Partnership
When you co-own a business with one or more other people
and don't choose one of the other business types, you are
automatically a partnership. (Technically, a "general partnership.")
While a sole proprietorship is low on the list of desirable business
structures for a small business, a partnership is even lower.
Like a sole proprietorship,
you can be sued personally for any harm you cause as a result of
your business activities. Even worse, you can be sued for any harm
caused by your partner! Not only that, if your partner signs a
contract or takes out a loan on behalf of the business, you are
automatically bound by the terms of that contract, whether you agree
with it or not. This is scary stuff, and I simply never recommend
this structure. This is an example where "doing nothing" can be a
big mistake.
Income tax wise, a
partnership must file a Form 1065, U.S. Return of Partnership
Income, to report its revenues and expenses. The partnership itself
does not pay income taxes. Rather, each partner reports his share of
the profit or loss from the business on his individual tax return.
As with a sole proprietorship, an active partner must pay the 15.3%
self employment tax on his first $94,200 (for 2006) of the
partnership income, and 2.9% on any amount above that.
There is a different
kind of partnership, called a Limited Partnership, that restricts
the liability of certain "passive" partners, called limited
partners. This is used primarily in real estate syndications and is
outside the scope of this article.
The bottom line on
partnerships: Stay away from them.
Corporation
A corporation is a separate legal entity, or legal "person"
if you will, formed by filing certain documents with a state
government. Most big companies you're familiar with are
corporations, and will usually have the word "corporation" or "Inc."
in their business name. Corporations have several advantages,
including the ability to raise money by selling stock, and the fact
that each owner's, or stockholder's, risk is limited to their
investment in the company. A corporation can have one owner, or
millions of owners, or any number in between.
As mentioned above, your
risk in case of a lawsuit is generally limited to the amount of
money you have invested in the corporation. There are important
exceptions to this general rule, a few of which are worth
mentioning. First, if you are in one of the classic professions,
usually including doctors, lawyers, accountants, and engineers among
others, you cannot escape personal liability for your professional
activities. In other words, if you're a doctor and you amputate the
wrong leg on a patient, you can still be sued personally. On the
other hand, if a patient trips over a chair in your waiting room and
breaks their leg, the normal corporate protection would apply.
A second exception has
to do with how you operate your business, and how you present
yourself to the outside world. When you form and run a corporation,
you are obligated to make sure everyone you deal with knows they're
dealing with a corporation. So, for example, you would want to make
sure you included your full corporate name on all letterhead,
business cards, advertising etc. You don't want anyone to be able to
say they thought they were dealing with you as an individual and not
your corporation.
Another liability
exception has to do with recordkeeping. This is where many small
business owners get themselves in trouble. A corporation must
maintain books and records separate from that of its owners. Also,
by definition a corporation issues stock and has a board of
directors. That board of directors must have a meeting at least once
per year, and formal minutes must be kept. Any significant
activities of the corporation, such as taking out a loan, usually
require approval by the board. Now the reality is that in a small
business you may be the owner and only member of the board of
directors. But you still have to keep up the formalities required by
your state, and the state where you incorporated (if different). If
you don't, a good attorney might argue that you should be able to be
sued personally, thereby "piercing the corporate veil" and leaving
your personal assets exposed. An IRS agent can make the same claim,
thereby disallowing certain deductions and tax benefits you receive
by operating as a corporation. So consult a competent attorney, and
make sure your corporate books and records meet the legal
requirements.
For state law purposes,
a corporation is a corporation. But for tax purposes, a corporation
can be either a regular "C corporation" or receive special tax
status by being an "S corporation."
C Corporation
Unless a corporation qualifies for and chooses to be an S
corporation, it is automatically classified as a C corporation. A C
corporation pays taxes on its profits, and files a Form 1120 with
the IRS. Any excess profit is then distributed to the corporation's
owners, or stockholders. These profit distributions are called
dividends, and the stockholders must pay income taxes on them. This
is why it is said that a C corporation results in "double taxation."
Notice that the corporation's profits are taxed twice: Once at the
corporate level, and again when distributed to the owners.
Due to this double
taxation, most small businesses are not well served by being a C
corporation. That said, there are very limited circumstances where a
C corporation can be used by a small business owner in order to gain
certain tax advantages. Check with your tax advisor.
