tax attorney. There are a number of issues to consider in making a choice, including:
-Your vision regarding ultimate size and nature of the business
-The level of control you wish to have
-The business’s vulnerability to lawsuits
-The amount of profit (or loss) the business will generate
-The tax implications of the different ownership structure
Types of Business Ownership Structures:
Most small businesses are organized as sole proprietorships. These firms are owned by a single individual who also manages
it. A sole proprietorship is not considered a separate organization, but is inseparable from the person who owns it.
Advantages: Easiest and least expensive to organize, the owner is in complete control and receives all income
generated by the business to keep or reinvest, the profits from the business flow directly into the owner’s personal tax return and the business is easy to dissolve.
Disadvantages: The owners of sole proprietorships have unlimited liability and are legally responsible for all debts and legal judgments against the business. All of the owner’s assets are at risk. Sole proprietorships may be at a disadvantage in raising funds, and are often limited to using funds from personal savings or consumer loans. High-caliber employees who would like to own a piece of the business may find a sole proprietorship unattractive, and some employee benefits (such as medical insurance premiums) are not deductible from business income.
A partner is legal structure in which 2 or more people share ownership of a single business. For a partnership, like sole proprietorships, the law does not distinguish between the business and its owners. Partners determine up from how much time and money each will contribute to the business and in addition, they must agree on how decisions will be make, profits will be shared, disputes will be resolved and future partners will be admitted to the partnership. Experts strongly advise that partners have an attorney draw up a legal agreement that clearly sets out these and other important details.
Advantages: Partnerships are relatively easy to establish. Aside from drawing up a partnership agreement, they are as simple to set up as sole proprietorships. The business can benefit from partners who have complementary skills, and since there is more than one person involved, the ability to raise funds may be increased. The profits from business flows directly through to the partners’
personal income tax returns and prospective employees may be attracted to the business if given incentive to become partner.
Disadvantages: Partners are jointly and individually liable for the actions of other partners; profits must be shared with others; decisions are shared, hence disagreements may arise; some employee benefits are not legitimate deductions from business
income and a partnership has a limited life- it may end on withdrawal or death of a partner.
Limited Liability Company
A limited liability company (LLC) is a relatively new type of hybrid business structure that is now available in most stars. It is
designed to provide the limited liability feature of a corporation and that tax efficiency and operational flexibility of a partnership. Like a limited partnership, the formation of an LLC is more formal and complex than that of a general partnership.
Advantages: Combines the pass-through taxation of a sole proprietorship with the limited liability of a corporation. Therefore there are no federal taxes imposed on the LLC as an entity. LLC’s provide personal limited liability to members, and there is greater flexibility in management and responsibilities. Income to members can be distributed with more flexibility.
Disadvantages: Earning of most LLC’s are generally subject to self-employment tax. An LLC that is considered a partnership can’t take advantage of incentive stock options, businesses operating in more than one state may receive inconsistent treatment.
A corporation is considered by law to be unique entity, separate and apart from those who own it. Like an individual, a corporation can be taxed; it may be sued; it can enter into contractual agreements with others. A corporation has a life of its own, and will not dissolve when the owners change. The owners of a corporation are its shareholders. These individuals have the right to elect a board of directors for the corporation to represent the interest of the shareholders in overseeing the major policies and decisions made by the company’s offers. In small business, it is common for shareholders, directors and officers of the company to be the same individuals.
Advantages: Shareholders have limited liability for the corporation’s debts or judgments against the corporation. Generally, the shareholders can only be held accountable for the amount they have invested in the stock of the company (although officers and others can be held personally liable for their actions, such as failure to withhold and pay employment taxes). The corporation has the opportunity to raise additional funds, through the sales of stock. The corporation may deduct the costs of many of the benefits it offers to its officers and employees and it has an unlimited life – its operations will not cease with the death or absence of its founder or individual stockholders.
Disadvantages: The process of incorporation takes more time and money than that involved in setting up a sole proprietorship or
partnership and usually requires the assistance of a paid professional. Corporations are monitored by state and federal agencies and as a result, they may require more paperwork to comply with regulations. Incorporating may result in higher taxes overall.
Most corporations (C corporations) are taxed as a separate entity; they can deduct wages and benefits for officers and other employees. However, dividends paid to a corporation can be taxed twice; first at the corporate level, then again at the individual level if it is paid out to shareholders as dividends.
S Corporations have a significant advantage for small business owners. Unlike C Corporations, S Corporations are taxed similar to partnerships, with all business profits and other specified items passing through to the shareholders’ personal federal income tax returns. A company must meet certain requirements to be accepted as an S Corporation. If a company wishes to be an S Corporation it must make a specific request to the IRS during the incorporation process, otherwise the company will be assigned a C Corporation status.
Advantages: Corporate losses can be passed through to shareholders. The protection of limited personal liability is provided without having to pay corporate tax. Self-employment & FICA taxes can be reduced since your profits, as a shareholder, aren’t taxed in this manner. It is easier to raise capital than a sole proprietorship or partnership.
Disadvantages: Numerous regulations apply, including a limit on number of shareholders. All shareholders must be US citizens. Benefits such as health or accident insurance for employee shareholders are not deductible. An S Corporation must follow corporate formalities. The IRS will closely scrutinize the shareholder employees to ensure that they have received reasonable compensation before any non-wage distributions are made.
Personal Service Corporations
A personal service corporation (PC) is one that provides personal services in certain occupational areas including health, law, accounting, and engineering, when the employee-owners are the primary providers of the service. The income of this type of corporation is taxed at a flat rate (the highest corporate rate) instead of the graduated tax rates applied to other corporations.
A Nonprofit Corporation, otherwise known as the popular 501(c), is reference to the Internal Revenue Code § 501 (c). This IRS Code provides that 28 types of nonprofit organizations are exempt from some federal income taxes and often times state. Although this entity is call “nonprofit”,they operate similar to any business with the intention to make a profit and stay in business. "Tax exempt" also does not excuse an organization from maintaining proper records, and filing any required annual or special-purpose tax returns. Previously, annual returns were not generally required from an exempt organization accruing less than $25,000 in gross income yearly. However, from 2008 onwards, many such organizations must file a yearly "e-Postcard" known as Form 990-N, or risk losing their exemption.
Review your Secretary of State website for more information. Here’s a link to Washington Secretary of State FAQ.
Choosing your business structure is a critical part of your success. It will become the foundation for the objectives and mission you set out to achieve. Take your time to do your research and most importantly, create a Business Plan before you begin. Especially if you plan to have partners, having an agreement in writing will go a long way and provide directions to disagreements later.
Avoid these Twelve Worse Start-Up Mistakes:
1. Rushing to the market.
2. Guessing instead of digging.
3. Weak/wrong business plans.
4. Targeting the wrong people.
5. Falling in love with your idea.
6. Ignoring the competition.
7. Hiring someone to prepare your plan without your involvement.
9. Shortage of cash
10. Incorrect sales forecasts.
11. Failure to pay your taxes in a timely manner.
12. Not working with the right Accounting Resources.