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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 Corporation. Here are the
basics.
HOW SHOULD YOU SET UP YOUR NEW BUSINESS?
When you start a business, you have many choices to make. 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,
C-Corporation, S-Corporation, LLP (Limited Liability Partnership) or an
LLC (Limited Liability Company).
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 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. Overall, the tax picture for C-Corps is far from ideal for
small businesses. Even the current 15% tax rate on dividends does not
completely do away with the disadvantages of double taxation.
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!
That leaves LLCs, LLPs, and S-Corporations. LLPs and LLCs are similar in
many ways. One key difference is that LLPs must be owned by more than
one individual. 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,
and 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, 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.
DISTINGUISHING CHARACTERISTICS
An S Corporation might be more restrictive than an LLC. There can't be
more than 100 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 from
an S Corporation are allocated on a per-share/per-day basis. 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. The
more you have invested, the more “write-offs you can claim when there
are losses.
LLCs offer more flexibility than S Corporations. They 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." In addition, the status of the business's net income as
subject to Self-Employment taxes is unclear.
The amount of 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. (In an LLC, loans to the
company can increase your tax basis if they are guaranteed by you. In an
S corporation, only direct loans to the company by you can increase your
tax basis.)
LLCs provide more ways to increase your tax cost basis. This illustrates
a significant advantage of LLCs over S Corporations. Because of the way
these calculations are done, your cost basis may be higher for an
investment in an LLC than if you set up shop as an S Corporation.
CONCLUSION
Many businesses should probably start as an LLC. Advantages include
flexibility of ownership, ability to gain tax basis through liabilities,
and pass-through of profits and losses. If a corporate entity is
determined to be required later, the change from LLC to corporation is
quick and tax-free.
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