Sometimes these are small decisions - or lack of a solution - that have the greatest impact on your business.
Take the choice of what legal structure you use to manage your business. Many small business owners are so happy that they are starting their own business, that they don’t think at all about this very important decision. Should you turn on? Build LLC? Partnership? Would you rather not do anything and run your business as an individual enterprise?
Before you contact the first person you ask, or the first book you read, consider all the legal, tax, financial and operational implications of your choice. Let's look at your choice one by one.
Sole proprietorship
When you open your business without a partner (the spouse is usually not considered a partner for this purpose) and without submitting any documents to select one of the other types of business, you are automatically the sole owner. You do business with your customers directly, like yourself, a person. This is true even if you have a name for your business and a file with a “fictitious name” or “doing business as” documents with your state or local government.
For income tax purposes, there are no separate forms for doing business. You simply join Schedule C to your 1040 form. Schedule C is where you add up your income and expenses in a business. You pay tax for any profit at the rates of the ordinary individual tax. If you have losses, you can usually deduct the loss from your other income.
In addition to income tax, you must pay self-employment tax. The self-employment tax rate is 15.3% for the first of $ 94,200 (for 2006) profits and 2.9% for any amount above $ 94,200. The tax is intended to replace the taxes on social security and medical care that you and your employer pay when you have a regular job. Since you are an “employer” and “employee”, you pay twice as much as if you worked for someone else.
The biggest person who is the sole owner is your legal responsibility. If someone is injured, be it physically, financially, emotionally, etc. As a result of your business activity, you may be personally sued. In today's judicial environment, where people are prosecuted for falling hat, this is a risk that a serious business owner should not have. While insurance may provide some protection, you still risk losing your personal assets and / or be able to file for bankruptcy because of a lawsuit.
While this form of business may be excellent for part-time or “side-based” companies, most small business owners should choose another option.
partnership
When you are a co-owner of a business with one or more other people and do not choose one of the other types of business, you are automatically a partner. (Technically "general partnership"). Although an individual entrepreneur is not on the list of desirable business structures for small businesses, the partnership is even lower.
As a sole proprietorship, you can be personally sued for any harm you have caused as a result of your business. Worse, you can be sued for any harm caused by your partner! Not only that, if your partner signs a contract or takes a loan on behalf of a business, you are automatically bound by the terms of this contract, whether you agree with it or not. This is scary stuff, and I just never recommend this structure. This is an example where “doing nothing” can be a big mistake.
Income tax wise, the partnership must file form 1065, the profitability of income from the US partnership to report its income and expenses. The partnership itself does not pay income tax. Rather, each partner reports its share of the profit or loss from the business on its individual tax return. As in the case of an individual entrepreneur, an active partner must pay a 15.3% self-employment tax on his first $ 94,200 (for 2006) income from the partnership and 2.9% on any amount above that.
There is another partnership called the Limited Partnership, which limits the liability of certain “passive” partners, called limited partners. This is mainly used for real estate syndication and is beyond the scope of this article.
The point of partnership: Stay away from them.
corporation
A corporation is a separate legal entity or a legal “person”, if you wish, formed by submitting certain documents to the state government. Most large companies with which you are familiar are corporations and usually have the word “corporation” or “inc” in their trade name. Corporations have a number of advantages, including the ability to receive money through the sale of shares, as well as the fact that the risk of each owner or shareholder is limited to their investments in the company. A corporation can have one owner, or millions of owners, or any number between them.
As mentioned above, your risk in the event of a claim is usually limited to the amount of money you invested in the corporation. There are important exceptions to this general rule, some of which deserve mention. Firstly, if you are in one of the classic professions, including doctors, lawyers, accountants and engineers, you cannot avoid personal responsibility for your professional activities. In other words, if you are a doctor and you amputate the wrong foot on a patient, you can still be sued in person. On the other hand, if the patient leaves the chair in your waiting room and breaks your leg, the usual corporate protection applies.
The second exception relates to how you manage your business and how you present yourself in the outside world. When you form and manage a corporation, you have to make sure that everyone you deal with knows that they are dealing with a corporation. For example, you would like to make sure that you include your full company name on all letterhead, business cards, advertising, etc. You do not want anyone to say that they thought they were dealing with you as a person and not with your corporation.
Another liability exclusion is related to record keeping. This is where many small business owners face problems. A corporation must keep books and records separate from its owners. Also, by definition, a corporation issues shares and has a board of directors. This board of directors should hold a meeting at least once a year, and official minutes should be kept. Any significant activities of a corporation, such as obtaining a loan, usually require approval by the board of directors. Now the reality is that in a small business you can be the owner and only a member of the board of directors. But you still have to follow the formalities required by your state, and the state in which you are included (if it is different). If you do not do this, a good lawyer may argue that you must be personally sued, thereby “breaking through the corporate veil” and leaving your personal assets exposed. An IRS agent can make the same claims, thereby not allowing certain discounts and tax breaks that you receive, acting as a corporation. Therefore, consult with a competent attorney and make sure that your corporate books and records comply with legal requirements.