S Corporation
Subchapter S of the Internal Revenue Code was created and
reworked by Congress late in in the 20th Century in order to allow
small business owners to incorporate without being subject to double
taxation. Thus, the "S corporation" was born, and has been the
preferred tax structure for small businesses ever since (but see the
section on LLC s below).
With an S corporation,
the corporation files a Form 1120S with the IRS, but the corporation
does not pay income tax (with a few rare exceptions). Rather, each
owner pays tax on her share of the corporation's profits, much like
a partner in a partnership. The difference here of course, is that
since it is a corporation under state law, there are none of the
legal liability problems associated with partnerships. And since the
corporation does not pay income tax, there is no double taxation as
there is with a C corporation. In effect, it allows a corporation to
be taxed like a partnership.
Unlike a partnership, if
handled properly, you do not pay self employment taxes on the
profits of the S corporation. Instead, you are paid a salary, and
the applicable social security, medicare and other payroll taxes are
paid accordingly. Any dividends in excess of your salary are not
subject to payroll or self employment taxes. So if you have a low
salary and high dividends, you save 15.3% in taxes on the dividend
portion. Of course the IRS knows this, and they require you to pay
yourself a "reasonable" salary. How much salary you should pay
yourself vs. dividend distributions is a much debated topic between
taxpayers and the IRS, and also offers many opportunities for tax
planning.
Not every corporation is
qualified to be an S corporation, though most small businesses
qualify. There are restrictions on such things as the number of
stockholders and what type of entities can be stockholders. The
basic purpose of the rules is to prevent large, publicly traded
companies from qualifying, and to prevent various tax avoidance
schemes using trusts and foreign entities.
A corporation must elect
S status no later than the 15th day of the third month of the year
in which it wishes to be treated as an S corporation. For example,
for a calendar year business, a corporation must make the election
by March 15, 2008 in order to be treated as an S corporation for
2008. You make the election by filing Form 2553, which must be
approved by the IRS in order for it be effective.
Overall, the S
corporation is an excellent structure for most small businesses.
Limited
Liability Company (LLC )
The newest of the business structures is the limited
liability company or LLC . The LLC affords much the same protection
against lawsuits as the corporation, without most of the somewhat
burdensome paperwork and recordkeeping requirements, such as stock
certificates, board of directors meetings, board minutes, etc. In
addition, the LLC is very flexible from a tax standpoint, allowing
you the choice to be taxed as either a C corporation, an S
corporation, a sole proprietorship (for businesses with one owner)
or a partnership (two or more owners).
Each state has its own
rules for who can form an LLC , but most states now allow an
LLC to
have just one owner (that wasn't always the case). Most small
businesses will qualify. Forming an LLC is usually quite simple and
relatively inexpensive, and can often be done right over the
internet.
For tax purposes, an
LLC
with one owner will be taxed as a sole proprietorship, unless the
owner makes an election to be taxed as a corporation (C or S). An
LLC with multiple owners will automatically be taxed as a
partnership, unless the LLC chooses to be taxed as a corporation (C
or S). Do you see the beauty of this structure? You get liability
protection akin to a corporation, but you don't have all the nit
picky paperwork to do and the "corporate book" to maintain. At the
same time, you get to choose how you're treated for tax purposes!
That's enough to make a tax accountant's heart flutter!
As you can probably
tell, I really like the LLC structure. My own
business, Thomas
Norton & Company, LLC , is obviously structured this way. I have also
elected to be taxed as an S corporation, since it gives me certain
advantages in my circumstances. It should be noted that you can
start an LLC and be taxed as a sole proprietorship at first, and
elect to be treated as an S corporation at some future date.
Though the S corporation
still rules the roost among small businesses, the LLC is fast making
inroads as more and more business owners discover its simplicity,
flexibility and effectiveness.
Which Structure
is Best for You?
Since your circumstances might be different, you should
consult a qualified tax advisor before making this important
decision. That said, most small businesses are and should be
structured as either an S corporation or an LLC . Whether your
LLC
should be taxed as a sole proprietorship, partnership, C corporation
or S corporation is very situation dependent, so ask that tax
advisor what he or she thinks.
No matter what form of
business you choose, make sure it is a conscious choice, made after
carefully considering the legal and tax ramifications involved.
While it may seem mundane, it is one of the most important business
choices you will ever make.
