Small Business Tax Tip - Corporation, LLC, Partnership or Proprietorship

Small Business Tax Tips

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By Thomas Norton

Sometimes it's the small decisions -- or lack of a decision -- that have the greatest effect on your business.

Take the choice of what type of legal structure you use to operate your business. Many small business owners are so excited about starting their businesses that they give little or no thought to this very important decision. Should you incorporate? Form an LLC? A partnership? Would you be better off just doing nothing and running your business as a sole proprietorship?

Before you take the advice of the first person you ask or the first book you read, consider all of the legal, tax, financial and operational effects of your choice. Let's look at your choices one by one.

Sole Proprietorship

When you open your business without a partner (a spouse does not usually count as a partner for this purpose) and without filing any paperwork to choose one of the other business types, you are automatically a sole proprietorship. You are doing business with your customers directly as yourself, an individual. This is true even if you have a name for your business and file "fictitious name" or "doing business as" papers with your state or local government.

For income tax purposes, there are no separate forms to file for the business. You simply attach Schedule C to your Form 1040. Schedule C is where you summarize your business revenues and expenses. You pay tax on any profit at the regular individual tax rates. If you have a loss, you can usually deduct the loss against your other income.

In addition to income tax, you must pay self employment tax on your business profit. The self employment tax rate is 15.3% on the first $94,200 (for 2006) of profit, and 2.9% on any amount over $94,200. The tax is designed to replace the social security and medicare taxes you and your employer pay when you have a regular job. Since you're both "employer" and "employee," you pay twice as much as you would if you worked for someone else.

The biggest pitfall of being a sole proprietor is your legal liability. If someone is injured, whether physically, financially, emotionally, etc. as a result of your business activities, you can be sued personally. In today's litigious environment where people are sued at the drop of a hat, this is a risk no serious business owner should take lightly. While insurance may offer some protection, you still run the risk of losing your personal assets, and/or of having to file bankruptcy, due to a lawsuit.

While this form of business may be fine for some part-time or "sideline" businesses, most small business owners should choose a different option.

Partnership

When you co-own a business with one or more other people and don't choose one of the other business types, you are automatically a partnership. (Technically, a "general partnership.") While a sole proprietorship is low on the list of desirable business structures for a small business, a partnership is even lower.

Like a sole proprietorship, you can be sued personally for any harm you cause as a result of your business activities. Even worse, you can be sued for any harm caused by your partner! Not only that, if your partner signs a contract or takes out a loan on behalf of the business, you are automatically bound by the terms of that contract, whether you agree with it or not. This is scary stuff, and I simply never recommend this structure. This is an example where "doing nothing" can be a big mistake.

Income tax wise, a partnership must file a Form 1065, U.S. Return of Partnership Income, to report its revenues and expenses. The partnership itself does not pay income taxes. Rather, each partner reports his share of the profit or loss from the business on his individual tax return. As with a sole proprietorship, an active partner must pay the 15.3% self employment tax on his first $94,200 (for 2006) of the partnership income, and 2.9% on any amount above that.

There is a different kind of partnership, called a Limited Partnership, that restricts the liability of certain "passive" partners, called limited partners. This is used primarily in real estate syndications and is outside the scope of this article.

The bottom line on partnerships: Stay away from them.

Corporation

A corporation is a separate legal entity, or legal "person" if you will, formed by filing certain documents with a state government. Most big companies you're familiar with are corporations, and will usually have the word "corporation" or "Inc." in their business name. Corporations have several advantages, including the ability to raise money by selling stock, and the fact that each owner's, or stockholder's, risk is limited to their investment in the company. A corporation can have one owner, or millions of owners, or any number in between.

As mentioned above, your risk in case of a lawsuit is generally limited to the amount of money you have invested in the corporation. There are important exceptions to this general rule, a few of which are worth mentioning. First, if you are in one of the classic professions, usually including doctors, lawyers, accountants, and engineers among others, you cannot escape personal liability for your professional activities. In other words, if you're a doctor and you amputate the wrong leg on a patient, you can still be sued personally. On the other hand, if a patient trips over a chair in your waiting room and breaks their leg, the normal corporate protection would apply.

A second exception has to do with how you operate your business, and how you present yourself to the outside world. When you form and run a corporation, you are obligated to make sure everyone you deal with knows they're dealing with a corporation. So, for example, you would want to make sure you included your full corporate name on all letterhead, business cards, advertising etc. You don't want anyone to be able to say they thought they were dealing with you as an individual and not your corporation.