For state law, a corporation is a corporation. But for tax purposes, a corporation can either be an ordinary corporation “C” or receive a special tax status, being an “S” corporation.
Corporation C
Without a corporation that can claim to be an S corporation, it is automatically classified as a C corporation. AC pays taxes on its profits and fills out form 1120 with the help of the IRS. Any excess profits are then distributed between the owners of the corporation or the shareholders. These profit distributions are called dividends, and shareholders must pay taxes on them. That is why they say that corporation C leads to "double taxation." Please note that corporate profits are taxed twice: once at the corporate level and again when distributed among owners.
Because of this double taxation, most small businesses are poorly served, being a C corporation. However, there are very limited circumstances in which a C corporation can be used by a small business owner to get certain tax advantages. Consult your tax advisor.
S Corporation
The sub-chapter S of the internal revenue code was created and revised by Congress at the end of the 20th century in order to allow small business owners to include without double taxation. Thus, S was born and has since been the preferred tax structure for small businesses (but see the Section on LLC below).
With Corporation S, a corporation registers form 1120S with the IRS, but the corporation does not pay income tax (with rare exceptions). Rather, each owner pays tax on his share of the profits of the corporation, as a partner in a partnership. Of course, the difference here is that since this is a corporation under the jurisdiction of the state, there is not a single problem of legal liability related to partnership. And since the corporation does not pay income tax, there is no double taxation, as in Corporation C. In fact, this allows the corporation to be taxed as a partnership.
Unlike a partnership, with proper treatment, you do not pay self-employment taxes on the profits of the S corporation. Instead, you are paid wages, and the corresponding taxes on social security, medical care and other wage taxes are paid accordingly. Any dividend exceeding the salary is not subject to payroll tax or self-employment tax. Therefore, if you have a low salary and high dividends, you save 15.3% of taxes on the dividend part. Of course, the IRS knows this, and they demand that you pay yourself a “reasonable” salary. How much salary you have to pay yourself against dividend distribution is a much debated topic between taxpayers and the IRS, and also offers many opportunities for tax planning.
Not every corporation is eligible to be an S corporation, although most small businesses are eligible to participate. There are restrictions on things like the number of shareholders and which companies can be shareholders. The main purpose of the rules is to prevent qualified large companies with public trade and prevent various tax evasion schemes using trusts and foreign organizations.
A corporation must choose S status no later than the 15th day of the third month of the year in which it wants to be rated as S corporation. For example, a corporation must hold elections for business in a calendar year before March 15, 2008 to invest in S corporation for 2008 . You make choices by submitting Form 2553, which must be approved by the IRS for this to be effective.
Overall, S is an excellent structure for most small businesses.
Limited Liability Company (LLC)
The newest business structure is a limited liability company or LLC. LLC provides the same protection against litigation as a corporation, without most of the sober requirements for paperwork and documentation, such as certificates for stocks, board meetings, meeting minutes, etc. In addition, the LLC is very flexible from tax point of view, allowing you to be taxed as a corporation, corporation S, individual enterprise (for enterprises with one owner) or a partnership (two or more owners).
Each state has its own rules for those who can form an LLC, but most states now allow an LLC to have only one owner (this is not always the case). Most small businesses will qualify. Forming an LLC is usually quite simple and reliable inexpensively and often can be performed directly via the Internet.
For tax purposes, a single-owner LLC will be taxed as a sole proprietorship if the owner does not elect to be taxed as a corporation (C or S). A multi-owner LLC will automatically be taxed as a partnership, unless the LLC is taxed as a corporation (C or S). Do you see the beauty of this structure? You get a liability protection close to a corporation, but you do not have all the documents you need to do and a “corporate book” for support. At the same time, you can choose how you are treated for tax purposes! This is enough to perpetuate the heartbeat of a tax accountant!
As you can probably tell, I really like the LLC structure. My own business, Thomas Norton & Company, LLC, is clearly structured in this way. I also decided to be taxed as an S corporation, as it gives me certain advantages in my circumstances. It should be noted that you can start an LLC and be taxed first as a sole proprietor, and you can choose S as a corporation on some future day.
Despite the fact that S still regulates growth among small businesses, LLC is rapidly moving forward as more and more business owners find their simplicity, flexibility and efficiency.
Which structure is best for you?
Since your circumstances may be different, you should consult a qualified tax advisor before making this important decision. However, most small businesses are and should be structured as an enterprise or LLC. Regardless of whether your LLC should be taxed as a sole proprietorship, partnership, C corporation or S corporation is very dependent on the situation, so ask your tax advisor what he or she thinks.
No matter what form of business you choose, make sure it is a conscious choice made after careful consideration of the legal and tax implications. Although it may seem mundane, it is one of the most important business decisions you have ever made.
