Be sure to make the best entity choice for your business.
One of the first major decisions you will have to make as you start your new business is to decide what form of business entity to adopt. Depending on how you have organized your business and whether you intend to work on your own or in conjunction with others will play a large role in determining the type of entity you select. The issues here can be complicated which is why it is so important to do some research and seek out the advice of a professional. Choosing the wrong business entity or not properly understanding all the filing and compliance issues can prove costly in taxes, and it may be very difficult to undo or change the entity type later. So, before you do anything, save yourself headaches and costs down the road and ask what makes the most sense for you. As a CPA providing tax services in Allentown, I can certainly help clarify all of this for you.
The form of entity you choose will govern the liability protection of your company, as well as, have an impact on the way you are affected by income tax regulations and tax rates. The basic forms of business organizations can be broken down into five general types. Each type has both advantages and disadvantages with regard to both taxation and legal issues. The following is a brief overview of each.
A sole proprietorship is a business owned and operated by one individual where no seperate structure has been created. A sole proprietorship is not actually a separate legal entity under the law, but is merely an extension of the individual who owns it. As the owner has possession of the business assets, he/she is personally liable for the debts and obligations incurred by the business as well. The income or loss of a sole proprietorship is reported on Schedule C which then flows to page one of the tax return and gets combined with any other earnings of the individual or spouse. Unlike a corporation, the net income is not potentially subject to double-taxation.
Also be aware, however, that the net profit of the business will be subject to Self Employment Tax. This is analogous to the FICA tax you may be familiar with that gets deducted from your earnings if you are an employee. If you are an employee, what you must also be aware of is that the employer must "match" or pay an equivalent amount of Social Security and Medicare tax as gets withheld from your paycheck. Well, if you are self employed, you are in essence paying both sides of this tax for a combined rate of 15.2%
A distinct advantage of a sole proprietorship is that it is the easiest form of business to own and operate since it does not require any specific legal organization. Therefore, it tends to be quick, farily uncomplicated, and relatively inexpensive to create. Also, many states do not impose a fee for the mere privilege of existing. Of course, the normal registration requirements for licenses, permits and payroll must still be satisfied. A sole proprietorship typically does not have rules or operating regulations it must adhere to. The business decisions are solely the result of the owner's abilities.
Give some thought as well to whether you will operate the business under a "fictitious name" (which simply means any name other than your last name). If so, then you will need to file a "Fictitious Name Registration" wtih the state. Also be aware that you may need to obtain an Employer Identification Number (EIN) as well and you will definitely need to do so if you will be hiring employees.
The primary disadvantage of a sole proprietorship is that, unlike a corporation, there is no limited liability protection to the owner. Since the owner and the business are considered to be legally one in the same, the owner is personally responsible to creditors for debts of the business activities.
If you wish to setup a business with shared ownership between two or more owners then a partnerships must be considered. Partnerships can be of either two forms, general or limited. In a general partnership, two or more individuals join together to run the business enterprise which will operate under the partnership name. Each of the individual partners will have an ownership interest in the partnership assets and will also be personally responsible for partnership liabilities. The duties of the partners, as well as, the determination of how profits or losses are to be shared will typically be detailed in the partnership agreement. Generally, partnership creditors typically have recourse to the personal assets of each of the partners for settlement of partnership debts.
A limited partnership, on the other hand, is comprised of one or more general partners who are personally liable for partnership debts and one or more limited partners who contribute capital and share in the profits or losses of the business but do not play an active role in running the business and are not personally liable for the debts of the partnership. The rights, responsibilities and obligations of both the limited and general partners will typically be detailed in a partnership agreement.
Generally, like sole proprietorships, partnerships do not have to file formation documents with the state in order to begin operations, unlike corporations and LLC's. However, that is not to say that they may still need to file for state and/or local business licenses and permits to operate. In addition, partnerships will require a Fictitious Name Registration unless each partner's name is part of the company name. Also, you will need to apply for a Federal EIN.
A partnership is required to file a federal income tax return. In some states such a Pennsylvania, they must also file a state partnership return. However, a partnership typically does not pay income tax at the entity level. Rather, the profit or loss is passed through to the personal income tax returns of the partners to be combined with other components of income and deductions to determine the overall tax liability at the partner's personal tax level.
So, even though partnerships, like sole proprietorships require relatively little time and expense to create, the trade-off is that like sole proprietorships, they also have some disadvantages. Notably, the owners and the business are considered legally the same. Therefore, partners are personally liable for the debts taken on by the partnership. Also, partners are responsible for the business related actions of all other partners.
