Business Entities

One of the most important decision in starting a business is deciding what kind of entity you want to be. There are several choices. What kind of entity you set up can affect your tax liability and your personal liability. Here are your choices:

SOLE PROPRIETOR

A Sole proprietor is when you simply get a business license and start doing business. It is easy to set up, easy to run and easy to understand. It is a one owner business. It can be established anywhere, anytime and by anyone and it is easy to get out of. You just stop doing business. However, it is the highest taxed entity (15.3% self employment tax on all profits up to $80,400). It offers no protection from liability. Because it there is no entity separate form the individual that owns the company, when the owner dies, the business ceases to exist. The only real benefit is that it is easy.

PARTNERSHIP

A partnership is usually formed when two or more people want to go into business together. A partnership is a good way to define the rules and relationship of the partners. It is a good way for a group of individuals to participate in a venture without having to deal with payroll issues and partners can receive unequal distributions of income if all parties agree. Like a Sole Proprietor, a Partnership is easy to form and to run. There are no organizational documents that require state approval. But, it is wise to have a written document outlining the rights and responsibilities between the partners It helps avoid the problem up the road of a faulty memory or subsequent changes of heart. There are really no tax benefits to a partnership. The income comes to the partners and is taxed like a sole proprietor. There is no liability protection and all the partners are liable for the actions of the other partners.

LIMITED LIABILITY COMPANY

Limited liability Companies are a newer entity. The first LLC statute was formed in Wyoming in 1977. Since then the other states have passed statutes that allow LLC’s to be organized in each state. They were created because there was a gap between the simple Sole Proprietor and Partnership and the more complex Corporations. Limited Liability Companies require filing Articles of Organization with the state. They offer limited protection of personal assets. They are flexible and reasonably easy to operate. The problem with an LLC is that because they are so new, they haven’t established solid court cases to firmly establish the rules. So, the laws for LLC’s keep changing. For example, an LLC used to be taxed much like a S-Corporation. About 5 years ago, they changed the legislation which took away that tax benefit and made them taxed as an sole Proprietor. Then about the time of 9/11, the Congress started trying to change the way an LC was taxed back to the original law. But with the events of 9/11, the legislation was put on hold. It is still in limbo. You can file a form and request to be taxed as an S-Corp though. Also, some states only require one member of an LLC, but recently the IRS has decided that they require two members. It really is an unstable entity.

An LLC is good for two things. One, it is good for rental or investment Real Estate. Second, it is good for when people want to invest their money together for a one time project.

CORPORATIONS

When most people think of a corporation they think of a huge publicly traded company with thousands of employees. There are several millions of corporations in our country and only about 15,000 of them are big enough to publically trade. In reality most corporations are small closely held companies with only shareholders ( or owners). They usually know one another or are family members and work together. So what is a corporation? It is a legal entity made up of other entities. Those other entities can be human or artificial (such as another corporation or a trust). It is unique because the law recognizes it as a thing separate from the ones who own it and operate it. It is often treated like a human being. It can make contracts and do business. It is protected by the many of the same rights under the constitution that a human is. It can sue for defamation of character of it’s good name and it can be punished if it breaks a law. In a way, creating a corporation is like giving birth to a child.

There are two kinds of Corporations that we will discuss. One is a for profit Corporation and the other is a for profit S corporation

S CORPORATION

S Corporations are good entities for a small business. They offer lots of tax benefits such as saving on social Security and Medicare tax. The give you flexibility for running your business as well as for tax purposes. They offer liability protection. In most states you only need one person as the President and one as the director and they can both be the same person. So, if you want to be the only share holder, a S-Corp is a good choice. The profits from the S-Corp flow to the shareholder’s personal tax returns and are taxed at the individuals income tax rate. But on the flip side, if the company experiences losses, they can be reported on the shareholders tax returns and offer tax savings.

C CORPORATION

A C-Corporation is usually formed for two reasons. One is that the owners want to eventually go public and sell stock on the stock exchange. The other is when they want the business to be completely separate form them in every way. It offers good liability protection and good tax benefits although in some cases there can be some double taxation. Up to $50,00 annually are taxed at 15% if retained by the corporation rather than at the potentially higher shareholder’s rate. If the corporation losses money, you can’t deduct on your personal return.

One word about liability. Corporate structures including S Corps and LLC allow you as an owner to limit some of your personal liability. For example, creditors of these entities generally can go after only the assets of the corporation, not the owner’s, if debts are unpaid or a lawsuit is filed. Legal protection is not ironclad, but you definitely have a better chance with an legal entity. Owners need to be careful to keep their personal affairs separate form entity. Also, any illegal action on the part of an officer or shareholder is still subject to the punishment of the law.

If you are still unclear on the legalities of each entity, contact an attorney in your area. It is important enough to make sure you understand the rules before you decide.

Business Entity setup is just a part of running a successful business. Check out our Be the Boss: Start Your Own Business book.