Small-business startups are often in a hurry to get a product and service out to the paying public and gloss over the importance of choosing the right formation of the company for legal and tax purposes. Primary choices include sole proprietorship, general partnership, limited liability partnership, single-member limited liability company (LLC), multimember LLC, S corporation and C corporation, and choosing the right one depends on the type of business and the leadership and management structure. Each choice impacts the legal liability of both the owner and the business, and determines what and how much taxes are paid by an individual or company. For more on this continue reading the following article from The Street.
New business owners often pay lip service to mundane details such as entity formation — meaning how your business will be structured for legal and taxation purposes — but I urge all would-be business owners to work with legal and financial professionals well-versed in the choices.
A new business can be set up as a sole proprietorship, general partnership, limited liability partnership, single-member LLC, multimember LLC, S corporation or C corporation. Selecting the right legal entity really is unique to each business and depends on the circumstances.
A person who starts a business without even making a choice has actually chosen to be a sole proprietor. A sole proprietorship is simple from an administrative perspective and does not require the services of an attorney to form, but generally makes sense only in the simplest of circumstances. The downside is you have unlimited exposure to business problems on a personal level. For tax purposes, an owner reports the tax results on their personal income tax return on IRS Schedule C and typically needs to make quarterly estimated personal income tax payments. In addition, the sole proprietor pays self-employment taxes (FICA) calculated on his or her self-employment income when filing an annual tax return. If the sole proprietor has W-2 employees, payroll taxes and withholdings are handled like any other business entity.
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A general partnership is when two or more people start a business. Each partner has unlimited personal liability in a partnership, including on professional malpractice. Even though a partnership pays no taxes, an informational partnership tax return is filed with the IRS on Form 1065. Each partner gets a K-1 from the partnership picking up their share of the partnership’s results and will typically need to make quarterly estimated personal income tax payments. Partners also pay their self-employment taxes calculated on their partnership income when filing their personal return. If the partnership has W-2 employees they must handle payroll taxes and withholdings like any other business entity. To avoid the unlimited liability of general partnerships, many professionals such as doctors, lawyers and accountants form limited liability partnerships. A partner in an LLP is not liable for the malpractice of the other partners, but remains liable for their own acts.
A popular choice today is the limited liability company, which typically protect personal assets from business creditors. Forming an LLC does not provide protection from professional liability, though. So, for example, errors and omissions insurance would still be recommended to protect the business owner from professional liability. For tax purposes a single-member LLC works the same as a sole proprietorship and is reported on the individual’s Schedule C; for a multimember LLC, the taxation works just like a partnership. LLC owners technically known as members are not "employees" of the LLC. From a tactical perspective this means any cash they get regularly from the business is a "draw" and not W-2 wage income. An LLC can also have non-owner employees, for which it must withhold and remit payroll taxes. Owners will also typically need to make quarterly estimated personal income tax payments.
Another entity choice is an S corporation, which limits restrictions on the type and number of owners it can have. For example, all owners must be U.S. citizens, and there can be only 100 or fewer shareholders — and all are in a single share class. The structure provides protection for personal assets, and an owner can be an employee and get a W-2 for tax purposes. Just like a partnership, an S corporation files an informational tax return with the IRS (Form 1120S). The S Corporation itself pays no income taxes, but each owner reports income on personal returns. With an S corporation only the owner’s W-2 wages are subject to FICA taxes, but the owner’s share of distributive income is not subject to self-employment taxes. The key here is to determine a reasonable level of compensation for the owner. The IRS wants to see you are not paying an unreasonably low level of compensation to avoid FICA taxes. Finally, remember that the Medicare component of FICA (1.45%) is unlimited.
The last entity type is the C corporation. This structure typically requires the most administrative upkeep but provides excellent liability protection. It also provides the biggest opportunity for deductibility of fringe benefits for the owners at the entity level. The corporation files and pays corporate taxes on its earnings. The biggest drawback is the double taxation; the entity pays a corporate income tax, and distributions are taxed to the shareholders when received. In the other entities there is only one level of taxation.
Before selecting an entity structure for your business, consult with your accountant and legal counsel. Appropriate counsel and advice can give you the specific rules for the state in which you seek to do business.
This article was republished with permission from The Street.