Deciding to start a business is no easy task for women entrepreneurs and business owners. It is a courageous endeavor that involves making many decisions from determining product and service offering, license, insurance and permit requirements to developing your sales and marketing strategy to attract customers and much more. But, one of the most overlooked decisions I have discovered throughout the years of advising clients in my accounting practice has been entity formation. This is a decision that should not be rushed and requires some time and attention because it has significant consequences down the line relating to taxes, limiting liability, raising capital for growth and expansion, and ultimately protecting yourself by selecting the right business structure.
First and foremost, do some research and consult with an attorney who specializes in entity formation, because this is a decision that can go wrong if not carefully planned. Knowing someone, like a tax professional, who understands the tax consequences that affect the business structure you select is also important. There is a lot of information available online and ready-made corporate kits you can purchase, however, it does not take away from the need to have a healthy dialogue regarding the best formation for your business based on your plans and ideas.
There are four basic forms of business entity structure; these are the sole proprietorship, partnership, corporation and the limited liability company (LLC) structure. The beauty of these structures is that you can make changes over time to best fit your needs, however, the tax consequences are very different depending on the route you take.
The most widely used structure is the sole proprietorship form because it is the most basic and simplest to create. It is easy to form, as is the tax preparation. If you don’t have a complex business structure and plan to work alone in your business, then this may be the right structure for you. Sole proprietorship is referred to as an unincorporated business, run by one person with no distinction between the business and the owner because you are one in the same. As a sole proprietor, the owner is entitled to all profits and loss. From a tax standpoint, the business itself is not taxed separately, the net profit of the business, which are the total revenues less total deductible expenses (with some exceptions) are taxed on your personal tax return and subjected to self-employment taxes, which is approximately 15.3 percent. The disadvantage to this as an entity choice is that it is burdensome for one person, difficult to raise capital and liability is unlimited, thus the owner is solely responsible for the business liabilities and debt.
If there will be more than one owner, looking at the partnership structure is a great option. The tax treatment of partnerships makes it advantageous because the partnership does not pay tax on income; it is referred to as a “pass through” entity where the profits or losses flow directly to the partners. With partnerships, there are primarily two types: general partnerships and limited partnerships. In a general partnership structure, all the partners manage the company and assume responsibility for the partnership’s debts and other obligations. On the other hand, the limited partnership has both general and limited partners. In this situation, the general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only. The limited partners have no control over the business and are not subject to the same liabilities as the general partners.
Legal affairs and personal liability can be a major concern for the general partners. The disadvantage to the general partnership structure is that it will require more time to complete the accounting. The partnership must file a separate tax return and may be required to file a state tax return. Many seem to be favoring the LLC structure, which I will mention later in this article, but there are differences between the two forms.
The most expensive and complex structure is the corporate structure; it is considered a separate entity that must abide by heavy laws, rules and regulations but it offers a lot of protection from a liability standpoint. There are two types of corporations: the C corporation and the S corporation. For both structures, the debt of the corporation is not considered liable to its owners, this means that owners, referred to as shareholders, are not personally held liable or at risk; the corporation is liable for all debts. The entity can also continue indefinitely, even if one of the shareholders should die, sell their shares or become incapacitated. Raising capital with ease makes it an attractive form; also the C corporation has the ability to have different classes of stock such as common and preferred shares, and an unlimited number of shareholders. The S corporation, which is a special type of corporation, with a special election by the Internal Revenue Service (IRS), is attractive to small business owners rather than the C corporate form, however, it restricts the number of shareholders to 100 and is referred to as a “pass through entity” because the profit and loss flows through directly to the shareholders on their personal tax return. The disadvantage of the C corporation form is double taxation, the corporate’s earnings are subjected to tax and dividends distributed to shareholders is also subjected to tax. The corporate structure is a complex structure that is heavily regulated by state laws and it requires more legal services, accounting and tax preparation. The S corporation is also regulated in some states; for example in the state of Florida, S corporations are exempt from corporate state filing but this is not the case in every state. Also, there are strict compensation requirements for S corporate shareholders that are heavily scrutinized by the IRS.
The most recent structure created is the limited liability company, which was established around the 1970s, and it is becoming very popular amongst entrepreneurs and business owners today. The LLC is a hybrid of the C corporation and the partnership structure, bringing together some of the best features of the two. It is very easy to operate within most states but there are disadvantages regarding self-employment taxation and the LLC having a limited life after an owner departs unless the operating agreement specifically states otherwise.
Deciding on the right business structure for your business is an important decision and it makes sense to get it right because it can be costly. But once you have settled on the right business form, it is important to note that over time, your circumstances might change based on your needs or legalities. It makes sense to reassess your entity selection from time to time to make sure you are using the one that provides the most benefits because it is more than just dollars and cents.
Gerri Lazarre, CPA, MS Tax is a certified public accountant in the state of Florida and Georgia. She is principal of TriMergeCPA and TriMergeTax in Miami, Florida. Lazarre specializes in providing professional advisory services in the areas of accounting, audit and tax planning to individuals, businesses and nonprofit organizations for over 13 years. For more information, please visit www.TriMergeTax.com and www.TriMergeCPA.com.