How should you set up your small business?

When you form a small business, you have many options. For starters, you can set up your business as a Sole Proprietorship, C-Corporation, S-Corporation, LLP (Limited Liability Partnership) or an LLC (Limited Liability Company).

How can you narrow down these possibilities? You may want to decide against a C-Corporation, because C-Corps generate two levels of federal income tax. The C-corporation pays one level of tax when it files its federal corporate tax return, form 1120. A second layer of tax occurs when the C-Corporation’s profits are distributed to the shareholders as dividends. Those dividends are reported and taxed on the individual’s federal tax return, form 1040. Together, these two levels of taxes are referred to as “double taxation.” In addition, state taxes also typically apply to both C-corporation profits and distributed dividends. All in all, the tax picture for C-corps is far from ideal for small businesses.

Becoming a sole-proprietor eliminates the double taxation curse. There are no corporate taxes to pay, since no corporate entity exists. In other words, you only pay individual taxes on your net profits, which are typically reported on Federal form 1040, Schedule C. However, as a sole proprietor, you lack the legal protection that corporate status gives you. Simply stated, the owners of corporations enjoy limited liability, but sole proprietors do not. In other words, if you’re a sole-proprietor, your personal assets are at risk if the business is sued - very risky indeed!

That leaves LLCs, LLPs and S-Corporations. LLPs and LLCs are similar in many ways. One key difference is that LLPs must be owned by more than one individual. Remember, the “P” in LLP stands for partnership---by definition a single individual can’t own a partnership. So if you had an LLP with two owners and one dies, serious problems that could even cause the business to close may result.

The remaining choice has now been narrowed. S-Corporation or LLC? Which is more appropriate for your business?

Well, they share one crucial tax attribute in common; they are “pass-through” entities. That means both S-corporations and LLCs allow you to avoid double taxation and operate a business without paying corporate taxes. As with a sole proprietorship, net profits are attributed to the owners and are taxed when you file your individual tax return.

When choosing between an S-Corporation and an LLC you need to consider many things. What may be appropriate under one set of circumstances may not be in another. For example, just because your friend formed an S Corporation doesn’t automatically mean that you should form one as well. Every business is different, and every owner has different needs and expectations.

Overview:  The S Corporation -

Created in 1958, the S Corporation had for many years been the standard form of organization for conducting a small business. S Corporation status provides a way for you to avoid the double taxation (business & personal taxes) imposed upon C Corporations. One advantage of the S Corporation is that income is taxed personally to the shareholders. However, your personal risk remains limited to your investment. In other words, double taxation is avoided and you get the protection of limited liability.

You must choose “S-Status” by filing a special election form. Bear in mind that the “5” status of the Corporation only impacts taxes. Shareholders of S Corporations have all of the same legal protections as those in C Corporations. But as once said by a famous Tax Court judge, “becoming a corporation is like a lobster pot. It’s easy to get into...difficult to get out of.” In other words, once you have established an S Corporation, it would first have to be liquidated if you wanted to change to an LLC.

The Limited Liability Company (LLC) -

LLCs started in 1977 in Wyoming and have quickly become the preferred manner of doing business across the country. By default, LLCs with more than one owner (member) are taxed as Partnerships, while single-member LLCs are taxed as sole proprietorships. As with S corporations, with an LLC you only pay taxes with your personal return. However, if you decide to do business as an LLC, you are not stuck with it. Through special arrangements, an LLC can be set up to become an S Corporation without having to liquidate. There is little risk of triggering a tax by changing from this form of doing business.

Setting Up Shop -

Establishing an S corporation is relatively simple and inexpensive. An attorney, or even you, can form a corporation by completing a series of “boilerplate” documents. These forms require you to complete the following information: who will own the business, the business’s activity, address, and other miscellaneous details. Aside from being registered as an “Inc., Co. or Corp.”, a corporation can also be registered as P.C. (Professional Corporation). This designation is for professionals who choose to operate in corporate form and is popular with doctors, lawyers, and accountants.

An LLC requires a bit more work to get started. Articles of Organization, like a Partnership Agreement, need to be drafted by a lawyer and filed with the state. In addition, business information about the LLC needs to be placed in a published ad to give notice to the public that the company is being started. An LLC can choose to be registered as a P.L.L.C. (Professional Limited Liability Company) when its owners are licensed by the state to engage in a professional practice -- doctors, lawyers, accountants, and so forth.

The Bottom Line -

So which is better, the LLC or the S-Corporation? It depends. LLCs are often preferable when setting up leveraged ventures such as a real estate or investments. They may also be better for businesses that would like to allocate specific items of income and expense to specific owners.

S Corporations may be better when the business is not a service-oriented venture. Non-service S Corporations do not have the obligation to pay out all profits as wages. This allows the shareholders to distribute profits without being subjected to payroll taxes. S Corporations may also utilize rules in the Tax Code (Section 144) which allows increased deductions if the business fails.

The ultimate decision as to which entity is best for you is not an easy one. In addition to the points mentioned here, there are also estate planning, pension & state tax implications as well.

These laws are highly complicated and mistakes can prove extremely costly. We are highly experienced with these issues. Please feel free to consult our office if you have any questions.

Note:

This information was extracted from http://cpawebsite.com