Which Corporate Status Is Right For You?

You are starting a new business, great news.  Of course, there are a million things to think about.  Things seemed so much easier when it was just you and your great idea.  Now there are a million details all clamoring for your attention.  Among those, the one decision that may have the most influence on your success, long term, is your company entity.  So with that in mind you find yourself at the “Commerce Are Us” store.  A tiny bell sounds as you open the door and a short man in a black suit smiles as he says,

“Welcome to Commerce Are Us, how can I be of assistance?”

You stare at the man with a blank look on your face as you shrug your shoulders.

“Ah, well let’s see now, just what type of an enterprise are you planning to build?  How about a nice Sole Proprietorship.  We have those over here on Isle 12.  If you’ll just follow me.”

“Wait, I’m not sure that’s what I want”, you reply.

“Oh, so sorry.  Perhaps something a bit more exotic, say an S-Corporation?  Wait, you look like the adventurous type.  I’ve got just the thing, a sporty little 1120 C Corporation model; it’s there against the wall.”

“An 1120 What?  I don’t even know what you’re talking about!”

“Oh, you’re a newbie.  Well perhaps you’d simply like to look around then.  Be my guest, you’ll find the Sole Proprietorship, Limited Liability Corporations and S-Corporations down Isle 12.  Partnerships and Limited partnerships are along Isle 10 and Non Profit charities are… well in the back.  We don’t make a lot of money on those.”

“Stop”, you cry.  “I don’t know anything about any of that.  Can’t you just tell me what the best option is?”

The clerk gives you an annoyed look as he turns up his nose and in an agitated voice says,

“No, we don’t do that here.  However, we do offer a complimentary research alcove, if you’ll follow me.” 

Under his breath, you hear him mutter,

These freebies are killing me.  Don’t they know I have a family to feed…

Sometimes the world of income taxation and business can seem a lot like our fictitious “Commerce Are Us” example.  To help clear up the confusion we offer a brief look at the pros and cons of the various business entity options available.  Let’s begin with the least complex option.

Sole Proprietorship

The Internal Revenue Service Defines this business classification as:

A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

            IRS Website Definitions

In layman’s terms it means you are striking out on your own, much like the child with the lemonade stand on the corner.  Your profits are yours alone, as are your losses.  It all flows like a river onto your personal 1040 tax return via the Schedule C business form.

Some reasons to choose this business model:

• Easy to setup
• no complicated tax ramifications
• fits well for the small entrepreneur looking to set up shop quickly.
• You have full control of your future
• You have the flexibility of being taxed as a sole proprietor, partnership or an S corporation.
• There are no separate tax forms to fill out (with the exception of a standard Schedule C).
• You don’t have to worry about those pesky financial statements, balance sheets, or income statements because all income and expenses flow through on your regular 1040 tax return.

Reasons this solution might not be for you:

• All your eggs are in one basket.  If anything happens to the owner, often the business will fail as well
• There is no protection against harmful law suits that could potentially wipe out your company’s assets and your creditors can attack your personal holdings as well
• No matter how large you grow your business you will always be perceived as a “Mom and Pop” operation.
• Acquiring growth capital is extremely difficult and often requires leveraging personal assets as collateral.

S-Corporation Status

S corporations are ordinary business corporations (or, in some cases, limited liability companies or even partnerships) that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes.

Why you might elect a Sub S Classification:

• The ability to shield a portion of your income from self-employment double taxation. Instead of the Profit flowing to you personally, which would make you subject to FICA, FUTA, and other self-employment taxes.
• It makes it easier to take certain deductions such as a home office or travel expenses
• An S Corporation status establishes a corporate veil, protecting you and your assets from liability suits
• An added benefit is that in many states, if you need to, you can fire yourself and collect unemployment (but you didn’t hear that from me, got it?)

Why you might want to avoid this election:

• Having an S Corporation requires you to process payroll, because you are an employee as well as the owner. That brings with it a whole other set of issues.
• At the end of the year, you will need to file a separate business tax return, in addition to your personal return (Not a problem for those savvy folk who have a quality CPA on board.)

Partnerships and Limited Partnerships

There are only subtle differences between these two classifications.  The main differentiation is that in a general partnership, all partners share assets, liabilities and risk equally or in percentages set forth in the partnership agreement.  Generally, a limited partnership has on over-riding partner who controls all those things and the other partners are classified as limited.  However, they are limited to profit sharing as well. For our purposes, we will discuss the pros and cons of the general partnership only.

Why you might elect this business classification.

• There is a sharing of risk.  You don’t bear the full brunt of a catastrophic corporate event. (Also a down side)
• Income flows to partners as distributions of income instead of salary, thus avoiding payroll taxes

Why you might choose to avoid a general partnership.

• Sharing of risk. Unlike a corporation, which offers a corporate veil to protect your assets from litigation, General partnerships have full exposure to all partners, including their personal assets.
• Possible conflicts with the partners. If you know and trust all the partners there is no problem, but sometimes, greed can upset the apple cart.  You might run into a situation of to many Chiefs in the Tepee.

C Corporation (Schedule 1120)

A C corporation, under United States federal income tax law, refers to any corporation that is taxed separately from its owners.  It is a legal entity.  It can, through its proxy agents, establish bank accounts; enter into debt obligations and anything else a business entity can do.  Think of it as a paper businessman.  As such, its debts, revenues and business dealings are completely separate from its owners/shareholders.

Why you might choose this election for your business.

• There is a complete separation of risk from the corporation and the owners. This might be true for larger corporations, but most small corporations will still have to have a co-signer for many financial transactions as required by the financial institutions themselves, that would be you the small business owner.
• Selling corporate shares can be a lucrative way of building working capital for future growth.
• The business will survive the death of the founding officers and startup principles.

Why you might avoid this option.

• If you are not a financial wiz kid, you’ll need professional accounting help. That means a CPA.
• Access to profits are strictly governed by Corporate rules, you cannot simply take money out whenever you want.
• Multiple filings are required to governing bodies including the S.E.C., I.R.S., etc… Detailed financial statements must be maintained constantly.

There are many more complexities associated with choosing a business entity however, this will hopefully be of help as you do your research.  If it all seems overwhelming you can always call upon the experts at Advanced Tax Solutions.  They are more than willing to help you sort out all the details and help you get your new business off on the right foot.  Call today for a free half hour consultation.  Your business success is our number one priority.