There are many challenges a new business faces upon start up, and tax issues are one of the most frustrating and common stumbling blocks upon inception. Throughout the year we will be featuring tax articles that will allow you to make informed decisions related to your business and also personal tax situation.
Though the primary audience of this article will be those starting a new business, many of the issues discussed will also be of interest to established businesses, since fundamental considerations are often overlooked in the initial stages of business formation. We strongly encourage you to discuss these issues with your current CPA, as well as your attorney, to ensure that prudent and well informed decisions are made, with the knowledge that decisions made upon formation will have long lasting effects well into the future of the business.
This article will focus on the answer to the first question that should be addressed when starting a business, “What types of business entities are available to me and which is the best choice?”
In general, there are 5 choices that most business owners consider:
• Sole Proprietorship
• Limited Liability Company (LLC)
• Corporation (C-Corp)
• S-Corporation (S-Corp)
The factors that a new business owner should consider when selecting an entity type include, but are not limited to; ease of formation, liability protection, ability to raise capital, continuity (going concern), and control and last but not least, taxes.
From a purely tax perspective, one of the most important considerations to keep in mind is that other than a C-Corp, all of the business entities discussed in this article provide for only one level of taxation. That is, the profits are taxed only once at the individual level. Once the profits are taxed, the owner can distribute the profits to themselves without incurring a second level of tax.
The profits of a C-Corporation are generally taxed twice. The first layer of tax occurs at the corporate level, where corporations are required to pay tax on their earnings. The second layer of tax occurs when those same profits are distributed to the owners of the corporation, where they will be taxed again as a dividend. Therefore, small businesses generally avoid forming as a C-Corp, due to its onerous tax aspects, and will instead elect to form the business as a flow-through entity. The profits of flow-through entities are only subjected to only one level of tax.
What are some of the key aspects to consider in each type of entity? Below we provide a brief summary of each.
In general, other than local and city permits, there are no filing requirements to begin your business. As far as liability protection, a sole proprietorship offers little protection. The owner is generally personally liable for all company actions, including any debts incurred. Using a sole proprietorship will make obtaining long term financing difficult, and the life of the business is tied to how long the owner desires to keep the business going. Your business activity will be reported on a Schedule C, which is part of an individual’s tax return, Form 1040.
With the tax structure and tax law of partnerships now applicable to LLCs, general and limited partnerships are not as common as they used to be. However, a brief discussion of them is still important. Partnerships occur when there are two or more owners who share in the profits and losses of the business. Similar to sole proprietorships, general partnerships provide little liability protection to the owners, since creditors can attach to the personal assets of a general partner. In addition, general partners are personally liable for all financial and non-financial liabilities associated with a business. A general partnership is required to register with the state upon formation.
A limited partnership (LP) provides greater liability protection than a sole proprietorship or general partnership. Though a limited partnership offers limited liability to some of the owners, at least one of the owners is required to be a general partner who retains general liability. However, changes in state laws now allow for partnerships where all owners benefit from limited liability. Limited Liability Partnerships (LLPs) and Limited Liability Limited Partnerships (LLLP) offer this type of protection to all owners. From a tax perspective LPs, LLPs and LLLPs function similarly to a General Partnership. Again, we encourage you to contact an attorney to obtain legal advice, along with your CPA for tax advice, to determine which form of partnership will be most beneficial to you. Under all types of partnerships, the income will be reported via Form K-1 that is used by the owner to report the income and loss items on Schedule E of their individual tax return.
Limited Liability Company (LLC)
An LLC can have one member (owner) or multiple members. If it is owned by a single member, it is referred to as a single member LLC (SMLLC). A SMLLC reports its income and losses on Schedule C that is included on an individual’s Form 1040. An LLC that has multiple owners can also file as a partnership that offers limited liability to all members/owners. The key here is that similar to a partnership, it will offer flow-through taxation to its owners and only subject the earnings of the business to one level of tax. If an LLC has multiple owners and files as a partnership, the income will be reported via Form K-1 that is used by the owner to report the income and loss items on Schedule E of their individual tax return.
Similar to LLCs and partnerships, S-Corps also act as a flow-through entity, where the profits and losses are taxed only once and are reported on the individual tax returns of the owners. An S-Corp will need to file with the state and record its articles of incorporation pursuant to state law. Limited liability is offered to the owners of an S-Corporation, though there are certain unique limitations imposed on S-Corporations by tax law that must be considered, such as limiting the amount of S-Corp owners to 100 and only allowing the issuance of once class of stock. S-Corp owners are also generally limited to individual taxpayers subject to U.S. tax, and certain types of trusts. Profits from an S- Corp are not subject to self-employment taxes (as is the case for sole proprietorships, general partnerships and in certain circumstances LLCs), but the owners are required to pay themselves a fair wage based on the services they provide to the corporation.
Similar to LLCs, LLPs, LLPs, LLLPs and S-Corps, this entity type offers liability protection to the owners. Upon formation, it will need to file articles of incorporation with the state. Unlike the limitations imposed on S-Corps’s, C-Corps’s can have an unlimited number of shareholders, different classes of stock, and in general, offer great flexibility when raising capital. However, given the fact that this type of entity leads to double taxation, it is not commonly used by small business unless there are very specific situations that warrant its use, and the benefits override the potential tax considerations.
As you form and grow your business, the type of entity you choose upon inception will have long lasting effects; including your ability obtain liability protection, the flexibility to have additional owners and/or investors, and opportunities for tax savings in the long run. We have only scratched the surface of the issues you need to consider, though we hope that this article will allow you to ask the right questions as you begin your new business venture. Consult with your tax advisor or attorney and make sure that you investigate all of the options available to you so, you gain full understanding that the potential for business and tax implications exist in both the short, as well as long-term.