CHOOSING AN ENTITY………
How should you set up your new business?
If you're forming a small business, you face several choices: One key
decision is choosing the form of business entity you will operate under.
For starters, you can set up your business as a Sole Proprietorship,
Partnership, C-corporation, S-corporation, Limited Liability Partnership
(LLC) or a Limited Liability Company (LLP). Lets explore the basic pros
and cons you need to know.
How can you narrow that list down? Small businesses typically decide
against a C-Corporation, because C-Corps generate two levels of federal
income tax. The C-Corporation pays one level of tax when it files its
federal corporate tax return, Form 1120. A second layer of tax is imposed
when the C-Corporation's profits are distributed to the shareholders
as dividends. Those dividends (when and if paid out) are reported and
taxed on the individual's federal tax return, Form 1040. Together, these
two levels of taxes are referred to as “double taxation.”
In addition, state taxes also typically apply to both C-Corporation
profits and distributed dividends. Pros do include, most importantly,
the protection of personal assets as the Corporation is considered a
“separate individual” capable of contracting it’s
own debts, owning property, etc.. A corporation has flexibility in choosing
a “fiscal” year vs. calendar year – this election
is generally made the first year of operation. Other entities generally
are required to have the same tax year as the owner(s), i.e. a calendar
year – a “fiscal” year for non-corporates generally
requires an explanation and approval by IRS. There are many types of
“businesses” that should seriously consider incorporation
for these and other reasons.
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
That leaves LLCs, LLPs, and S-Corporations. LLPs and LLCs are similar
in many ways. One key difference is that more than one individual must
own LLPs. Remember, the “P” in LLP stands for partnership---by
definition a single individual can't own a partnership. So if you had
an LLP with two owners and one died, serious problems that might even
cause the business to close could result.
The choice quickly narrows to an LLC or an S-Corporation. Which is more
appropriate for your business?
Well, they 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 in their individual tax
returns. However, both also offer protection from unlimited liability.
Your liability will be limited to your investment in either entity.
When choosing between an S-Corporation and an LLC you need to consider
many things. 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. Let’s review the attributes
of each type of entity to help you decide.
The S Corporation
Created in 1958, the S Corporation was, for many years, the standard
form of organization for conducting a small business. S Corporation
status provides a way for you to avoid the double taxation imposed upon
C Corporations and their shareholders. One advantage of the S Corporation
is that income is taxed personally to the shareholders. However, your
personal risk remains limited to your investment. In other words, double
taxation is avoided and you get the protection of limited liability.
Your corporation chooses “S-Status” by filing a special
election, Form 2553. Bear in mind that the “S” status of
the Corporation only impacts taxes. 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.
The Limited Liability Company (LLC)
LLCs started in 1977 in Wyoming and have quickly become a popular form
of business entity across the country. By default, LLCs with more than
one owner (member) are taxed as Partnerships, while single-member LLCs
are taxed as sole proprietorships. As with S corporations, with an LLC
you only pay taxes with your personal return. However, if you decide
to do business as an LLC, you are not stuck with it. Through special
arrangements, an LLC can be set up to become an S Corporation without
having to liquidate. 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.
An attorney, your tax practitioner or even you, can form a corporation
by completing a series of “boilerplate” documents. These
forms require you to complete the following information: who will own
the business, the business's activity, address, and other miscellaneous
details. Aside from being registered as an “Inc., Co. or Corp.”,
a corporation can also be registered as P.C. (Professional Corporation).
This designation is for professionals who choose to operate in corporate
form and is popular with 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. 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, and so forth.
An S Corporation might be more restrictive than an LLC. There can't
be more than 75 shareholders in an S Corporation. In addition, only
individuals, estates & qualifying trusts can qualify 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. The income and expenses