Business Legal StructureNow that we have a business idea that has passed the tests in “How to Test Your Small Business Idea Part 1 & Part 2”, it is time to decide upon what type of business legal structure is best.  What is best depends upon many variables including tax implications, liabilities and ownership.  Review the options below to better understand their purpose.  While these are specific to Texas, they are very similar to all states.  The descriptions below are a very high level summary.  For a complete description, go to www.texaswideopenforbusiness.com for more comprehensive descriptions. I highly recommend that you consult experts in taxes, accounting and legal before making your decision.

DISCLAIMER

LLC VS CORP SIGN POSTThis information is at a very high level.  Description of tax implications is a simplistic overview and not intended to be comprehensive.  Tax references are limited to federal income tax.  Sales tax, franchise taxes, and other taxes are not discussed in this article.

 

 

SOLE PROPRIETORSHIP

When to use: If you are just starting up a very small company with no outside funding and the risks of liability are very low.  Your personal assets are not protected from creditors or lawsuits (damages).

Restrictions:

  • One individual owns the business
  • Owner is personally liable for all debts and risks (damages)
  • Limited to the life of the owner
  • Non-transferable

Description:

This is the simplest way to start a business.  It is often used when first starting a very small business with low liability risk and the owner wants to keep things simple and inexpensive.  These are often operated under the name of the owner.  If a different name is used, you must file for an “Assumed Name Certificate” with the county clerk of the county in which the business will operate.

Federal taxes are filed on the owner’s personal return (form 1040 – Schedule C).

GENERAL PARTNERSHIP

When to use: Very similar reasons to a Sole Proprietorship except there are 2 or more individuals who own the company.

Restrictions:

  • Partners are personally liable for all debts and risks (damages)
  • An Employer Identification Number (EIN) must be obtained
  • Assumed Name Certificate must be filed with the county clerk

Description:

This option is used when two or more individuals want to start a very small business with low liability risk and they want to keep things simple and inexpensive.  Partners usually share equally in assets and liabilities unless stated otherwise in a partnership agreement. Creditors and lawsuits may go after personal assets and if one partner does not have the financial resources, the other partners may be liable for the entire debt.

Federal taxes are filed on each partner’s profits and losses per the equal split or the partnership agreement and are filed on their personal return (form 1040 – Schedule C).  The Partnership must file a form 1065 annually as a checks and balance for the IRS to ensure all profits are being reported.  General partners must also pay a self-employment tax.

LIMITED LIABILITY COMPANY

When to use: When owner(s) want to limit liability to personal assets and there are no tax incentives to establish a corporation.

Restrictions:

  • Certificate of Formation with a unique company name must be filed with Secretary of State

 Description:

This option limits personal liability to money and assets put into the company.  It is also advisable to purchase business insurance to further protect your business assets.  Owners of an LLC are called “members”.  Members are governed by an Operating Agreement.  This is a legal document internal to the company that defines the member ownership of assets, allocation of profits and losses, and the responsibilities and authorities of the members.  Find a unique name and register your LLC through the Secretary of State’s office. An Employer Identification Number (EIN) is not required for a single-member LLC.  If you hire employees or have multiple members, the IRS requires you to obtain an EIN.

Federal taxes depend upon several factors.  If there is a single LLC member (owner), taxes are the same as a Sole Proprietorship with business income reported in Schedule C of your 1040 form. Similarly, multiple members report income consistent with their percentage of the profits and losses.  Note that even if the profits are reinvested in the business (retained earnings), those profits must still be reported by the members on their respective returns.  The LLC must file a form 1065 annually as a checks and balance for the IRS to ensure all profits are being reported.  There are ways to optimize taxes and you should consult your tax advisor / accountant for guidance.

LIMITED PARTNERSHIP

When to use: When there are multiple owners of the business with some playing an active role in the business and others are simply investors.

Restrictions:

  • Certificate of Formation with a unique company name must be filed with Secretary of State
  • An Employer Identification Number (EIN) must be obtained

Description:

A limited partnership is a more formal partnership and generally has general partners and limited partners.  General partners’ role is as the name implies the same as in a General Partnership.  They have the most responsibility, often manage the business and have a share of the assets, profits and debts.  Limited partners are generally investors in the business and therefore have less involvement in the management of the business and have less liability with respect to debt.  Their exposure is typically limited to their investment.  Distribution of profits is typically allocated based upon the initial capital investment by each partner.

