Lester Bahr CPA, LLC
Allentown, Pennsylvania
Enlightened solutions within your grasp
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 your research and seek out the advice of your attorney and CPA. 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, this is definitely not something you should do on your own without the guidance of an attorney and CPA.
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 general types, each with certain characteristics, advantages and disadvantages.
Sole Proprietorship
A sole proprietorship is a business owned and operated by one individual where no separate business entity has been created. It 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 as part of the taxpayer's individual tax returns and the net profit will be subject to federal, self-employment, state and local taxes.
Partnership
If you wish to setup a business with shared ownership between two or more owners, then a partnership 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.
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.
A partnership is required to file a federal partnership income tax return. In 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.
C Corporation
A corporation is a separate legal entity created under the authority granted by state law. 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. It is recommended that you should always engage the services of an attorney to do this.
From a taxation standpoint, a corporation must file separate income tax returns for both federal and the state(s) purposes and pay taxes on any income it derives through operations at the corporate entity level. (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 considered. This is because C Corporations experience double taxation which simply means that profits of the business will be first reported and taxed at the corporation entity level. When 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.
S Corporation
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 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 (unless a timely election is filed with IRS to be taxed as an alternative entity type), 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?
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.
