Entity Choices - To Be a Corp or Not to Be

Purchasing or opening a new business is a huge undertaking. Choosing how to set up the company is not an easy task and many factors can affect this decision. How a business entity is set up will affect how a business is taxed, the extent of liability its owners must bear, the number of partners or stockholders that can share in the ownership, and the capital structure of the organization. This article will attempt to explain some of the factors that must be considered and explain the basic entities you can choose from and their general characteristics.

I am starting a new business. What type of business entity should I choose?

That is an excellent question. There are many options to choose from ranging from a Sole-Proprietorship to a Corporation. Depending on your situation, any can work for you, but there is probably one that will do a better job for you than the others. Knowing which to choose involves understanding how each entity is set up and how it works.

What are the different types of entities that I can choose from?

Historically there have been three types of basic entity choices: Sole-Proprietorship; Partnership; or a C-Corporation. More recently the S-Corporation was added to alleviate some of the liability that owners incur with the sole-proprietorship or partnership forms, yet keep a single tax in most instances. The S-Corporations keep the ownership within a more defined group of investors than for most C-Corporations. Even newer to the scene in most states is the Limited Liability Company, or LLC (and its relative, the LLP) which allow protection to the owners from liability while allowing taxation as a sole proprietorship or partnership.

What is a Sole Proprietorship and why would I want to use this form of entity?

You only need to be in business attempting to make a profit to be considered a sole proprietor. This makes it one of the easiest entity choices to set up and maintain. There can be only one owner and all risk of loss and liability falls upon you, the owner. Income and expenses are reported directly on your personal tax return on Schedule C and you are responsible for self-employment tax on any earnings over four hundred dollars.

Can you explain how a partnership works and what I have to do to set one up?

A partnership is a group of two or more owners who have established a partnership agreement that lays out how each partner will share in the income and expenses that are generated from doing business each fiscal year. Although also very easy to establish, a partnership should have an agreement in writing signed by you and all of your partners which delineates how profits, expenses and liabilities and managerial responsibilities for the partnership are to be shared. You should consult a legal and income tax expert when formulating a partnership agreement. If you do not have a written partnership agreement, the state you are in has one for you and you may or may not agree with the tax treatment or other provisions you are subject to.

Liability exposure falls upon general partners for all partnership obligations. Limited partners are only liable up to a dollar amount equal to their capital contributions. Taxation is at the partner level, with each partner being taxed on his/her individual share of the partnership income or loss. The partnership files a Form 1065, Partnership's Return of Income and Expenses, and a K-1 is given to each partner showing each one's individual share. Each partner then claims this income or loss on their personal return and are subject to self employment tax on the earnings.

Some one told me to set up my new company as a corporation. I was told that there are two kinds of corporations. Can you explain a little about each to me?

Yes, legally all corporations are the same but there are two kinds of corporations that are very different in their tax characteristics. For all corporations, incorporation papers must be filed with the state you are incorporating in. Shareholders of all Corporations are liable only for their capital contributions and are not personally liable for the obligations of the Corporation unless personal guarantees are given or the individual has personal liability. You must make an election with the Internal Revenue Service to be treated as an S-Corporation. S-Corporations are limited to only 75 shareholders and one class of stock. S-Corporations report their income and expenses on Form 1120S. Shareholders receive a K-1 and report their proportionate share on individual tax returns. There is no self- employment tax on the income from an S-Corporation, only on wages received from an S-Corporation which are reported on a W-2. Losses from an S-Corporation can be used by a shareholder only with sufficient basis.

C-Corporations (more commonly known as Corporations) have no limit on the number of shareholders. C-Corporations have the disadvantage of double taxation. They report their earnings on Form 1120 paying any corporate tax due from within the corporation. The earnings are taxed a second time when they are distributed to the shareholders as dividends. These dividends are reported on shareholders' individual income tax returns. No deduction is allowed to the C-Corporation for these distributions to the shareholders.

Isn't there a way I can have the best of both worlds? Is there any way I can have the limited liability without the entity level taxation?

Yes, the S-Corporation does this for you and a relatively new type of entity called the Limited Liability Company, or LLC. LLC's can be taxed as a partnership, a sole proprietorship, (or a corporation) depending on how the structure is set up and whether you make an election (see below). Owners of an LLC are referred to as members. LLC tax reporting is usually done on Form 1065 or on the individual owner's personal return. When an LLC borrows money, the member's basis (or ownership interest) increases unlike S-Corporation borrowing, which does not increase a shareholder's ownership basis. However, the at-risk rules or the passive loss rules may limit a member's ability to use losses.

How many owners must an LLC have? I was told you need 2 owners to have an LLC.

This was the case when LLC's first started. But new rules in most states allow a single owner LLC. Also, there is no limit to the number of owners an LLC may have, unlike an S-Corporation which is limited to 75 shareholders.

How do I set up an LLC?

LLC's must register with the state and should have a written operating agreement, just as Corporations should have By-Laws.

How will my LLC be taxed?

This all depends on the number of members, or owners, you have. An entity with two or more members will be taxed either as a partnership or can be classified as an association taxed as a corporation. An entity with only one member will be disregarded as an entity separate from its owner or can be classified as an association taxed as a corporation. A single member LLC cannot elect partnership status. The default classification for entities existing before January 1, 1997, is the classification the entity claimed when filing their income taxes immediately prior to that date. For new entities that do not file an election, an entity with two or more members is classified as a partnership, and an entity with only one member is ignored and is treated as a sole proprietor for tax purposes.

How can I ensure the tax treatment of my LLC?

You can elect your entity's tax classification on Form 8832. This is more commonly referred to as the "check the box rule" for entity classification. On Form 8832 you check the appropriate boxes for your entity's specific wishes, then mail the form to the IRS. You must also attach a copy of the form to your Federal income tax return for the first tax year of the election.

A useful guide for comparing the various classifications of entities is available by clicking on "Entity Comparison Chart" at the end of this paragraph.  It will give you a quick summary of the various characteristics of each of the choices available for organizing your business.

Entity Comparison Chart

An article entitled "Start-up Write-offs Help New Business"  would be valuable reading for anyone going into business. Access this article by clicking the following link. Start-up Write-offs Help New Business

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