A corporation is actually a separate legal entity created under the authority granted by state law. It has its own legal rights as well as liabilities. To create a corporation, the proper formation documents, typically called the articles of incorporation or certificate of incorporation, must be filed with the appropriate Department of State along with a state filing fee. While you can certainly form a corporation by filing the paperwork yourself with the Department of State, we highly recommend instead that you work with an attorney to do this for you. The articles of incorporation and by-laws govern the rights and obligations of its shareholders, directors and officers.
One of the primary advantages of being a corporation is that its shareholders are protected from the liabilities of the business. However, in the case of a small corporation, creditors may still require the personal guarantees of the principal owners before extending credit. Depending on the type of business, the additional up front expense of incorporating and the ongoing cost to administer the corporation will usually pale in comparison to the benefit of the limited liability protection to the shareholders.
Another advantage of incorporating is that it can facilitate bringing in additional equity capital as well as allow efficient ownership transfer among shareholders of the business. This in turn allows for business continuity when shareholders retire or sell their ownership interest. C corporations can have an unlimited number of shareholders.
A corporation must file separate income tax returns with both IRS and the state and pay taxes on any income it derives through operations (unless an S-corporation election has been filed as discussed later). When setting up a corporation, this tax aspect is one of the primary matters that must be weighed. This is because C Corporations may experience double taxation. The profits of the business will be first reported and taxed at the entity level. If the corporation then distributes any portion of the profit to the shareholders in the form of dividends, the shareholders must then report the dividend income on their personal returns and pay taxes on it at the individual level. Thus, the concept of double taxation.
If there are additional perceived disadvantages of incorporating, they would be: corporations are more expensive to form than either sole proprietorships or partnerships, require ongoing filing requirements and possible state fees. Also, corporations have more ongoing formalities which must be followed such as holding and properly documenting annual meetings of directors and shareholders.
A variation to the above corporation is an S corporation. S status can be adopted by filing an election within the required time parameter. All shareholders must consent to the S election. As an S corporation, the entity is taxed similar to that of a partnership in that there is no tax assessed at the entity level. Instead, the net income or losses flow through to the shareholders to be included with other components of income and expense on their individual income tax return. S-corporations are more restrictive in terms of the maximum number and type of eligible shareholders (currently 100) and the fact that there can only be one class of stock.
Requirements for S-corporations vary from state to state. Therefore, you should contact your State Department of Revenue or your CPA to determine your state's specific requirements.
Limited Liability Company
A limited liability company (LLC) operates and is taxed as a partnership for federal tax purposes, but provides the liability protection of a corporation. An operating agreement determines how income or loss is allocated among owners as well as other operating matters.From this perspective, the ability to allocate components of income and expenses according to an agreement gives the LLC more flexibility than an S-corporation. Also, unlike the S-corporation, they can have an unlimited number of owners and any person, business or trust can own one. LLC's are often preferable over S-corporations when setting up highly leveraged ventures such as real estate since, unlike under an S-corporation, your share of the LLC debt owed to others counts as "basis" meaning you have a larger investment against which to deduct any LLC losses.
So, which entity should you choose?
Unfortunately, there is not one simple answer. It depends on the type of business you operate as well as other factors such as your aggregate tax situation. The place to start, however, is to discuss your objectives with your CPA and your attorney. You can save yourself a lot of grief and perhaps enough in tax savings alone to easily justify the cost of professional counsel at the very beginning. It's usually easier to set up your business correctly from the beginning rather than try to rectify the results of a poor decision later because there can be adverse tax affects when trying to do that.
If you decide to incorporate, what are the next steps you must take?
In terms of ongoing requirements imposed on corporations and LLC's after the formation is complete, corporations have more strict obligations to follow. After a corporation is formed, an organizational meeting of directors must be held. At this meeting, bylaws are adoped, stock is issued, and the incorporation process is completed. Minutes of the organizational meeting should be kept in a corporate record book. Corporations are also required to hold annual meeting of directors and annual meetings of shareholders. Not having these meetings and failure to keep proper records of them can have serious consequences for corporations.
For LLC's, although the requirements are not as strict, it is still advisable to hold an organizational meeting of the members after formation in order to adopt and operating agreement and issue membership units. It's also a good idea to hold regular meeting of the members to properly document major business decisions and to keep complete company records.
In addition to these formalities, keep in mind that the states impose annual requirements on all corporations and LLC's, such as filing an annual report. The report allows the state to keep updated information on corporations and LLC's formed or qualified to do business there. Each state's requirements for the report differ, as to the costs associated with them. Many states impose annual franchise taxes on corporations and LLC's. It is recommended to research the annual requirements of the state in which you are evaluating incorporating your business so that you know what to expect on an ongoing basis.
(The above discussion is intended to be only an overview of this topic. You should consult with legal counsel and an accountant before implementing any of the above concepts.)