Choosing a business structure when starting up a new business venture is an important part of the business set up process. The business entity search for the right combination of factors that will benefit the owner or owners, must involve some careful consideration. If the wrong business entity is chosen then the tax ramifications could drastically affect the owners of the new business!
An entity is defined as something that has a real existence, it is considered as distinct, independent, or self-contained. So that would mean a business entity is a distinct, separate and a self-contained formulation of the essence and ideas of the ownership of it.
That being said, there are several important options to consider when starting a new business entity search. There is the option of choosing a sole proprietorship, the general partnership, the c-corporation, and the s-corporation, and the limited liability company. These would be the most popular choices to consider when looking to launch a small business entity.
The Sole Proprietorship
Sole Proprietorships are the most popular of the business entities that can be chosen. The reason that is so is that they are easy and inexpensive to set up. But, does that mean it is the best way to go when you are doing your business entity search?
A sole proprietorship is a single owner business. It is owned and operated by one person who is the captain of the ship, so to speak. That person makes all the decisions in regard to the business direction. Although, any profits that the business generates are the sole responsibility of the business owner. Is that a bad thing? Well, self-employment tax could be significant and there is no way to avoid it in this type of business entity.
Another consideration is that the freedom and benefits of this complete control of the business also come with unlimited liability. The sole proprietor is personally liable for all the actions of the business. All debts of the business become the owner’s debts. A sole proprietor could lose everything if the business becomes insolvent. Most would say this is the riskiest form of business ownership.
When beginning a business entity search most people do not invest the time to research all their options and just start operating their new business without fully investigating other options. So, by default, their new business is launched as a sole proprietorship, such as John Smith DBA RV Inspections For All. The DBA stands for doing business as. This form of business entity is the most common in the United States.
The sole proprietorship is just an extension of the owner of it. It does not live apart from the owner of it. It has no legal separation from the owner. It can’t sue or be sued. If there are problems with credit payments that the sole proprietorship has taken on than the creditors must sue the owner. Those that harm the business must be sued by the owner, in his or her own name.
Any employees of the sole proprietorship are the owner’s employees. If anything should happen because of what an employee did or said, the owner is personally responsible for their actions, not the DBA company.
The sole proprietorship is easily transferable. The owner can sell the business to someone else. The sole proprietorship is the business. If it is sold or transferred to someone else, the proprietorship ends with the old owner and a new one is formed by the buyer. The ability to raise capital for the business to grow is limited by what the business nature is. This part is very important when doing a business entity search because the short and long-term needs of raising capital to grow the business will be limited to a sole proprietorship. It basically falls on the creditworthiness of the owner and the investor’s willingness to take on the loan based on the owner’s financials.
The business entity search and a decision on choosing a business structure should definitely take into consideration the federal and state tax ramifications that the business will have. Typically, a sole proprietorship is taxed by the personal income of the owner of it. The business does not pay taxes. This business entity type does not have the tax advantages that other types do! The owner will have to pay FICA on all the profits of the business. This comes in at 15.3% at this current time. Do the math on fifty thousand of profit from a sole proprietorship! You are talking over $7,500 dollars! This is where another business entity might be a better choice.
Read on, I will get to that!
What About a General Partnership?
A general partnership is when two or more people decide to form a partnership and go into business together in order to earn a profit from their combined efforts. They become general partners and have a responsibility to each other and are bonded by trust and loyalty.
This arrangement is very similar to the sole proprietorship in most of the basic business setup that was discussed above. If one decides to separate from the partnership then the business is likely dissolved as such. The partners of the business are also burdened with the liability of the business and the financial burdens too. Creditors, if money was borrowed jointly by the partnership, can demand assets of personal property be liquidated to pay the debt if bankruptcy occurs.
Partners may make any business decisions they choose as long as they can get the other partners to agree. In this type of relationship the majority rules, but when there are only two partners, things can get interesting! Also, each partner is liable for the other’s actions for the business. Each partner becomes an agent of the others.
A partner can leave the business and transfer their share to another but that does not automatically make the person an owner. The state in which the partnership operates will have a say in this unless a partnership agreement was initially created by the forming partners.
Business profits and losses are shared by the partners which are reported on their individual income tax returns. That means because the general partnership does not pay any corporate taxes, the income or losses are passed through to the partner. This makes this type of business entity a pass-thru entity. But, the partnership still needs to file an information return, a form 1065, so the IRS knows what the gross income and deductions flow through to the named partners on that form.
