Small Business Taxes & ManagementTM--Copyright 2008, A/N Group, Inc.
Many articles have been written about choosing the best type of business entity. They generally go through the pros and cons of each, but usually without much thought to the practical issues many small business owners encounter. This article deals with the practical aspects. Before deciding you might want to check all the pros and cons. While the discussions below apply to most states, there can be differences, so check the rules in your home state.
Pros. This is generally the cheapest way to do business. There are generally no fees to start the business. You may not even have to get a federal ID number. You will have to register to collect sales tax and you may need a state, county or town license (e.g., restaurant license, plumber's license, etc.). But that's true for any business. If the business doesn't succeed, dissolving it is easy. Except for turning in your sales tax authority, you generally don't have to file anything when stopping the business (assuming you don't have employees).
Tax filing is also easy. You'll file a Schedule C with your regular individual income tax (Form 1040). You don't need a balance sheet, reducing time and cost, and the difficulty of completing Schedule C will depend mostly on the complexity of your business.
If you want to change the way you're doing business, it's easy to incorporate a sole proprietorship or change to a partnership or LLC. You can usually avoid any tax consequences on switching. (But see below.)
Cons. You and the business are one and the same. If you buy a truck, you'll title it in your name, not the business, since there is no separate business. That's good, since if things don't work out you won't have to retitle the truck if you're going to use it personally. The downside, of course, is that you're not insulated from liability. If you're sued, you're personally liable and a creditor can attach your personal assets.
While this sounds like a deal breaker, the amount of concern will depend on several factors. First, most lenders, lessors, etc. advancing any substantial amount of credit to a small corporation, LLC, etc. will require the principals to guarantee the loan, lease, etc. That means you'll be personally liable, even if you do business as a corporation or LLC. Trade creditors usually don't require such a guarantee. Second, if you're the only employee, the businesses may get little protection from the limited liability of a corporation or LLC. More than likely you'll be sued personally if a customer or third party is injured. For example, you're a plumber doing business as Madison Inc. You leave your torch on at a job and someone in the house is injured. The injured party may sue Madison, but you're ultimately responsible since you caused the injury. An attorney will most likely bring suit against Madison and you. On the other hand, if your employee is to blame, a corporation or LLC can provide at least some protection. Thus, if you have employees that deal with customers, drive for your business (even if only to the store for supplies), etc.
The extra protection of a corporation or LLC is cheap insurance, if it's needed and can be used. This is definitely a issue to discuss with your attorney. The consideration should increase if you have employees, are in a risky business, deal with the public regularly, use vehicles in the business, etc.
The case for a corporation becomes stronger if you're doing business under an assumed name. For example, instead of operating as Fred Flood, Plumber, Fred operates his sole proprietorship under a DBA, No Leak Plumbing. In most states Fred will have to register the name in every county in which he intends to do business. That can be a nuisance, and, in some cases expensive. Corporations automatically avoid the problem.
Clearly, you can't take on other investors. A sole proprietorship is, by definition, a one-man show. That can also make raising additional equity capital difficult.
Sole proprietors don't take a salary. All the income and losses are automatically taxable to you personally. Generally, all the income is subject to the self-employment tax, up to the maximum Social Security base ($102,000; indexed for inflation; go to www.smbiz.com/sbrl001.html for annual updates). The tax rate is 15.3%, but half of the tax is deductible on your individual return. (The actual computations are more complicated.)
Pros. An S corporation is a regular corporation that has elected special tax treatment for federal and, usually, state purposes. You get the protection of a corporation and ease of setup. Filing corporation papers with your home state has always been relatively easy. Today that's even more true. Filing fees typically run $100 to $200; getting an attorney or service to do the filing can easily bring the total over $500. But that's a one-time fee and not a big expenditure if you're serious about the business.
While there are other tax implications, the major difference between an S and a regular corporation is that the S corporation doesn't pay taxes. Instead, the profits and losses are passed through to the shareholders and included on their personal returns. (Some states do not recognize S corporations; they're taxed as regular corporations.)
Corporations are recognized on an equal footing in all the states. That makes doing business in another state is as easy as filing as a "foreign" corporation and paying a one-time and/or annual fee. (Caution. If your corporation's name is already in use in the other state, you could have a problem.)
It's important to note that corporation law has a long history, making most legal issues clearer. The organization, accounting, etc. structure of a corporation is simple. The status of shareholders is clear. Taking on new shareholders is easy. They give you a check (or contribute property) and you give them a stock certificate. Getting rid of shareholders is just the reverse. A shareholder's interest is clear from the number of shares he owes and the number outstanding.
Small corporations, including S corporations, can take advantage of Code Section 1244 which allows you to take up to a $100,000 (per shareholder) ordinary loss on a sale, exchange or worthless corporate stock. That amount can be used to offset ordinary income. Losses in other entities would generally be capital losses which can only be used to offset capital gains or used to offset no more than $3,000 of ordinary income per year.
