| Sometimes it's the small decisions -- or lack of a | | | | IRS agent can make the same claim, thereby |
| decision -- that have the greatest effect on your | | | | disallowing certain deductions and tax benefits you |
| business. | | | | receive by operating as a corporation. So consult a |
| Take the choice of what type of legal structure you | | | | competent attorney, and make sure your corporate |
| use to operate your business. Many small business | | | | books and records meet the legal requirements. |
| owners are so excited about starting their businesses | | | | For state law purposes, a corporation is a corporation. |
| that they give little or no thought to this very important | | | | But for tax purposes, a corporation can be either a |
| decision. Should you incorporate? Form an LLC? A | | | | regular "C corporation" or receive special tax status by |
| partnership? Would you be better off just doing | | | | being an "S corporation." |
| nothing and running your business as a sole | | | | C Corporation |
| proprietorship? | | | | Unless a corporation qualifies for and chooses to be |
| Before you take the advice of the first person you | | | | an S corporation, it is automatically classified as a C |
| ask or the first book you read, consider all of the legal, | | | | corporation. A C corporation pays taxes on its profits, |
| tax, financial and operational effects of your choice. | | | | and files a Form 1120 with the IRS. Any excess profit |
| Let's look at your choices one by one. | | | | is then distributed to the corporation's owners, or |
| Sole Proprietorship | | | | stockholders. These profit distributions are called |
| When you open your business without a partner (a | | | | dividends, and the stockholders must pay income |
| spouse does not usually count as a partner for this | | | | taxes on them. This is why it is said that a C |
| purpose) and without filing any paperwork to choose | | | | corporation results in "double taxation." Notice that the |
| one of the other business types, you are automatically | | | | corporation's profits are taxed twice: Once at the |
| a sole proprietorship. You are doing business with your | | | | corporate level, and again when distributed to the |
| customers directly as yourself, an individual. This is true | | | | owners. |
| even if you have a name for your business and file | | | | Due to this double taxation, most small businesses are |
| "fictitious name" or "doing business as" papers with | | | | not well served by being a C corporation. That said, |
| your state or local government. | | | | there are very limited circumstances where a C |
| For income tax purposes, there are no separate forms | | | | corporation can be used by a small business owner in |
| to file for the business. You simply attach Schedule C | | | | order to gain certain tax advantages. Check with your |
| to your Form 1040. Schedule C is where you | | | | tax advisor. |
| summarize your business revenues and expenses. | | | | S Corporation |
| You pay tax on any profit at the regular individual tax | | | | Subchapter S of the Internal Revenue Code was |
| rates. If you have a loss, you can usually deduct the | | | | created and reworked by Congress late in in the 20th |
| loss against your other income. | | | | Century in order to allow small business owners to |
| In addition to income tax, you must pay self | | | | incorporate without being subject to double taxation. |
| employment tax on your business profit. The self | | | | Thus, the "S corporation" was born, and has been the |
| employment tax rate is 15.3% on the first $94,200 (for | | | | preferred tax structure for small businesses ever since |
| 2006) of profit, and 2.9% on any amount over $94,200. | | | | (but see the section on LLCs below). |
| The tax is designed to replace the social security and | | | | With an S corporation, the corporation files a Form |
| medicare taxes you and your employer pay when you | | | | 1120S with the IRS, but the corporation does not pay |
| have a regular job. Since you're both "employer" and | | | | income tax (with a few rare exceptions). Rather, each |
| "employee," you pay twice as much as you would if | | | | owner pays tax on her share of the corporation's |
| you worked for someone else. | | | | profits, much like a partner in a partnership. The |
| The biggest pitfall of being a sole proprietor is your | | | | difference here of course, is that since it is a |
| legal liability. If someone is injured, whether physically, | | | | corporation under state law, there are none of the |
| financially, emotionally, etc. as a result of your business | | | | legal liability problems associated with partnerships. And |
| activities, you can be sued personally. In today's litigious | | | | since the corporation does not pay income tax, there |
| environment where people are sued at the drop of a | | | | is no double taxation as there is with a C corporation. |
