A Sole Proprietorship is a one-person business. There is no paperwork to fill out to accomplish this. The profit or loss from the business is carried to the personal tax return of Sole Proprietor. The Sole Proprietor is liable for all debts and other liabilities of the company.
A Fictitious Name Registration (DBA = doing business as) is required in most states. You must file your fictitious name registration before starting the operation of your business. In some cases, it must be filed within 30-40 days of your first business transaction. In addition, several states require that you publish your DBA statement in a local newspaper, and then file proof of publication with the proper government office. The purpose of the publication requirement is to ensure the public is informed of new businesses in the area, their legal name and ownership.
A Partnership has two or more people involved. The profit or loss is divided between the partners and carries to their personal tax returns. Each partner is personally liable for the debts or other liabilities of the company.
A Corporation is a separate and distinct legal entity. That means that a Corporation can open a bank account, own property, and do business all under its own name. Corporations are managed by a Board of Directors which is responsible for making major business decisions and overseeing the general affairs of the Corporation. Directors are elected by the Shareholders of the Corporation. Officers who run the day to day operations of the Corporation are appointed by the Directors.
The main advantage of the Corporation is that its owners, known as Stockholders or Shareholders, are not personally liable for any of the debts or liabilities of the Corporation. For example, if a Corporation gets sued or it is forced into bankruptcy, in most cases, the owners will not be required to pay the debt with their own money if the assets of the corporation are not enough to cover the debts. The creditor cannot, in most circumstances, go after the Shareholders, Directors or Officers of the Corporation to recover any loss.
Investors in business often risked everything they had if the new business turned bad. When the company was out of money and didn’t have the cash to pay creditors, the investors had to make up the difference with their own money. With the advent of the Corporation, investors could avoid this type of liability by forming a Corporation and as a result more people are more willing to invest their money in business ventures. The formation of Corporation as a business entity can help reduce your taxes but more importantly you can provide for peace of mind by protecting your personal assets.
There are two types of Corporation. The IRS allows for a Corporation to be taxed either as a C Corporation or as an S Corporation.
A C corporation’s profits are taxed at two levels which is commonly referred to as double taxation. A C Corporation pays the corporate tax on its corporate income then the C Corporation distributes profits as dividends to shareholders who pay income tax on those dividends.
The way to avoid the double taxation of a C corporation is to make a special election with the IRS to be taxed as an S Corporation. This means that your income will be taxed like a partnership or sole proprietor. That way there’s only one level of taxation. Corporate profits and losses are passed through to the owners who pay the taxes on the profits at the individual personal tax rates instead. You can use income shifting to take advantage of lower tax brackets
Let’s look at an example:
For purposes of this example we will assume that ABC Company is a sole proprietorship and has an income of $100,000. As a sole proprietorship the tax rate is 25%. If it were ABC Corporation instead, let’s assume business owner takes $50,000 in salary and leaves $50,000 for profit. The federal corporate tax rate would be (15% of $50,000) The personal tax rate is at (15% of $50,000) as well. This is a distinct advantage of forming a Corporation.
Corporations can provide employee benefit packages for your employees. You can lease assets to your Corporation. The business pays a lease fee and can claim rental income and expenses including interest, depreciation, repairs, maintenance, insurance and administrative costs.
In a Corporation there are no restrictions on the amount of capital or the operating losses that a Corporation may carry back or forward to subsequent tax years. A sole proprietor can’t claim a capital loss greater than $3,000 unless he or she is offsetting capital gains.
The money the sole proprietor earns is subject to self-employment taxes. The taxes are currently 13.3% on the first $106,800 of income. In a Corporation only salaries are subject to such taxes, profits are not. This can save you thousands of dollars a year.
Let’s look at another example:
If a sole proprietor earns $80,000; 13.3% tax would have to be paid on the entire $80,000. Let’s assume that the Corporation also earns $80,000 but $35,000 of that amount is paid in salary. $45,000 is deemed his profit in this case his self-employment tax would not be paid on the $45,000 profit. This saves you over $5,000 per year. It’s important to note that you should pay yourself a reasonable salary and take advantage of all the tax benefits that a Corporation offers you. Don’t forget however there are responsibilities of owning a Corporation and the Corporate Book is probably the most important one of them. We will talk about that later on.