It is recommended when a general partnership is formed, that a partnership agreement is created. It is not required, but in the case of a dispute, this agreement could make the resolution a much easier process between partners, employees, sub-contractors, and consultants.
What About Corporations?
Corporations are the reason that the United States has seen such economic growth since the industrial revolution. It is easier for them to grow because they can raise capital due to the corporate law structure. Corporations can grow faster because they can raise capital by allowing ordinary individuals to invest in the company and have part ownership of the corporation without the personal liability or many of the other responsibilities that go along with business ownership.
The two main corporate entities are the C-Corporation and the S-Corporation. The difference between the two is how each is operated and taxed according to the structure set up by the Internal Revenue Service. That being said, both still share the same basic principles of the standard corporation.
Most large businesses are corporations’. Corporations can own property, be sued and sue using its own corporate name. A corporation is created by the secretary of state in which the corporation registers. Once approved the incorporators create a board of directors, issue stock to stockholders, and elect officers of the corporation.
There are common elements to most all corporations’. The first deals with the stockholders. They are the ones who put up the money for the corporation so it can raise capital. The shareholders are the owners but they benefit from limited liability. They are not liable for the debts of a corporation apart from their investment. Unless an investor breaks the law their only risk is the loss of the original investment. The reward for their investment is the possibility of a high return with little effort.
The beauty of the corporation is something called the corporate veil. The corporate law creates an imaginary boundary between the corporation and its shareholders. This protects them from the liability of the corporation’s actions. The actions of the corporation are not considered the actions of the shareholders as long as no illegal actions were engaged in. That’s a pretty cool thing!
The ownership interest in a corporation is easily transferable. A shareholder can sell their shares to whoever they want. The person who purchases them becomes a shareholder with the same rights as the seller.
Another element of the corporation is the board of directors. These people are voted in by the shareholders in hopes they will help the corporation earn a profit. They are the ones that establish the corporate mission, its values, and establish policies for the corporations’ growth. They also have other duties for the corporate structure, evaluate external risks to the corporation, keep on target with the strategic plan, and deal with the folks who will manage the corporations’ daily tasks.
Then there are the officers of the corporation. These are the ones who are under the constant eye of the stockholders. They are elected by the board of directors who can determine how many are necessary for the proper function of the corporate entity. A person can hold several positions, like be both president and secretary, for example. Corporate protection can be set up for officers where two signatures are required as a safety measure.
Officers are agents of the corporation and can make decisions based on those that are set up by the bylaws or the board of directors. They are expected to achieve the goals of the corporation, be loyal, honest, and act in the best interests of the corporation.
As mentioned earlier, corporations’ are separated into two different classifications for tax purposes. Next, we will look at the C-Corporation and the S-Corporation and the advantages and disadvantages of each one.
The C-Corporation (C-Corp)
When we here the term C-Corp some people think of a large corporation like GE, General Motors, or Walmart. A C-Corp is rarely the proper choice when performing a business entity search for a small business like an RV inspection business. The main reason one would choose a C-Corp is to raise capital and to have numerous stockholders and investors.
The first benefit of the C-Corp is that it can deduct one hundred percent of all employee health insurance including the shareholders. It can also deduct the costs of all medical reimbursements. Other items like qualified education costs, group term life insurance up to fifty thousand per employee, the employee provided vehicles, bus or public transportation passes can also be deducted in most cases.
The second benefit of the C-Corp is the ability to go public and have more than one hundred shareholders so that more capital can be raised. The potential for raising money by an outside company, although regulated by the Securities and Exchange Commission, is very advantageous.
The biggest disadvantage to the C-Corp is the corporate tax that gets assessed to the net profit of the company. After all salaries and expenses have been paid, the C-Corp pays taxes on the profits that remain. The profits are then passed to the shareholders where they then pay personal income tax on the dividends. This is a double taxation set up where both the corporation and the shareholders are both taxed. After the first fifty thousand of profit taxed at fifteen percent, the rest can be taxed at thirty-four to thirty-nine percent! This is a big concern for the small business owner!
The S-Corporation (S-Corp)
An S-Corp, a Limited Liability Company, or any other eligible business entity may elect to be taxed under the Subchapter S of the Internal Revenue Code. Unlike a regular corporation, an S-Corp does not pay any corporate income taxes on its profits. The individual shareholders pay taxes on their fair share of the portion of the corporation that they own. This is referred to as a flow-thru business entity.
