Good Tax Idea: Picking the correct business entity.

One of the worst things a person (or group of people) can do is pick the wrong type of business entity when they are starting up a business. There have been horrible web offers and bad information telling people to incorporate to save money and take advantage of tax breaks so they will not only have a zero tax liability – they will get money back.

It is baloney.

In states where there is a state tax, a lot of them have an incorporation tax as well as other laws regarding employment taxes, social security taxes and a plethora of other compliance issues. In California for instance, if you incorporate, whether you make money or not, you are on the hook for a minimum tax of anywhere from $600 – 800 depending on what the tax law says the minimum payment is for that year.

That has been a nasty surprise to a lot of people who started up their business late in the year and find themselves on the hook for at least a minimum payment at their respective state level!

There are also a lot of required filings that you must comply with – whether you are making money yet or not – if you opt for incorporating.

My suggestion is to start small with a sole proprietorship and as you grow, you can either become a partnership, C Corporation or an S Corporation.

Are Corporations audited more than individuals? No more or no less if they are not fitting into whatever profiles that the IRS and the respective states have programmed into their software for kicking out tax returns for review (or even just line items for review).

Do you know the differences between the three types of business models?

Here is a quick review in terms of tax information:

Sole Proprietorship – One owner, who has unlimited personal liability for the obligations of the business. Say you start up John Doe’s Hamburgers and somebody chokes and dies on your burger, you get sued and they can go after all your assets. Your taxes are filed on a Schedule C and your business isn’t taxed, your profits or losses are passed through to you, the solr proprietor.

Generally, the only legal filings you have at the simplest level, depending on your type of business, is a DBA (Doing Business As) filing where you advertise in a newspaper for several weeks stating you will be using a certain name for doing business. After the publishing of the filing, you can take a clipping from the newspaper to your bank and open a checking account with the name of your DBA.

Two other items of note with a sole proprietorship are that – you manage your business and you contribute whatever capital is needed. If say, from our previous example, the hamburger business is good, and you want to raise money, you would go to a local bank and they would look at your assets, the business, etc and make the decision to loan YOU the money for the business or not.

The next type of business that is a step up in complexity from a Sole Proprietorship is a Partnership. Partnerships come in two flavors – Limited and General.

In terms of ownership- you can have an unlimited number of partners in both the limited and general partnerships with unlimited numbers of general and limited partners in the limited partnership.

For liability issues – in the general partnership, there is unlimited personal liability of the general partners for the obligations of the business.

For a limited partnership, there is unlimited personal liability of the general partners for the obligations of the business and the limited partners generally have no personal liability.

For both limited and general partners, the partnership is not taxed per se, the profits and losses are passed through to the general or general/limited partners. The Federal form 1065 is usually used for partnerships.

To file for a partnership you need a General Partnership Agreement and whatever local filings if your partnership holds real estate.

For a Limited Partnership you need a Limited Partnership Certificate and a Limited Partnership Agreement.

Who manages a partnership? In the general partnership there is equal management say between the partners unless they have agreed otherwise. For the limited partnership, the general partner manages the business, subject to any limitations of whatever was spelled out in the Limited Partnership Agreement.

Money is raised for the general partnership by contributions of money or service from the partners who receive an interest in profits and losses. In a limited partnership, the general and limited partners generally behave the same way.

Corporations generally are the most complex of the business entities and come in three flavors:

LLC – Limited Liability Corporation

C Corporations

S Corporations

In terms of ownership size, the C Corporations and the LLCs generally can have an unlimited number of shareholders. For the C Corp there is no limit on the different classes of stock that they offer. The S Corporation is generally limited to 100 members (I think that number is right – I may be off so please double check yourself if you are planning on opening an LLC with over 100 members!) and is only allowed to issue one class of stock.

For all three types of corporations there is generally no personal liability of the shareholders for the obligations of the corporation.

Usually Form 1120 is used Federal Corporation taxes. Taxes for the LLC are
not taxed (unless chosen to be taxed), as the profits and losses are passed through to the members.

S Corporations are generally not taxed as the profits and losses are passed through to the shareholders (“pass-through” taxation).

C Corporations are taxed on its earnings at the corporate level and the shareholders have a further tax on any dividends distributed (subject to some exclusions) (This is also known as “double taxation”).

The legal documents you generally need for an LLC are – Articles of Organization and an Operating Agreement.

The C Corp needs Articles of Incorporation, Bylaws, Organizational Board Resolutions, Articles of Incorporation, Stock Certificates and a Stock Ledger.

The S Corp requires Articles of Incorporation, Bylaws, Organizational Board Resolutions, Articles of Incorporation, Stock Certificates, Stock Ledger and the IRS & State Corporation election.

An LLC is managed by the Operating Agreement which sets down how the business is to be managed and a manager can even be designated to run the business.

For the C and S Corporations, the Board of Directors has overall management responsibility and the officers of the corporation have responsibility for the day-to-day operations.

Money is raised for an LLC through contributions from the members of money or services and they receive interest in profits and losses.

For a C Corp, shareholders generally purchase stock in the corporation – either common or preferred.

S Corp shareholders typically can only purchase one class of stock.

Okay, so you can see the different levels of complexity involved and generally most of the hassles start to occur from my experience as a tax pro at the state level where people did not research the state requirements for filing correctly or anticipate the level of complexity that corporations are subjected to.

Again a good rule of thumb is to start small, with a sole prop if you are running a small business for yourself initially and then build up as you need more liability coverage or need to raise more money.

Please remember this if you don’t do anything else:

It is a lot easier to get into a complex and different business entity then to get out of it!

Some other bits of trivia that I have seen from over the years. In places like California, some corporations may be treated as shells if you are sued and they may go after your personal assets.

I recommend that if you are starting a complex business that you consult with an attorney who has experience in the particular business you want to start and get their opinion as well from a legal point of view.

Also, as warned above – plan your exit strategy in advance. Do you want to run your business all by yourself forever? Do you plan on selling it later on if you are too old to run it by yourself? Keep things like that in mind!

2 Responses to “Good Tax Idea: Picking the correct business entity.”

  1. […] is sometimes hard to have to think what your exit strategy should be in a business, especially if you are just starting out but in all good business plans it pays to know how you are planning leaving – either eventually by […]

  2. […] the time to write your business plan, prepare for your business, consider what type of business you want, you have figured out what tax issues you have for the state you live in, and now […]

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