| hat, this is a risk no serious business owner should take | | | | In effect, it allows a corporation to be taxed like a |
| lightly. While insurance may offer some protection, you | | | | partnership. |
| still run the risk of losing your personal assets, and/or | | | | Unlike a partnership, if handled properly, you do not pay |
| of having to file bankruptcy, due to a lawsuit. | | | | self employment taxes on the profits of the S |
| While this form of business may be fine for some | | | | corporation. Instead, you are paid a salary, and the |
| part-time or "sideline" businesses, most small business | | | | applicable social security, medicare and other payroll |
| owners should choose a different option. | | | | taxes are paid accordingly. Any dividends in excess of |
| Partnership | | | | your salary are not subject to payroll or self |
| When you co-own a business with one or more other | | | | employment taxes. So if you have a low salary and |
| people and don't choose one of the other business | | | | high dividends, you save 15.3% in taxes on the dividend |
| types, you are automatically a partnership. (Technically, | | | | portion. Of course the IRS knows this, and they require |
| a "general partnership.") While a sole proprietorship is | | | | you to pay yourself a "reasonable" salary. How much |
| low on the list of desirable business structures for a | | | | salary you should pay yourself vs. dividend distributions |
| small business, a partnership is even lower. | | | | is a much debated topic between taxpayers and the |
| Like a sole proprietorship, you can be sued personally | | | | IRS, and also offers many opportunities for tax |
| for any harm you cause as a result of your business | | | | planning. |
| activities. Even worse, you can be sued for any harm | | | | Not every corporation is qualified to be an S |
| caused by your partner! Not only that, if your partner | | | | corporation, though most small businesses qualify. |
| signs a contract or takes out a loan on behalf of the | | | | There are restrictions on such things as the number of |
| business, you are automatically bound by the terms of | | | | stockholders and what type of entities can be |
| that contract, whether you agree with it or not. This is | | | | stockholders. The basic purpose of the rules is to |
| scary stuff, and I simply never recommend this | | | | prevent large, publicly traded companies from |
| structure. This is an example where "doing nothing" can | | | | qualifying, and to prevent various tax avoidance |
| be a big mistake. | | | | schemes using trusts and foreign entities. |
| Income tax wise, a partnership must file a Form 1065, | | | | A corporation must elect S status no later than the |
| U.S. Return of Partnership Income, to report its | | | | 15th day of the third month of the year in which it |
| revenues and expenses. The partnership itself does | | | | wishes to be treated as an S corporation. For |
| not pay income taxes. Rather, each partner reports his | | | | example, for a calendar year business, a corporation |
| share of the profit or loss from the business on his | | | | must make the election by March 15, 2008 in order to |
| individual tax return. As with a sole proprietorship, an | | | | be treated as an S corporation for 2008. You make |
| active partner must pay the 15.3% self employment | | | | the election by filing Form 2553, which must be |
| tax on his first $94,200 (for 2006) of the partnership | | | | approved by the IRS in order for it be effective. |
| income, and 2.9% on any amount above that. | | | | Overall, the S corporation is an excellent structure for |
| There is a different kind of partnership, called a Limited | | | | most small businesses. |
| Partnership, that restricts the liability of certain "passive" | | | | Limited Liability Company (LLC) |
| partners, called limited partners. This is used primarily in | | | | The newest of the business structures is the limited |
| real estate syndications and is outside the scope of | | | | liability company or LLC. The LLC affords much the |
| this article. | | | | same protection against lawsuits as the corporation, |
| The bottom line on partnerships: Stay away from | | | | without most of the somewhat burdensome |
| them. | | | | paperwork and recordkeeping requirements, such as |
| Corporation | | | | stock certificates, board of directors meetings, board |
| A corporation is a separate legal entity, or legal | | | | minutes, etc. In addition, the LLC is very flexible from a |
| "person" if you will, formed by filing certain documents | | | | tax standpoint, allowing you the choice to be taxed as |
| with a state government. Most big companies you're | | | | either a C corporation, an S corporation, a sole |
| familiar with are corporations, and will usually have the | | | | proprietorship (for businesses with one owner) or a |
| word "corporation" or "Inc." in their business name. | | | | partnership (two or more owners). |
| Corporations have several advantages, including the | | | | Each state has its own rules for who can form an |