Shareholders are required to report income and pay their taxes regardless of whether the shareholders receive distributions from the company. An S-Corp must file a Form the 1120S which is due on the 15th of the third month following the close of its corporate tax year.
To elect to be an S-Corporation the following requirements must be met:
- The new company must be an eligible entity of a domestic corporation, a partnership, or a single or multi-member limited liability company.
- There will be no more than one hundred shareholders
- Shareholders must be United States citizens or residents, be natural persons, so shareholders and partnerships can be executed.
- There must be only one class of stock issued.
- Profits and losses must be distributed in proportion to and depending on each shareholder’s interests in the company.
If the forming corporation meets these requirements and wants to be taxed as a Subchapter S, the shareholders must file with the Internal Revenue Service a Form 2553. There are some time requirements for this filing which can be dealt with when the election to do so is decided.
The main advantage of the S-Corp is in the way the shareholders pay their FICA. If they draw a salary from the corporation and pay their taxes on that amount, the rest of the profits of the company flow thru to become a K-1 distribution for the shareholders. This can be a substantial savings and the advantage of an S-Corp over an LLC for higher income companies.
The Limited Liability Company (LLC)
The last one I will deal with here in this article is the LLC, known as the Limited Liability Company. Most people like the sound of this because they here limited liability meaning they are not personally liable for the companies actions. Let look a little further into this!
The LLC provides the flexibility in operation with the tax status of a general partnership with limited liability protection normally associated with limited partnerships and corporations’. The LLC is a business entity that consists of one or more individuals who operate any lawful business. These could be individuals, general partnerships, limited partnerships, associations, trusts, estates, or corporations’.
An LLC can also be an incorporator, a general partner, a limited partner, the applicant of a DBA, the manager of any corporation, a partnership, or limited partnership. LLC’s have three main parts: members, managers, and employees. Management of the company is the responsibility of its members or managers which will be specified in the articles of organization.
Unlike most other corporations’, an LLC does not require the owners to hold annual meetings with all the shareholders or partners, but it is recommended to help maintain the corporate veil.
Many new companies form an LLC to protect personal assets from a legal claim relating to their real estate investment or business liabilities. Additional liability protection may be gained by properly forming and maintaining a separate LLC to hold each property or business entity. By forming a separate LLC, theoretically, only the assets owned by a specific LLC would be subject to claims or lawsuits arising against that LLC.
An LLC is subject to disclosure, recordkeeping and reporting requirements that do not apply to a general partnership. A single member LLC has just one member or partner. The main difference between this form of LLC and a regular LLC is the way it is taxed. In a single member LLC, the income, expenses and all the financial operations of the company are reported on the owner’s tax return, whether an individual, corporation or trust for example.
If the members are filing as a multi-member LLC then the company would file an IRS Form 1065. Members of the LLC would receive a K-1 at the end of the year to report their individual share of the income and expenses on their tax return.
If the income is considered ordinary income and thus subject to Self-Employment tax, the individual members would be required to account for and pay this tax. The LLC does not provide the opportunity to save on Self-Employment Tax. Again, an S-Corporation would be the entity of choice for this purpose. The principal purpose of an LLC is to provide various types of asset protection.
What Business Entity Did HMRVI Corporation Choose and Why?
Upon consideration of launching HMRVI Corporation back in early 2014, the ownership of the company was considered, the future projections of the revenues it would generate, and most importantly the tax structure that would best benefit the new corporation.
There were only two choices that Howard and Pam really needed to choose between. Having had sole proprietorships and S-Corps, the choice was obvious. Go with the S-Corp! Now there are small costs associated with maintaining an S-Corp each year but we figured that was minuscule weighed against the tax benefits for HMRVI Corporation and its goals as an RV Inspection/Information company.
The company could have launched as an LLC and later elected to switch to an S-Corp, which is a simple process, but given the financial projections of what was to occur, Howard and Pam elected to go straight to the S-Corp. HMRVI Corporation was born in March 2014. As I write this post we are about to complete four full years and begin our fifth.
We are truly blessed to have made it through four years. Has it been a lot of hard work? Sure, but what is not that is worth doing well! We are truly seeing the rewards of our efforts. With the right advice and counsel of our CPA and attorney, we have benefited greatly.
We want to thank Mark J Kohler for his contribution to this discussion on business entities. We have learned so much from his advice that has allowed us to also help many others who are following our path!