One of the first decisions that an entrepreneur must make is how to structure his business. This can have wide-ranging consequences. Because of this, it is important for anyone starting a business to understand the various business models that are available. It is also a subject that should be reviewed on a regular basis by all small business owners.
There are 3 basic entities, and one way to organize a non-corporate business. There are several factors that play into that decision, but for the small business or sole practitioner the most important are tax implications and legal liability. I will be emphasizing the tax ramifications of this decision, but will touch on the legal considerations as well. I am not a lawyer, though (and have never played one on TV:)).
Sole Proprietorship
The simplest entity is the sole proprietorship. This also has the fewest tax advantages and no protection against liability. This is the “default” structure because it requires no special filing, except possibly a DBA (does business as) which may be required for a business checking account. Even that is not legally required, as anyone can accept payment in his own name. The sole proprietor calculates his business income/loss using Schedule C. and includes that with income from all other sources in computing his tax liability on Form 1040.
Partnership
If 2 or more people go into business together they may elect to form a general partnership. This is similar to the sole proprietorship in that there is no protection against liability. The partners decide between/among themselves how the income/loss from the business is to be divided. The partnership files its own tax return on Form 1065 but does not pay tax. All items of income and expense are reported on Schedule K and the partners receive notice of their shares on Schedules K-1. The partners report the items of income and expense on their individual tax returns and pay tax at their individual tax rates.
They may also elect to structure the partnership as a limited partnership. The general partner(s) would run the business and the limited (silent) partners would invest in the business and share in the profits/losses but would not have any input into the operations and would not be liable for any liabilities incurred by the partnership. Until the mid-1980’s this structure was popular for tax shelters. The tax act passed in 1986 pretty much destroyed that business model by saying that limited partners could not use losses from limited partnership interests to offset other income. Today, the limited partnership is still a viable model in certain circumstances.
Limited Liability Company
The biggest drawback to the sole proprietorship or partnership structures is that there is no protection from legal liabilities or debts incurred by the business. This is overcome by the creation of a Limited Liability Company (LLC). The business must organize as a LLC through filings with the local government. It is not a corporation, merely an “umbrella” to protect business owners from liabilities arising in the course of business. The LLC is a relatively new concept in the US (the first LLC law statutes were passed in Wyoming in 1990), so the courts are still working out the kinks. If you operate as an LLC you must keep abreast of changes in the way they are treated. The rules governing the formation of an LLC also vary by state.
The IRS does not recognize an LLC “entity” for tax purposes. This gives the owners a lot of flexibility in that they can either do nothing, and they will be taxed as either a sole proprietorship or a partnership, or they can elect to be taxed as either a C-Corp or an S-Corp, even though the LLC is not a corporation. There are, of course, exceptions to this general rule.
Corporation
The third type of entity is a corporation. This is the most complex, both in its formation and its annual tax filing requirements. The corporation is a legal entity separate from its owners. There are 2 types of corporation…a Subchapter C corporation (C-Corp) and a Subchapter S corporation (S-Corp). Their names come from the part of the Internal Revenue Code which defines how they must report their income and losses. The C-Corp is the most well-known and includes all publicly-held companies. At its inception every corporation is a C-Corp. In order to be taxed as an S-Corp, it must make an election and must meet certain requirements. The S-Corp is much like a partnership in that items of income or loss are passed to the shareholders and reported on their individual returns. This is very valuable in the early years of a business when there may be startup losses, which can then be claimed by the owners on their individual returns.
There are some other corporate structures which have more limited use. You may have seen a lawyer or accountant with “PC” after his firm’s name. The PC stands for “professional corporation”. The professional is not allowed to protect himself from certain liabilities because of ethical codes, and a PC allows for this. A mutual corporation is one where the customers are owners and entitled to receive a share of the income of the corporation. This structure is used by many insurance companies and savings and loans. There are non-profit corporations, such as credit unions, which pay no tax, and all income is required to be reinvested in the business or paid out to members.
This has been a brief introduction to the various structures that a business can take, with an emphasis on the tax ramifications of each. I hope this gives you a basic understanding of the different models a business can follow. There are other considerations that the owner must take into account, as well. I will be discussing each business model in more depth in future articles.
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