What form is best for your new business: Proprietorship? Partnership? S corporation? Limited liability company? C corporation? Determining how you structure your business is an extremely important decision and can have an impact on everything from the amount of personal liability you have to the amount of taxes you'll have to pay. The decision can be difficult. Each business form offers both advantages and disadvantages, so it's important to choose the one that makes the most sense for you.
So, what exactly are the different types of structures and what are the advantages and disadvantages of each?
Proprietorships and Partnerships
A sole proprietorship is a simple and inexpensive way to begin operating a business. As a result, it's the most common in the business world. Unless you operate the business under a name other than your own, generally no legal documents or forms need to be filed other than any licenses or permits required by your state or local government. As the sole proprietor, you have complete control over the business. However, a sole proprietorship is limited to one owner. Therefore, if you have multiple owners, or expect to in the near future, a sole proprietorship isn't right for you.
One caveat of sole proprietorship is that it must be a business, not a hobby or an investment. It can be either part- or full-time work and can be a retail operation, a large company with many employees, a home-based business or a single-person consulting firm.
With a sole proprietorship, business income is reported on your personal federal income tax return and taxed at personal income tax rates rather than corporate rates. If your business is a partnership, it must file a partnership return, but your allocable share of the business' income, losses, deductions and credits passes through to you to be reported on your personal tax return.
The greatest disadvantage of a sole proprietorship or partnership is that, as the owner or general partner, you are personally liable for all obligations of the business. Creditors of the business can go after your personal assets if the business assets are not sufficient to cover the business' debt liabilities.
Corporate Forms
Incorporating your business limits your personal liability for business obligations, but generally involves greater start-up and operating expenses, as well as added paperwork. A corporation is a distinct legal entity that is responsible for paying its own debts and obligations. Shareholders risk only the loss of the funds they have invested.
Generally speaking, corporations are more complex than other structure types, require more oversight and must adhere to more regulations and requirements. Corporations can also be held legally liable.
C Corporations
A C corporation is taxed separately from its owners at corporate tax rates. This can result in double taxation. Corporate income may be taxed once to the corporation and again to the shareholders when it is paid out as dividends or when the corporation liquidates. The corporation cannot deduct these dividend payments. However, it can deduct reasonable compensation paid to you and other owners. Ordinary and necessary business-related expenses, such as a company car or office account expenses, are fully deductible. So, small corporations often pay out all or most of their net income to the owners as compensation, especially if the owners' top personal tax rate is lower than the corporation's rate. (The top federal personal rate was 35 percent in 2007, while the corporate federal tax rates vary significantly, based on taxable corporate income. The highest corporate federal tax rates may be as high as 38 percent.)
As far as protection goes, the owner of a C corporation is allowed to use the corporation to pay individual life insurance premiums under a wholly owned or split-dollar arrangement. These premiums are not deductible if the corporation is either directly or indirectly a beneficiary of the policy.
S Corporations
With an S corporation, income, losses, deductions and credits pass through to you and other owners to be reported on your federal tax returns just as they do with a partnership. Thus, S corporation income generally is taxed only once. Businesses operating as S corporations must meet several special requirements. For example, an S corporation can neither have more than one class of stock outstanding nor more than 100 shareholders. (A husband and wife are considered one shareholder.) Also, unlike other business forms, it cannot selectively allocate income and deductions.
Like a C corporation, it is a legal entity and is separate from its shareholders and officers. For the most part, corporate shareholders have limited liability. In addition, there are no unreasonable accumulation/accumulated earnings problems.
Limited Liability Company
As an alternative to incorporation, consider operating your business as a limited liability company (LLC). For the most part, forming an LLC is simpler and involves less paperwork than incorporating your business. Like a corporation, an LLC provides owners with protection from personal liability for business debts and obligations.
However, most LLC owners can choose to have their businesses treated as partnerships for federal income tax purposes. Partnership treatment means that income, losses, deductions and credits pass through to the individual owners (called "members") to be reported on their individual income tax returns, so LLC income is not subject to double taxation. Partnership tax treatment also permits an LLC to specially allocate income and expenses among its owners to the same extent that a partnership can.
Keep in mind, however, that there are some types of companies-banks and insurance companies, for example-that cannot be LLCs. Also, because LLCs are relatively new vehicles, there is a lack of uniformity among state LLC statutes. As a result, an LLC structure may not be the right choice for entities with activities in more than one state. You should also check your state's requirement and federal tax regulations for more information on LLCs.
In addition, if you are already doing business as a C corporation or S corporation, you may face a host of taxes, expenses and complications in converting to an LLC. Merging LLCs with other entities is also fraught with potential complications. Since LLCs are relatively new and untested, many legal issues have yet to be addressed by statute or by the courts. Additionally, failure to carefully follow the LLC guidelines established by the IRS could nullify the tax advantage, and there are no guarantees that earnings of businesses conducted as LLCs will not be subjected to some form of taxation in the future. A few states have already expressed such an interest.
Choosing the right business form for your business isn't an easy decision, but it is an important one. No one structure is better or worse than another. You need to assess your own needs and requirements to ensure you get the right one for you. For additional information and assistance in making your choice, work with your tax and legal team, along with a professional financial planner.
Construction Business Owner, September 2008
Disclosure
CRN200705-2004364 Any discussion pertaining to taxes in this communication may be part of a promotion or marketing effort. As provided for in government regulations, advice related to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.