There are differences in each business structure and you should choose the one that best meets your business needs. The biggest difference between a Sole Proprietorship, Partnership or DBA and the Corporation is taxation. You want to weigh all of your strengths and weaknesses before you decide which business structure to use. Remember that a Sole Proprietor or Partner in a business is liable for all the costs of operating the business. This means that they are liable for all business debts too.
A S Corporation helps avoid double taxation. This occurs where the corporate profits are taxed and then the dividends are sent to the shareholders and are taxed to the shareholder’s personal tax return as well. The most important thing to remember is that a C Corporation and a S Corporation can shield you from business liabilities. A Sole Proprietor or a Partner in a Partnership are personally responsible for the business debts. In a Corporation the owners are not responsible for most business debts or liabilities if the business fails.
An important issue to discuss is the Corporate Book. It is a 3 ring binder documenting all transactions or meetings carried out by the Corporation. This means everything from opening a bank account to selling property. The Corporate Book is the corporation’s main responsibility. Usually the Secretary or Treasurer of the corporation maintains the Corporate Book. Without documenting the Corporate Book you could possibly lose your status as a Corporation and would be subject to the appropriate tax. This is referred to as piercing the corporate veil.
Under certain circumstances individual shareholders may be liable for corporate debts, for example, if a shareholder personally guarantees a corporate debt then she or he will be liable for that debt if the business fails. If corporate funds are intermingled with personal funds this puts you in a position where the corporate veil can be pierced. Not documenting the Corporate Book can also cause the piercing of the veil. This means the shareholders would be personally liable for all debts and other liabilities of the corporation. There are strict rules and regulations governing corporations and the most important is maintaining the Corporate Book.
For businesses that want to avoid the regulations of a Corporation, the Limited Liability Company was developed. The Limited Liability Company, or LLC, was developed to protect the business owners from personal liability if the business failed. It is a type of business entity that combines the personal liability protection of a Corporation with the tax benefits and simplicity of Partnership.
The LLC has the same tax benefits as a S Corporation with limited liability of the business debts. The owners are called Members. There is no limit on the number of members allowed. LLC’s function similar to partnerships with flexibility and the pass-through of tax on profits to personal tax return of Members.
A Limited Liability Company (LLC) is a type of business ownership that combines several features of corporation and partnership structures. It is not a corporation or a partnership. Owners are called Members not Partners or Shareholders. The number of Members are unlimited and may be individuals, corporations, or other LLC’s.
Members of a LLC have the liability protection of a Corporation. Members cannot be held personally liable for debts unless they have signed a personal guarantee. A LLC exists as a separate entity much like a corporation.
Limited liability companies can select varying forms of distribution of profits. Unlike a common partnership where the split is x/x, the LLC has much more flexibility. The LLC business structure requires no Corporate Book reflecting Minutes or Resolutions and is easier to operate than a Corporation.
All your business losses, profits, and expenses flow through the company to the individual members. You avoid the double taxation of paying corporate tax and individual tax. Corporations can live forever, whereas a LLC is dissolved when a member dies or undergoes bankruptcy. Members with plans to take their company public, or issuing employee shares in the future, may be best served by choosing a corporate business structure.
A sole-proprietorship or partnership will have less paperwork and complexity. A LLC may federally be classified as a sole-proprietorship, partnership, or corporation for tax purposes. Classification can be selected or a default may apply.
Setting up a LLC may not be as simple as a sole-proprietorship, however, the process is much less than a corporation. There are two steps to becoming an LLC. The first is
1. Articles of Organization: If you plan to set up a Limited Liability Company, you will have to file Articles of Organization with the Secretary of State and pay the required fees.
2. Operating Agreement: The Operating Agreement defines your company arrangement such as profit sharing, ownership, responsibilities, and ownership changes. Each state has different rules governing the formation of a Limited Liability Company. Some states will want a publication notice with the local newspaper that a company has been formed.
A LLC is created by individual state statute. The IRS uses tax entity classification, which allows the LLC to be treated as a corporation, partnership, sole proprietor depending on elections made by the LLC and the number of members.
Multi-member LLCs can either be a Partnership or Corporation including S Corporation. To be treated as a Corporation a LLC has to file Form 8832 Entity Classification Election and elect to be taxed as a Corporation. A Multi-Member LLC that does not elect this will be classified under federal law as a partnership and taxed accordingly.
For more information on this or other business structures send us an email at [email protected].