| ability to raise money by selling stock, and the fact that | | | | LLC, but most states now allow an LLC to have just |
| each owner's, or stockholder's, risk is limited to their | | | | one owner (that wasn't always the case). Most small |
| investment in the company. A corporation can have | | | | businesses will qualify. Forming an LLC is usually quite |
| one owner, or millions of owners, or any number in | | | | simple and relatively inexpensive, and can often be |
| between. | | | | done right over the internet. |
| As mentioned above, your risk in case of a lawsuit is | | | | For tax purposes, an LLC with one owner will be |
| generally limited to the amount of money you have | | | | taxed as a sole proprietorship, unless the owner |
| invested in the corporation. There are important | | | | makes an election to be taxed as a corporation (C or |
| exceptions to this general rule, a few of which are | | | | S). An LLC with multiple owners will automatically be |
| worth mentioning. First, if you are in one of the classic | | | | taxed as a partnership, unless the LLC chooses to be |
| professions, usually including doctors, lawyers, | | | | taxed as a corporation (C or S). Do you see the |
| accountants, and engineers among others, you cannot | | | | beauty of this structure? You get liability protection akin |
| escape personal liability for your professional activities. | | | | to a corporation, but you don't have all the nit picky |
| In other words, if you're a doctor and you amputate | | | | paperwork to do and the "corporate book" to maintain. |
| the wrong leg on a patient, you can still be sued | | | | At the same time, you get to choose how you're |
| personally. On the other hand, if a patient trips over a | | | | treated for tax purposes! That's enough to make a |
| chair in your waiting room and breaks their leg, the | | | | tax accountant's heart flutter! |
| normal corporate protection would apply. | | | | As you can probably tell, I really like the LLC structure. |
| A second exception has to do with how you operate | | | | My own business, Thomas Norton & Company, |
| your business, and how you present yourself to the | | | | LLC, is obviously structured this way. I have also |
| outside world. When you form and run a corporation, | | | | elected to be taxed as an S corporation, since it gives |
| you are obligated to make sure everyone you deal | | | | me certain advantages in my circumstances. It should |
| with knows they're dealing with a corporation. So, for | | | | be noted that you can start an LLC and be taxed as |
| example, you would want to make sure you included | | | | a sole proprietorship at first, and elect to be treated as |
| your full corporate name on all letterhead, business | | | | an S corporation at some future date. |
| cards, advertising etc. You don't want anyone to be | | | | Though the S corporation still rules the roost among |
| able to say they thought they were dealing with you | | | | small businesses, the LLC is fast making inroads as |
| as an individual and not your corporation. | | | | more and more business owners discover its simplicity, |
| Another liability exception has to do with | | | | flexibility and effectiveness. |
| recordkeeping. This is where many small business | | | | Which Structure is Best for You? |
| owners get themselves in trouble. A corporation must | | | | Since your circumstances might be different, you |
| maintain books and records separate from that of its | | | | should consult a qualified tax advisor before making |
| owners. Also, by definition a corporation issues stock | | | | this important decision. That said, most small |
| and has a board of directors. That board of directors | | | | businesses are and should be structured as either an |
| must have a meeting at least once per year, and | | | | S corporation or an LLC. Whether your LLC should be |
| formal minutes must be kept. Any significant activities | | | | taxed as a sole proprietorship, partnership, C |
| of the corporation, such as taking out a loan, usually | | | | corporation or S corporation is very situation |
| require approval by the board. Now the reality is that in | | | | dependent, so ask that tax advisor what he or she |
| a small business you may be the owner and only | | | | thinks. |
| member of the board of directors. But you still have to | | | | No matter what form of business you choose, make |
| keep up the formalities required by your state, and the | | | | sure it is a conscious choice, made after carefully |
| state where you incorporated (if different). If you don't, | | | | considering the legal and tax ramifications involved. |
| a good attorney might argue that you should be able | | | | While it may seem mundane, it is one of the most |
| to be sued personally, thereby "piercing the corporate | | | | important business choices you will ever make. |
| veil" and leaving your personal assets exposed. An | | | | |