You have an innovative idea, a catchy name, a fool-proof business plan, and you feel ready to get your small business off the ground and running. Stop! Have you considered the long-term implications and tax consequences associated with setting up your business? Entity choice can have a widespread effect on your business. Internal structure, taxation of profits and how much cash you can take home will all be affected by how you structure your business. Even more, states will have their own sets of rules affecting these outcomes.
Although it is possible to switch entity types after initial start-up, the consequences of doing so may not be favorable. This is why getting it right from the beginning is important. A tax professional can help you answer the right questions and create the right entity to get your business moving in a positive direction.
The most important features of entity selection come down to the type of income you are trying to generate and how you would like it taxed as well as your exit strategy for the business. Each entity type has pros and cons depending on what you are trying to accomplish so choosing the right entity is paramount to your businesses success.
There are no formal procedures to form a sole proprietorship and it is considered the simplest form of business entity. Sole proprietorships do not pay taxes at the entity level, but rather the income and expenses flow through to the individual’s tax return on their schedule C and are taxed at the individual’s applicable tax rate. The downside is that the owner is personally liable for any debts and obligations of the business and pays self-employment tax on all earnings.
General and Limited Partnerships
In order to form a partnership there must be at least 2 owners, and like sole proprietorships, there are no formal procedures required to form a partnership. In a general partnership, partners share the full liability of any obligations of the business. In a limited partnership there must be at least one general partner and at least one more limited partner. The general partners retain unlimited liability, and the limited partners may have limited liability. Partnerships have a separate tax filing, but the income and losses pass through to the partner’s individual tax return and retain the original character.
Limited Liability Partnership (LLP)
A Limited Liability Partnership is similar to a general partnership, but it must formally register with the state. The state provides the partners the protection of limited liability for the malpractice or negligence of other partners, but they still retain unlimited liability for contractual obligations depending on the state. This entity is available to professional service groups including lawyers, architects and accountants.
Limited Liability Company (LLC)
This is the most common business entity formed today. Owners of an LLC are considered “members” and these members have liability protection similar to that of a corporation with the ability to be taxed as a partnership. Although you do need to formally register with your state, there are fewer formalities for an LLC than a corporation.
A C corporation is owned by individual shareholders who elect a Board of Directors which is responsible for company policy and hiring corporate officers. The day to day operations are performed by these officers who oversee the staff and carryout the corporate plan. The most apparent benefits of choosing a C Corporation is the ability to issue stock in order to raise capital and the individual shareholders have limited liability over contracts, debts, and actions of the company. C Corporations are taxed as a separate entity at graduated rates similar to an individual. The main problem with C Corporations is that any distributions to the shareholders are considered dividends and will be taxed at the individual level thus creating two layers of tax.
Once a C Corporation has been established it has the ability to make an election to be taxed as an S corporation. S Corporations must file a separate tax return with the IRS and the income is passed through to the individual and taxed and their applicable tax rate. In order for the election to be approved, the corporation must have only one class of stock, have a limited number of domestic shareholders, and must have no foreign shareholders. The main advantages of an S Corporation are that all income is passed down to the shareholders creating a single layer of tax and at the entities conclusion the shareholders have multiple exit options.
The choice of entity is an important decision that will affect the lifecycle of your business, be sure to evaluate your options carefully. Contact your L&B professional for more information.