One of the first decisions that you will have to make as a business owner is how the company should be structured. This decision will have long-term implications, so consult with knowledgeable accountants and business attorneys to help you form a business structure that is both tax-efficient and meets your business objectives.
This blog is not meant to be fully exhaustive but seeks to highlight many of the choices you will face in the decision process. In making a choice, you will want to consider the following:
- Your vision regarding the size and nature of your business.
- The level of control you wish to have.
- The level of “structure” you are willing to deal with.
- The level of investment you will place in the business.
- Whether or not outside investors will be involved.
- The business’ vulnerability to lawsuits.
- Tax implications of the different ownership structures.
- Expected profit (or loss) of the business.
- Whether or not you need to reinvest earnings into the business.
- Your need for access to the business income for yourself versus reinvesting.
- Whether your goals include expanding your business globally and will require setting up foreign subsidiaries.
- Whether you have non-U.S. owners or shareholders.
- Whether the business will operate in multiple states via e-commerce or with a physical presence, such as offices and warehouse facilities.
The vast majority of small businesses start out as sole proprietorships. These firms are owned by one person – usually, the individual who has day-to-day responsibility for running the business. Sole proprietors own all the assets of the business and the profits it generates. They also assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the public, you are one and the same with the business.
Advantages of a Sole Proprietorship
- Easiest and least expensive form of ownership to organize.
- Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.
- Sole proprietors receive all income generated by the business to keep or reinvest.
- Profits from the business flow-through directly to the owner’s personal tax return at the federal and state levels.
- The business is easy to dissolve if desired.
Disadvantages of a Sole Proprietorship
- Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
- May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.
- May have a hard time attracting high-caliber employees, or those that are motivated by the opportunity to own a part of the business.
- You will pay FICA & Medicare self-employed taxes on all of the net income with no limits.
In a partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, or what steps will be taken to dissolve the partnership when needed; Yes, it’s hard to think about a “break-up” when the business is just getting started, but many partnerships split up at crisis times, and unless there is a defined process, there will be even greater problems. Partners also must decide up front how much time and capital each will contribute, etc.
Advantages of a Partnership
- Partnerships are relatively easy to establish; However, time should be invested in developing the partnership agreement.
- With more than one owner, the ability to raise funds may be increased.
- The profits from the business flow directly through to the partners’ personal tax returns.
- Prospective employees may be attracted to the business if given the incentive to become a partner.
- The business usually will benefit from partners who have complementary skills.
Disadvantages of a Partnership
- Partners are jointly and individually liable for the actions of the other partners.
- Profits must be shared with others.
- Since decisions are shared, disagreements can occur.
- Some employee benefits are not deductible from business income on tax returns.
- You will pay FICA & Medicare on 100% of the net income with no limits.
- The partnership may have a limited life; it may end upon the withdrawal or death of a partner.
- Non-U.S. partners will also likely be subject to U.S. income tax filing requirements.
- All partnerships and partners will have state tax filings and registration requirements in the states that they do business.
Types of Partnerships that should be considered:
Partners divide responsibility for management and liability, as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
Limited Partnership and Partnership with Limited Liability
“Limited” means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short term projects, or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.
A joint venture acts as a a general partnership but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such and distribute accumulated partnership assets upon dissolution of the entity.
A corporation, chartered by the state in which it is headquartered, is considered by law to be a unique entity, separate and apart from those who own it. A corporation can be taxed; it can be sued; it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes.
Advantages of a Corporation
- Shareholders have limited liability for the corporation’s debts or judgments against the corporations.
- Generally, shareholders can only be held accountable for their investment in the stock of the company. (Note, however, that officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.)
- Corporations can raise additional funds through the sale of stock.
- A corporation may deduct the cost of most benefits it provides to officers and employees.
- Can elect S corporation status if certain requirements are met. This election enables the company to be taxed similar to a partnership.
- No federal income taxation of earnings repatriated from foreign subsidiaries.
- Non-U.S. shareholders generally will not be subject to U.S. income tax filing requirements with respect to their ownership in a C corporation.
- Disadvantages of a Corporation
- The process of incorporation requires more time and money than other forms of organization. The State Secretary of State for the state of incorporation as well as the states where the corporations do business will require registrations and legal filing documents.
- Corporations are monitored by federal, state, and some local agencies, and as a result, may have more paperwork to comply with regulations.
- Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible forms of business income; thus, this income can be taxed twice although the Trump Tax Act has reduced the overall effect of the double taxation by lowering the C corporate rate from 35% to 21%. This does not include state taxes as they vary depending on the state in which you are doing business.
Subchapter S Corporations
A tax election only on Form 2553, subchapter S corporations allow shareholders to treat the earnings and profits as distributions and have them pass through directly to their personal tax returns. The catch here is that the shareholder, if working for the company, and if there is a profit, must pay themselves wages, and it must meet standards of “reasonable compensation.” This can vary by geographical region as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit. If you do not do this, the IRS can reclassify some or all of the earnings and profits as wages, and you will be liable for all of the payroll taxes on the total amount. Unfortunately, you cannot have more than 100 shareholders or any corporate, partnership or multi-member LLCs or foreign, non-resident shareholders.
Limited Liability Company (LLC)
The LLC is one of the newest types of business structure. These were started in the state of Wyoming back in 1977 and have grown in popularity. Today, over two-thirds of all businesses formed select LLC as their entity of choice. It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The formation is slightly more complex and formal than that of a general partnership.
The owners are members opposed to partners, and the duration of the LLC is usually determined when the organization papers are filed. The time limit can be continued if desired by a vote of the members at the time of expiration. LLC’s must not have more than two of the four characteristics that define corporations: limited liability to the extent of assets; continuity of life; centralization of management; and free transferability of ownership interests.
As of January 1, 2018, the Trump Tax Reform Act went into effect, which created Code Section 199A. This is a 20 percent deduction off of income for federal tax purposes. There are limitations on the deduction when it comes to the amount of W-2 compensation. This should be heavily considered when deciding on the entity type as the 20 percent deduction is around until the end of 2025.
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