Federal taxes are similar to a general partnership except that limited partners generally don’t have to pay self-employment taxes.

S CORPORATION (S Corp)

When to use: When it is advantageous to issue stock to multiple shareholders with freedom to transfer shares and when there is a tax advantage for higher profits. S-Corps are often used by start-up companies to allow losses to be passed-through to individual tax returns.

Restrictions:

  • No more than 100 shareholders (owners)
  • Owners must be US citizens/residents
  • Cannot be owned by C Corps or trusts
  • The corporation can have only one class of stock
  • The corporation must be registered with the Secretary of State

 

Description:

S Corps are more formal that LLCs or Limited Partnerships and require considerable effort to adhere to strict government requirements.  Some of these requirements include adopting bylaws (including responsibilities and authorities of management), issuing stock to shareholders, holding annual director and shareholder meetings, and keeping meeting minutes within corporate records.

Responsibilities at a high level include shareholders who own portions of the company and elect directors, directors who oversee strategic direction and elect officers, and officers who operate and manage the day-to-day business.

Federal taxes for S-Corps, like LLCs and Limited Partnerships are pass-through entities with profits and losses distributed to the shareholders in proportion to the shareholder’s interest.  Owners of Subchapter S Corporations may deduct business losses on personal income tax returns, similar to a partnership. There may be favorable tax treatment in cases of higher profits.  For example, once employees have been paid “reasonable” salaries, additional profits can be paid to shareholders in the form of dividends which can have a more favorable tax treatment.  S-Corps file a form 1120-S which is a simplified version of the form 1120 required by C-Corps.

C CORPORATION (C Corp)

When to use: When the company is likely to retain earnings and it is desirable to have the company bear or share the burden of income taxes vs the owners (see below for more details).

Restrictions / Differences from S-Corp:

  • Unlimited shareholders, however once the company has $10 million in assets and 500 shareholders, it is required to register with the SEC
  • Foreign nationals have a right to own or invest in a C corporation
  • The owner (majority shareholder) of a C corporation has the option of issuing different “classes” of stocks to different shareholders with different voting privileges (e.g., common and preferred stock)
  • The corporation must be registered with the Secretary of State

Description:

C Corps, like S-Corps are more formal that LLCs or Limited Partnerships and require considerable effort to adhere to strict government requirements that are similar to those for S-Corps.  This will result in considerably more effort and cost for legal and accounting.  A C-Corp is treated as a legal person under law; thus, it can own property, enter into contracts, and sue or be sued.  The corporation may sell an unlimited number of shares of the corporation to raise funds for purposes such as operations, expansion and research.  The directors will limit the sale of shares to prevent their value from being diluted.  Most advantages for becoming a C-Corp are for tax advantages (see below).

As with S Corps, responsibilities at a high level include shareholders who own portions of the company and elect directors, directors who oversee strategic direction and elect officers, and officers who operate and manage the day-to-day business.

Federal taxes, unlike LLCs, Limited Partnerships, and S-Corps are not pass-through for C-Corps.  C-Corps are subject to double taxation because the corporation pays taxes on profits and shareholders are taxed on dividends which are not a deduction for the corporation.  Many corporations minimize this by using “income splitting” to pay out some profits to employees in the form of bonuses and fringe benefits before dividends are distributed.  Corporations pay a graduated income tax rate that is different from individuals with rates currently up to 39%.  Here are the 2015 tax rates for corporations:

Taxable income over            Not over      Tax rate

 

$         0                  $    50,000        15%

50,000                          75,000        25%

75,000                        100,000        34%

100,000                      335,000        39%

335,000                 10,000,000        34%

10,000,000            15,000,000        35%

15,000,000            18,333,333        38%

18,333,333                  ……….        35%

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drgilli

Dan Gillingham is a retired executive, business owner and is currently volunteering as a small business counselor and mentor with SCORE

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