How Should You Set Up Your New Business?

If you are forming a small business, you face several choices: Sole Proprietorship, Partnership, C-corporation, S-corporation, Limited Liability Partnership and Limited Liability Company.

When you start a business, you have many choices to make. One key decision is choosing which form of business entity you will operate under. When choosing between the options, you need to take many factors into consideration. What may be appropriate under one set of circumstances may not be in another. Every business is different, and every owner has different needs and expectations. We'd be glad to help you narrow that list down.

Here are the basics:

C-Corporations

Small business owners typically decide against a C-Corporation, because C-Corps generate two levels of federal and state income tax. The C-Corporation pays one level of tax when it files its federal and state corporate tax returns. A second layer of tax is imposed when the C-Corporation's profits are distributed to the shareholders as dividends. Those dividends are reported and taxed on the individual's federal and state income tax returns. Together, these two levels of taxes are referred to as "double taxation." Even the current 15% tax rate on dividends does not completely do away with the disadvantages of double taxation.

Sole-proprietorship

Doing business as a sole proprietor eliminates the double taxation curse. There are no corporate taxes to pay, and you only pay individual taxes on your net profits, typically reported on Form 1040, Schedule C. However, as a sole proprietor, you lack the legal protection that corporate status gives you. Owners of corporations enjoy limited liability, but sole proprietors do not. Simply stated, if you're a sole proprietor, your personal assets are at risk if the business is sued--very risky indeed!

LLP

LLP's must be owned by more than one individual. The "P" in LLP stands for partnership---so by definition, a single individual can't own a partnership. If you have an LLP with two owners and one dies, serious problems that might even cause the business to close could result.

LLC and S-Corporation

LLC's and S-Corporations are both "pass-through" entities that allow you to avoid double taxation, operating a business without paying corporate taxes. Net profits are reported by the owners on their individual tax returns, and both also offer protection of limited liability. Your liability will be limited to your investment in either entity.

S-Corporations
Another advantage of the S-Corporation is that while income is taxed personally to the shareholders, and your personal risk remains limited to your investment, shareholders of S-Corporations have all of the same legal protections as those in C-Corporations. But as once said by a famous Tax Court judge, "A corporation is like a lobster pot. It's easy to get into...difficult to get out of." In other words, once you have established an S-Corporation, it would first have to be liquidated if you wanted to change to an LLC, and liquidation of a corporation can result in taxable gains to the shareholders.

LLC
By default, LLCs with more than one owner (member) are taxed as Partnerships, while single-member LLCs are taxed as sole proprietorships. An LLC can become an S-Corporation without having to liquidate, and there is little risk of triggering a tax by changing from this form of doing business.

SETTING UP SHOP
Establishing an S-Corporation is relatively simple and inexpensive. All that is required is the following information: who will own the business, as well as the business' activity, address, and other miscellaneous details (for example, the choice between being registered as an "Inc., Co., Corp.", or as a P.C. (Professional Corporation)). This designation is for professionals who choose to operate in corporate form, such as doctors, lawyers, and accountants.

An LLC requires a bit more work to get started. Articles of Organization, to be filed with the state, and an Operating Agreement (like a Partnership Agreement), should be drafted by a lawyer. In addition, business information about the LLC must be placed in a published ad to give notice to the public that the company is being started. Also, an LLC can choose to be registered as a P.L.L.C. (Professional Limited Liability Company) when its owners are licensed by the state to engage in a professional practice -- doctors, lawyers, accountants, etc.

DISTINGUISHING CHARACTERISTICS
There can't be more than 100 shareholders in an S-Corporation. In addition, only individuals, estates, and qualifying trusts are permitted as shareholders. An S-Corporation may not have any non-resident alien shareholders. There can only be one class of stock ownership. Adding a second category or class of ownership terminates the "S" Election, which could lead to unintended and unexpected tax consequences. Your businesses' net income, after paying you a reasonable salary, would not be subject to self-employment taxes on your individual return.

The amount of your investment in the S-Corporation--your cost basis--includes:

1) Your contributions of cash & property.
2) Your share of S-Corporation profits not distributed to you.
3) Loans made directly to the Corporation by you.

This "Basis" calculation is important because it is your tax cost, as well as the limit of your legal liability. Also, the more you have invested, the more "write-offs" you can claim when there are losses.

LLC's can have an unlimited number of owners, and any person, business, or trust can be a member or owner. With an LLC, you can choose to allocate particular types of income and expenses between the owners. Doing this can get pretty complicated, so be sure to speak with us about "special allocations." On the negative side, the status of the business' net income as subject to Self-Employment taxes is unclear. Current thinking is that reasonable compensation should be paid in the form of guaranteed payments, subject to SE tax, with the balance of income - - attributable to capital or the work of employees - - not subject to SE tax.

Your basis in an LLC (your tax cost) includes:

1) Your contributions of cash & property.
2) Your share of LLC profits not distributed to you.
3) Your share of the LLCs debts to others, for which you are personally liable.

This "Basis" calculation is important because it is your tax cost, as well as the limit of your legal liability. Also, the more you have invested, the more "write-offs" you can claim when there are losses.

CONCLUSION
There are many choices to make, and many things to consider. Let us help you make the right decision for you both now and for the future. This is our expertise. Let us work for you.