When running a business, it is important (and cost effective) to spend time establishing a solid infrastructure for your business. This means understanding applicable laws, identifying risks, and setting policies and procedures. A qualified business attorney can advise you on best practices for your business. There are several types of business entities, which are commonly used for business formation.
The choice of entity depends on your objectives and the tax and legal aspects of the entity - set aside some time (and funds) to review your goals with your legal and tax teams before launching and you will set your business up for success!
Common Business Entities
Sole Proprietorship
A Sole Proprietorship is a one-owner business, created at a county or city level, that does not have a formation separate from their personal individual. Sole Proprietors are the default structure when formation documents are not filed but business owners are engaged in business. This type of structure is typically filed on a personal income tax return and a Schedule C. This structure has no liability protection shield between personal and business assets but is the easiest and cheapest way to form a business.
Partnership
A partnership is two or more people in business together. A partnership can be implied in law so it is often a legally risky form of business entity. It is usually better to form an entity to define the business relationship. A partnership is required to obtain city, county, and/or state licenses. It pays taxes on its income which is attributed to the partners according to the terms of their written or oral partnership agreement. The IRS has tax forms for partnerships (Form 1065). Individual partners receive K-1 forms declaring their share of the income which is reported on 1040 Schedule E. Partnerships can be default created by action as a operation of law but should always be accompanied with partnership agreements to outline all responsibilities, monies, debts and other important details.
Corporation
The corporation is considered to be a separate legal person under the law. It is run by a board of directors who appoint officers to run the day to day business affairs. It is owed by shareholders. Shareholders are either common or preferred. Preferred shareholders usually have more rights than common shareholders. Preferred shareholder rights are specified by the corporate charter and director's resolution. It is the most common entity used by public companies. Standard corporations are often referred to a "C corporations," a reference to Section C of the Internal Revenue Code where their tax treatment is defined. The IRS has tax forms for corporations (Form 1120). Individual shareholders receive K-1 forms declaring their share of dividend income (if any) which is reported on 1040 Schedule E. This results in a "double tax." The income is taxed at the corporate level and then on the individual level. Except for the rare federal charter, all corporations exist under the authority of state law and federal law generally defers to the state statute to determine the power and rights of corporations.
S Corporation
A Subchapter S Corporation is exactly the same entity as a corporation or a "C" corporation. The entity is defined by state law. The "S" and "C" designations are for federal tax law purposes only. The "S" designation comes from the name of the subchapter of the Internal Revenue Code, which defines its tax treatment. An S corporation was the first entity designed to help small business avoid the double tax C corporations must pay (at the corporate level and then at the shareholder level if dividends are paid). Because it has been in existence for over 50 years, the rules and regulations enacted by Congress and the IRS are complex.
The S corporation election taxes the shareholders for the profits of the corporation even if no dividends are paid. Losses are passed on to the shareholder but can only be deducted to the extent of the amount paid for the stock (called "basis"). Generally S corporations are complicated and have hidden risks. Limited liability companies are a better choice for most small businesses. The IRS has tax forms for S corporations (Form 1120S). Individual shareholders receive K-1 forms declaring their share of all income which is reported on 1040 Schedule E. If the S corporation had income, the shareholders must pay tax even if they received no distribution from the corporations. This is called "phantom income."
Corporation structures are more time and administrative intensive that other types of business but can bring great tax benefits depending on specific business situations.
Limited Liability Company
The best, and most popular, form of business entity is usually the limited liability company. It is taxed like a partnership (no double taxation - see above), is very flexible, and has legal advantages that are not available to corporations (e.g. no "piercing of the corporate veil"). If the business will have multiple owners it is best to have a lawyer set up the LLC property and accompany the formation with an operating agreement to manage possibilities such as death, retirement, divorce and conflict. LLC's also have the benefit of being filed on a personal income tax return (1040 Schedule C) like a Sole Proprietorship but have the option to elect a Corporation taxation through the IRS for additional tax benefits without the corporation administrative duty requirements.
How to choose?
Choosing a structure for your business may be a difficult decision but is not one to avoid simply because it is overwhelming. The first step is to examine the structures provided above and ask yourself the following questions:
- What is my financial budget for formation?
- How important is liability protection to my business and the nature of the business?
- What is my long-term goal with the business?
These questions will help to shape your business formation plan. A small business attorney can help you work through your plan and liability protection desires, while a Certified Public Accountant (CPA) can weigh in on the tax benefits for your specific tax situation.
Business formation may be an overwhelming, but legally required and important process to running a business. Don't avoid taking the legal bull by the horns simply because you are unaware of the process. Professionals are available to assist you in your business decisions but always be sure to communicate fully your intentions and long-term goals to reach the best decision with these professionals as possible.
Rachel Brenke is an author, photographer, lawyer and business consultant for photographers and bloggers. She is currently helping creative industry and blogging professionals all over the world initiate, strategize and implement strategic business and marketing plans through various mediums of consulting resources and legal direction. See more: http://www.thelawtog.com/meet-rachel-the-law-tog/
Disclaimer: I am a lawyer but I'm not your lawyer! View my entire disclaimer here
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