How Should You Set Up Your New Business?
If you have questions about this, please contact us.
When
you start a business, you have many choices to make. One key decision
is choosing the form of business entity in which you will operate. 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.” State income taxes may also 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 for small startups this may not provide much benefit.
Do not pay too much attention the all the radio ads for incorporating. Often they will say incorporate in Nevada. The people who hear this think, good not income tax in Nevade, but if you are doing business in California, you will pay California taxe anyway. The limited liability factor is also
If in California, then you face an minimum tax of $800 per year if you have a corporation, even if you lose money. I usually suggest that you start out as a sole proprietor and once the business is making money and you are sure that you will continue for some time, then incorporate.
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, and so
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, and liquidation of a
corporation can result in taxable gains to the shareholders.
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. Simply by filing a Form
2553 at the appropriate time, an LLC can 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 yourself 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 and 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, etc.
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, and qualifying trusts are permitted 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 business’s 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 and 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 among owners. Doing this can
get pretty complicated, so be sure to speak with us about "special
allocations." On the negative side, the status of the business's net
income as subject to self-employment taxes is unclear. Current thinking
is that reasonable compensation should be paid in the form of
guaranteed payments, subject to SE tax, with the balance of income --
attributable to capital or the work of employees -- not subject to SE
tax.
Your basis (tax cost) in an LLC includes:
1) Your contributions of cash and 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 you are personally liable for
them. In an S corporation, only your direct loans to the company can
increase your tax basis.)
LLCs provide more ways to increase
your tax 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
This is something that you should discuss with your tax advisor. Often we see situations that are not beneficial and usually the reason is that the entrepreneur goes out and does this without any professional guidance, often due to hearing a commercial about the benefits of incorporating.