Cons. A corporation is a separate entity. That means assets such as vehicles, buildings, equipment, etc. have to be titled in the corporate name. And the finances are very separate from the individual shareholders. For example, if the corporation needs $1500 to buy equipment the only way the shareholders can put the money in the corporation is by issuing stock or making a formal loan to the corporation.
You can't get very creative with a corporation. The structure is fairly rigid. That's particularly true of S corporations which can't even issue preferred stock. That can limit your ability to provide sweetners to some shareholders.
Shareholders can lose the protection of a corporation if the "corporate veil is pierced". That can happen if the corporation fails to act as a corporation. For example, you may be the president and sole shareholder, but when you're transacting business you'll have to use the corporate name with an Inc. (or Incorporated, or LLC for a limited liability company, etc.). You'll have to sign as "Fred Flood, President". Failure to give notice to the other party that you're doing business as a corporation can destroy your protection. So can dealing with your corporation at less than arms' length. For example, paying personal expenses out of the corporation, using business assets for personal purposes, co-mingling funds, etc. There can be other issues. Discuss them with your attorney.
Since corporations exist as separate legal entities, they must file their own tax returns. Even the simplest is four pages. Complex returns can be much more involved. While you may be able to prepare the return yourself, professional help is definitely recommended. While no tax is usually due with your federal return, most states have a minimum fee. That can be from under $100 to $500 or more.
Dissolving the business is a formal process with the IRS and state of incorporation. There are state filing fees and you'll most likely need an attorney and possibly an accountant to help you through the process. The filing fees are generally small, but professional fees can add up quickly. In addition, even though minimized, there are often tax consequences. While switching to a regular corporation is easy, switching to an LLC means dissolving the corporation.
There are certain restrictions on share ownership. For example, shareholders must be natural persons (e.g., not a corporation), there can be no more than 100 shareholders, shareholders must be citizens or resident aliens, etc. Most small business owners are unlikely to be concerned. However, you should review the requirements with your tax advisor before committing.
Limited Liability Companies (LLCs)
Pros. LLCs are still fairly new on the scene. They provide the limited liability of a corporation, with a capital structure that is more like a partnership. For tax purposes they are generally treated as a partnership (or sole proprietorship if there is only one member). The income and losses of a partnership are, like an S corporation, not taxed at the partnership level, but passed through and reported by the partners.
If there is only one member (owner), for federal purposes, the LLC files a Schedule C with the member's individual tax return. Most states follow the same rule. That makes tax filing as easy as that for a sole proprietorship. An LLC is a good choice for a small business that has only one owner (and is not likely to have additional owners) but wants the protection of a corporation.
Switching from a sole proprietorship to an LLC or from an LLC to a corporation is generally easy.
Multi-member LLCs have many of the same advantages as a partnership. That is, members' profit and loss and capital interests can be negotiated, and are not fixed as in a corporation. For example, Fred and Sue decide to form an LLC. For various reasons they agree that Fred will get 70% of the profits or losses, but only 40% of the capital in a liquidation.
Cons. LLCs are separate legal entities. Thus, you have to title assets in the LLC, not in the owner's name. That's the same disadvantage a corporation has.
The structure of an LLC is much more flexible than that of a corporation. Thus, multi-member LLCs need an operating agreement. For most small LLCs that's likely to be a off-the-shelf agreement available on line or through a legal forms supplier. However, if you decide to take advantage of the flexibility of LLC, you'll probably need an attorney.
You'll have to file a partnership return every year. Generally, it's about as involved as an S corporation return. However, the complexity can quickly increase if there are special allocations among members, special provisions in the operating agreement, etc. In many cases you'll need professional help.
Unlike an S corporation, but similar to a sole proprietorship, you take no salary. A member's share of the income is subject to the self-employment tax.
While LLCs are recognized in all 50 states, the rules governing LLCs can be different from state to state. In addition, you may have to register the LLC locally. Check the rules in your state.
While the income is taxed to the members, there is usually a filing fee with the state. That can vary substantially.
Taking in new members and handling resigning members can be much more complicated than for an S or regular corporation. How complex will depend on a number of factors, but in many cases you'll need help from your accountant.
Because LLCs have many of the advantages of partnerships without the disadvantages of unlimited liability, they generally are no longer an attractive alternative for most small businesses. However, for certain tax reasons they can be good choices for owning property held for investment or for rent, uncomplicated businesses where liability is not an issue, etc.
A C (regular) corporation is subject to its own tax. When the profits are passed through to the shareholders as dividends, they're subject to tax again. This double taxation generally makes it a poor choice. One of the few advantages is the corporation is subject to its own graduated tax rate. Thus, the first $50,000 of income is taxed at only 15%. The next $25,000 is taxed at 25%; the next $25,000 at 34%. Work through the numbers with your tax advisor to see if this could be advantageous.
Sometimes the choice is obvious. For example, you've got a part-time business repairing computers. You have no employees and are unlikely to have any for at least a couple of years. Operating as a sole proprietorship generally makes sense, at least for the time being.
Other times it is not so clear. If that's the case, we strongly suggest talking to your tax advisor, accountant, or attorney. An hour with a professional can save you time and expense later.
Copyright 2008 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 08/21/08