Written by: Steven J. Fromm, J.D., LL.M. (Taxation)
The decision to start your own business comes with many other important considerations. One of the first tasks you will encounter is choosing the legal form of your new business. There are quite a few choices of legal entities, each with their own advantages and disadvantages that must be taken into consideration along with your own personal tax situation.
The following offers a very general overview of some of the legal forms of operation available. However, the practical, legal and tax considerations need to be explored before choosing any of these vehicles for the opeartion of your business.
For more on the legal, financial and non-tax considerations review Choice of Business Entity: Legal, Financial and Other Non-Tax Concerns.
By far the simplest and least expensive business form to set up, a sole proprietorship can be maintained with few formalities. However, this type of entity offers no personal liability protection and doesn't allow you to take advantage of many of the tax benefits that are available to corporate employees.
Income and expenses from the business are reported on Schedule C of the owner's individual income tax return.
Net income is subject to both social security and income taxes.
Similar to a sole proprietorship, a partnership is owned and operated by more than one person. A partnership can resolve the personal liability issue to a certain extent by operating as a limited partnership, but partners whose liability is limited cannot be involved in actively managing the business.
In addition, the passive activity loss rules may apply and can reduce the amount of loss deductible from these partnerships.
Partners receive a Schedule K-1 with their share of the partnership's income or loss, which is then reported on the partner's individual income tax return.
This type of legal entity is somewhat of a hybrid between a partnership and a C corporation. Owners of an S corporation have the same liability protection that is available from a C corporation but business income and expenses are passed through to the owner's (as with a partnership).
Like partners and sole proprietors, however, more-than 2% S corporation shareholders are ineligible for tax-favored fringe benefits.
Another disadvantage of S corporations is the limitations on the number and kind of permissible shareholders, which can limit an S corporation's growth potential and access to capital.
As with a partnership, shareholders receive a Schedule K-1 with their share of the S corporation's income or loss, which is then reported on the shareholder's individual income tax return.
For more on S corporations please explore S Corporations: The Basics and for electing S status read S Corporation Election.
Although they do not have the shareholder restrictions that apply to S corporations, the biggest disadvantage of a C corporation is double taxation. Double taxation means that the profits are subject to income tax at the corporate level, and are also taxed to the shareholders when distributed as dividends. This negative tax effect can be minimized, however, by investing the profits back into the business to support the company's growth.
An advantage to this form of operation is that shareholder-employees are entitled to tax-advantaged corporate-type fringe benefits, such as medical coverage, disability insurance, and group-term life.
Limited Liability Company (LLC)
A relatively new form of legal entity, a limited liability company can be set up to be taxed as a partnership, avoiding the corporate income tax, while limiting the personal liability of the managing members to their investment in the company.
A LLC is not subject to tax at the corporate level. However, some states may impose a fee.
Like a partnership, the business income and expenses flow through to the owners for inclusion on their individual returns.
For more on LLCs please review LLCs: The Basics.
Limited Liability Partnership
An LLP is similar to an LLC, except that an LLP does not offer all of the liability limitations that are available in an LLC structure. Generally, partners are liable for their own actions; however, individual partners are not completely liable for the actions of other partners.
Remember one size does not fit all. The choice of entity depends on the particular business venture and its long and short term goals. Equally important is the particular tax posture of each of the parties involved.
The above is an extremely basic overview. In matters of taxation and corporate law the "devil is in the details" when determining the proper legal entity to choose to operate a business or venture. To determine the most advantageous entity to use requires discussion and analysis with tax and business counsel. To avoid costly misteps, such meeting and discussions should occur BEFORE a choice is made and money is expended in forming the organization.
Please do not hesitate to contact me if you would like to explore your specific tax or financial situation to determine the appropriate entity and to have it properly formed in compliance with the law.
“Steve is an excellent corporate attorney who has a deep understanding of corporate law, taxes and estate planning. He’s been extremely helpful to me in keeping my many companies and business ventures organized, focused and squeaky clean. He’s very strong in estate planning and wealth preservation as well. Finally, his follow through is air tight and utterly dependable.” Fred Marshall, February 27, 2009
As required by United States Treasury Regulations, you should be aware that this communication is not intended by the sender to be used, and it cannot be used, for the purpose of avoiding penalties under United States federal tax laws.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm’s full disclaimer.