Individuals starting a new business often approach us with basic questions surrounding their new venture. Typically, these individuals have heard that they need to “incorporate” their business to protect themselves from personal liability, and they are generally aware that there are tax implications that are driven by their decisions when forming the new business. Thus, the initial choices are (1) choice of entity, and (2) tax matters.
Choice of Entity When Forming a New Business
There are a variety of business structures available for the startup. The most common forms of business structure are (A) no entity (sole proprietorship), (B) partnership, (C) corporation, and (D) limited liability company. These structures each have their own unique benefits and burdens.
A. The sole proprietorship is the simplest business structure, since any individual who opens a shop with doing nothing more is an instant sole proprietorship. The downside, unfortunately, is that the business owner is 100% liable for all of the obligations of the business.
B. The partnership (general) is also simple to form, because any two or more persons joining together to pursue a business for profit are deemed a partnership, whether or not they intend to form a partnership. Again, the downside, is that the partners will be completely liable for all obligations and liabilities of the business.
C. A corporation is a more complex structure, that requires statutory formalities to form (typically the filing of Articles of Incorporation with the appropriate state governmental entity), and following certain formalities (annual reports, shareholder meetings, etc.) to maintain the corporation’s shield against the personal liability of its owners for the obligations of the corporation.
Limited Liability Company
D. A limited liability company is a more complex structure, similar to a corporation (must file Articles of Organization to form), but not requiring many of the corporate formalities associated with maintaining a corporation. This type of entity provides protection for its owners (typically called “members”) from personal liability for the liabilities and obligations of the company. The members of the company typically enter into an Operating Agreement to set out the rights and obligations of the members. As with corporations, there will be exceptions to the shield from personal liability, but the risk is far less than with a sole proprietorship or general partnership.
Tax Matters When Forming a New Business
The type of entity that you use in forming your business will generally affect what type of taxes the entity, and its owners may pay. The most common tax matters to consider are (A) Schedule C (individual tax return), (B) partnership return, or (C) corporate return.
A. For a sole proprietorship, everything will be reported on Schedule C to your personal income tax return. You will need to pay self-employment tax on all income of the entity, and may even be required to make quarterly advance payments.
B. For a partnership, the entity will file a tax return, but the partnership will not actually pay taxes. Instead, the information will be reported to the IRS, and then the partners will pay the tax on the income of the partnership through their personal income tax returns. A limited liability company will typically operate this way as well.
C. The most complex taxation would be where a corporation is formed. A corporation, where no exceptions apply, will typically be double taxed (at the corporation level, and then again at the shareholder level). The corporation would pay tax on its income, and then the shareholders will pay taxes on the distributions they received from the corporation. There are ways to structure the corporation to avoid the double taxation, including the filing of a subchapter S Election to allow the corporation to operate as a S Corporation (instead of the double-taxed “C” Corporation), and thus avoiding the second level of corporate tax.
The attorneys at GWC have significant experience representing business owners and other clients in business matters. Please do not hesitate to contact Tim Gillis at GILLIS, WAY & CAMPBELL with any questions.