurance coverage, disability insurance, medical reimbursement plan payments, some amount of the premium paid for group-term life insurance, etc.
A limited liability company can be set up to be taxed as a partnership, avoiding the corporate income tax, while limiting the personal liability of the managing members to their investment in the company.
A LLC is not subject to tax at the corporate level. However, some states may impose a fee.
Like a partnership, the business income and expenses flow through to the owners for inclusion on their individual returns by the issuance of K-1s.
For more on LLCs please review LLCs: The Basics.
An LLP is similar to an LLC, except that an LLP does not offer all of the liability limitations that are available in an LLC structure. Generally, partners are liable for their own actions; however, individual partners are not completely liable for the actions of other partners.
Remember one size does not fit all. The choice of entity depends on the particular business venture and its long and short term goals. Equally important is the particular tax posture of each of the parties involved.
Remember, the above is an extremely basic overview. In matters of taxation and corporate law the “devil is in the details” when determining the proper legal entity to choose to operate a business or venture. To determine the most advantageous entity to use requires discussion and analysis with tax and business counsel. To avoid costly missteps, such analysis and discussions should occur BEFORE a choice is made and money is expended in forming the organization.
Please do not hesitate to contact me if you would like to explore your specific tax or financial situation to determine the appropriate entity and to have it properly formed in compliance with the law.
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Steve is an excellent corporate attorney who has a deep understanding of corporate law, taxes and estate planning. He’s been extremely helpful to me in keeping my many companies and business ventures organized, focused and squeaky clean. He’s very strong in estate planning and wealth preservation as well. Finally, his follow through is air tight and utterly dependable.
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