So you’ve prepared a business plan, given your boss two weeks’ notice and you’re about to venture into the world of the self-employed. What should you do first?
Besides figuring out how you are going to market and deliver your product or service to your target consumer, you also need to consider the tax and legal aspects of running a business. This includes determining the appropriate structure for your business and understanding the associated tax filing and record-keeping requirements. All business owners need to address these issues, whether their businesses are big or small.
When selecting the best legal structure for your new business, you should ask the following questions:
- How many owners will be involved?
- How can I protect my personal assets against business liabilities?
- What are my long-term goals for the business?
- Will the business outlive me?
- Will I need to raise capital from outside sources?
There are basically five options: a sole proprietorship, a partnership (general or limited), a regular (or “C”) corporation, a small (or “S”) corporation, and a limited liability company (LLC).
Sole Proprietorship. A sole proprietorship is the simplest structure. The business does not exist as an entity separate from its owner, which is a single individual. The owner is personally liable for the tax and other liabilities of the business. There are no formalities and very little cost involved in establishing a sole proprietorship. Because the owner is the business, the sole proprietorship continues to exist only as long as the owner is willing to stay in business. This structure is most appropriate for a business owner who does not require personal liability protection and who has no intention of having the business continue after he or she retires. A good example would be a consultant who provides advice in a field in which he or she has prior work experience. The sole proprietorship is not often used by doctors or lawyers, because those professional practices typically expand by taking in other owners as shareholders or partners, and are usually intended to be transferred at the death or retirement of the founder.
Partnership. The process of establishing a partnership is more formal, but still relatively easy. It is a good idea to have an attorney draft a formal partnership agreement to protect the interests of all partners involved. There are two types of partnerships, general and limited, which differ mainly in the degree of personal liability assumed by their owners.
General Partnership. A general partnership has two or more owners who, usually, are all actively involved in operating the business. Each owner is personally liable for all of the business’s obligations. A well-drawn partnership agreement can include provisions to continue the business (if this is desired) after an individual partner’s death, retirement or other departure. The partnership agreement may include buy/sell provisions to set the terms by which surviving owners will buy out a departing owner’s stake, or these terms may be set in a separate buy/sell agreement. Regardless, all multi-owner businesses (including partnerships, corporations and limited liability companies) should consider both the terms of a buy/sell agreement and the funding of that agreement. Life and disability insurance are often used to provide cash when needed to implement a buy/sell agreement.
Limited Partnership. A limited partnership also has one or more general partners who run the business. However, the other owners are limited partners who solely invest capital in the business and partake in its profits. They do not participate in managing the business. More important, their potential losses are limited to the amount of their capital contributions. The business’s creditors cannot seek a limited partner’s personal assets to settle partnership debts. The partnership agreement can be constructed to avoid dissolution upon the death or incompetency of one of the general partners. A limited partnership structure is most appropriate for active owners who want to maintain control of the business, but who seek capital infusions from outside investors.
C Corporation. C corporations also limit the owners’ liability to the amount of their investment in the company. A regular corporation issues shares of stock to its owners. To raise capital, the corporation can sell undistributed shares. This entity is suitable for business owners who intend to take their company public or sell the company in the future. Also, an existing shareholder can sell his or her shares to another owner without any disruption to the business if he or she decides to part ways with the company. However, setting up a corporation involves some expense. You should hire an attorney to draft various corporate documents, such as corporate by-laws and articles of incorporation. A corporation is required to hold formal annual directors’ meetings. Double taxation, as discussed below, is a potential drawback of this corporate structure. Also, business losses, which are often incurred during the first few years the company is in business, do not flow through to the shareholders to be claimed on their individual tax returns, unlike other structures discussed here.
S Corporation. An S corporation is simply a regular corporation that qualifies to receive, and chooses to receive, more favorable tax treatment similar to that of a partnership. To become an S corporation, a qualifying corporation must file Form 2553, Election by a Small Business Corporation, with the IRS. Some states require a similar filing. To be eligible to elect S status a corporation must meet the following requirements:
- Have a maximum of 75 shareholders.
- Have only shareholders who are U.S. citizens or permanent resident aliens; non-resident aliens are not allowed. Certain trusts and charities are allowed to be S shareholders, as well.
- Must only issue one class of stock.
- Must not have passive investment income that exceeds 25% of gross income.
The cost of establishing an S corporation is similar to that of a C corporation. An S corporation is also required to observe the formalities of a regular corporation, such as holding annual meetings.
Limited Liability Company. A limited liability company is the most flexible of all business entities. Today, many small business owners are drawn to this structure because it provides personal liability protection as well as the flexibility to be treated as a sole proprietorship (single-member LLCs only), a partnership or a regular corporation for tax purposes. The owners are referred to as members. Ownership interests can be transferred to a new member, though this is often restricted in the company’s organizing documents or through buy/sell agreements. Setting up an LLC can be as costly as establishing a corporation, but the additional benefits that this structure provides can make it worth the expense, depending on your needs.
The type of entity you choose for your business determines how income will be taxed and the type of income tax return your entity will be required to file. For example, partnerships, S corporations and LLCs are known as pass-through entities. Income and losses flow through to the business owners, who report this information directly on their individual income tax returns. Thus, for federal purposes, business income generated from these entities is taxed solely at the owner level. Income from a C corporation, on the other hand, can be taxed at both the entity level and the owner level if the corporation passes earnings on to its shareholders in the form of dividends. President Bush’s tax cut plan proposes to address this issue of double taxation by eliminating income taxes that investors incur on corporate dividends.
Pass-through entities are required to file informational tax returns with the IRS even though no tax is assessed at the entity level. These businesses must also provide the owners with a Schedule K-1 statement. Schedule K-1 informs the owners of their proportional shares of business income, losses, credit and deductions to be reported on their individual income tax returns.
A sole proprietorship has no registration requirements for federal tax purposes and has no separate income tax return. The he owner reports all business income and expenses on Schedule C, which is attached to Form 1040, U.S. Individual Income Tax Return.
With the exception of the sole proprietorship, the IRS views each type of entity as being separate from its owner(s). As a result, these entities are required to file for federal employer identification numbers (EINs) to be included in any correspondence with the IRS, such as the businesses’ income tax returns. Even a sole proprietor will need to obtain an EIN if he or she has employees or establishes certain types of retirement plans.
The accompanying table lists the tax form that must be filed by each type of entity and identifies the level at which business income is taxed.
|Sole Proprietorship||Form 1040, Schedule C - Profit or Loss from Business||Owner level|
|Partnership||Form 1065 - U.S. Return of Partnership Income||Owner level|
|LLC||Form 1040, Schedule C (single-member LLC) Form 1065 (multi-member LLC)||Owner level|
|C Corporation||Form 1120 - U.S. Corporate Income Tax Return||Corporate and owner levels|
|S Corporation||Form 1120S - U.S. Income Tax Return for an S Corporation||Owner level|
Please keep in mind that the information provided in this article pertains to federal tax requirements. State requirements vary. You should do your own research, or consult an experienced tax professional, to determine the registration and tax filing requirements you must address before you hang your shingle.
Organizing a business requires a great deal of work before you even sell your first widget. The June 2003 issue of Sentinel will discuss what you need to do once your business is up and running.