When I talk to my clients that are new business owners or clients who are considering starting a business, a major question I get is: How should I operate and structure my business?
Well, simply put, how you set up your business and whether you plan on going it alone or operating it with others will determine the type of entity you should select.
Navigating through these decisions is not so simple. In fact, some of the issues can become quite daunting. That is why you need the services of a CPA. CPAs have worked with all types of entities and can walk you through all the filing and compliance issues as well as the tax benefits or detriments of the choices that you make.
You should consider both tax and non-tax issues when deciding on the best structure for your business. These include ownership changes and continuity; protection from legal liability; federal and state income taxes; and Social Security taxes. Other factors to consider include (1) whether you have or plan to have family members involved in the business; and (2) the ability to attract and manage capital.
This article will discuss the four choices that you have for forming the business:
1) Sole Proprietorship;
2) Partnership – either General or Limited;
3) Corporation – either a S or a C Corporation; and Limited Liability Company.
I will briefly discuss the structure and tax characteristics of each entity and then go into greater details on the reporting and general tax rules associated with each type.
Let’s start with a sole proprietorship. A sole proprietorship is a business owned and operated by one individual and is not a separate legal entity under the law. The business is just an extension of its owner. A sole proprietorship is simply a one-person business that is not registered with the state as a limited liability company or a corporation. Generally, you don’t have to do anything special to set up a sole proprietorship. However, some states do require registering a sole proprietorship and obtaining a license or permit. With this type of structure, all business receipts and expenses are reported on your personal income tax return.
A sole proprietorship can be advantageous to operate since it generally does not require legal filing or organizational structure. Further, a sole proprietorship typically does not have to comply with rules or operating regulations that a corporate form would require. However, there is no limited liability protection to the owner of a sole proprietorship. A corporate form provides this protection. What this means is that, in a sole proprietorship, you would be personally liable for any business debts or court judgments not covered by insurance. All the business decisions and results are based on the actions and abilities of the owner. And the owner is liable.
Of all the entity structures, a sole proprietorship is the simplest for tax purposes. There is no need for a separate return since sole proprietors report their business income on Schedule C of Federal Form 1040. This means that the business’s income is not subject to tax at a separate entity level. Instead, you as the owner will report items of income or loss on your individual income tax return, possibly resulting in a single level of taxation.
In terms of continuity and liability, the business ceases to exist upon the death of it owner or its sale.
Another form of ownership you may consider is a partnership. A partnership is a relationship between two or more persons to conduct a trade or business. It includes a syndicate, group, pool or joint venture and is not classified as a corporation. The partnership operates with the rights and responsibilities of a separate entity.
Even though it is not always required by law, if you form a partnership you should consider drafting a partnership agreement. If you don’t have such an agreement and later on you experience a problem, the partnership laws in your state will govern your partnership. A written agreement will enable you and your partners to discuss the roles of each party and the level of participation. Most important, it can uncover any issues before they become major problems. It’s easy enough to create a valid agreement that clearly addresses issues of potential concern.
Speaking of the agreement, when forming a partnership, be sure an attorney sets up a partnership agreement describing the role of each partner, the money that is involved, the property and skills to be contributed by each partner, profit and loss allocations, and the terms under which the partnership can be dissolved.
Usually when you hear the term partnership, most people think that it involves all the partners sharing equally in the day-to-day operations of the business. However, there are really two types of partnerships: general and limited.
The general partnership is the type as I just described; two or more partners are involved in running the business enterprise together. The business operates under the partnership name. The individual partners will have an ownership interest in the partnership assets and also will be personally responsible for partnership liabilities. The partnership’s creditors have recourse to the personal assets of each partner for any debts or legal claims. If the partnership is small, many creditors first obtain personal guarantee from all the general partners before extending any credit.
In contrast, a limited partnership consists of one or more general partners who are personally liable for partnership debts or legal claims as I just described, AND one or more limited partners. These limited partners contribute capital and share in the profits or losses of the business but they do not have an active role in running the business. Unlike the general partners, who are responsible for partnership liabilities, the limited partners are not responsible for the partnership liabilities above the amount of their investments. The limited partners contribute capital to the business but have minimal control over the daily business decisions. The rights, responsibilities and obligations of both the limited and general partners must be explained in the partnership agreement.
As for continuity, if one partner dies, retires, or wants to leave the partnership, you and your partners should decide what steps will be taken. An ounce of prevention, such as a “buy-sell” agreement, makes a lot of sense and will help avoid serious problems of resentment or lawsuits later on. The buy-sell agreement can either be part of an overall partnership agreement or a separate agreement. It typically covers decisions about the future ownership of the partnership such as:
Stay tuned for more discussion on this topic.