Another liability exception has to do with record keeping. This is where many small business owners get themselves in trouble. A corporation must maintain books and records separate from that of its owners. Also, by definition a corporation issues stock and has a board of directors. That board of directors must have a meeting at least once per year, and formal minutes must be kept. Any significant activities of the corporation, such as taking out a loan, usually require approval by the board. Now the reality is that in a small business you may be the owner and only member of the board of directors. But you still have to keep up the formalities required by your state, and the state where you incorporated (if different). If you don't, a good attorney might argue that you should be able to be sued personally, thereby "piercing the corporate veil" and leaving your personal assets exposed. An IRS agent can make the same claim, thereby disallowing certain deductions and tax benefits you receive by operating as a corporation. So consult a competent attorney, and make sure your corporate books and records meet the legal requirements.

For state law purposes, a corporation is a corporation. But for tax purposes, a corporation can be either a regular "C corporation" or receive special tax status by being an "S corporation."

C Corporation

Unless a corporation qualifies for and chooses to be an S corporation, it is automatically classified as a C corporation. A C corporation pays taxes on its profits, and files a Form 1120 with the IRS. Any excess profit is then distributed to the corporation's owners, or stockholders. These profit distributions are called dividends, and the stockholders must pay income taxes on them. This is why it is said that a C corporation results in "double taxation." Notice that the corporation's profits are taxed twice: Once at the corporate level, and again when distributed to the owners.

Due to this double taxation, most small businesses are not well served by being a C corporation. That said, there are very limited circumstances where a C corporation can be used by a small business owner in order to gain certain tax advantages. Check with your tax adviser.

S Corporation

Sub-chapter S of the Internal Revenue Code was created and reworked by Congress late in in the 20th Century in order to allow small business owners to incorporate without being subject to double taxation. Thus, the "S corporation" was born, and has been the preferred tax structure for small businesses ever since (but see the section on LLCs below).

With an S corporation, the corporation files a Form 1120S with the IRS, but the corporation does not pay income tax (with a few rare exceptions). Rather, each owner pays tax on her share of the corporation's profits, much like a partner in a partnership. The difference here of course, is that since it is a corporation under state law, there are none of the legal liability problems associated with partnerships. And since the corporation does not pay income tax, there is no double taxation as there is with a C corporation. In effect, it allows a corporation to be taxed like a partnership.

Unlike a partnership, if handled properly, you do not pay self employment taxes on the profits of the S corporation. Instead, you are paid a salary, and the applicable social security, medicare and other payroll taxes are paid accordingly. Any dividends in excess of your salary are not subject to payroll or self employment taxes. So if you have a low salary and high dividends, you save 15.3% in taxes on the dividend portion. Of course the IRS knows this, and they require you to pay yourself a "reasonable" salary. How much salary you should pay yourself vs. dividend distributions is a much debated topic between taxpayers and the IRS, and also offers many opportunities for tax planning.

Not every corporation is qualified to be an S corporation, though most small businesses qualify. There are restrictions on such things as the number of stockholders and what type of entities can be stockholders. The basic purpose of the rules is to prevent large, publicly traded companies from qualifying, and to prevent various tax avoidance schemes using trusts and foreign entities.

A corporation must elect S status no later than the 15th day of the third month of the year in which it wishes to be treated as an S corporation. For example, for a calendar year business, a corporation must make the election by March 15, 2008 in order to be treated as an S corporation for 2008. You make the election by filing Form 2553, which must be approved by the IRS in order for it be effective.

Overall, the S corporation is an excellent structure for most small businesses.

Limited Liability Company (LLC)

The newest of the business structures is the limited liability company or LLC. The LLC affords much the same protection against lawsuits as the corporation, without most of the somewhat burdensome paperwork and record-keeping requirements, such as stock certificates, board of directors meetings, board minutes, etc. In addition, the LLC is very flexible from a tax standpoint, allowing you the choice to be taxed as either a C corporation, an S corporation, a sole proprietorship (for businesses with one owner) or a partnership (two or more owners).

Each state has its own rules for who can form an LLC, but most states now allow an LLC to have just one owner (that wasn't always the case). Most small businesses will qualify. Forming an LLC is usually quite simple and relatively inexpensive, and can often be done right over the internet.

For tax purposes, an LLC with one owner will be taxed as a sole proprietorship, unless the owner makes an election to be taxed as a corporation (C or S). An LLC with multiple owners will automatically be taxed as a partnership, unless the LLC chooses to be taxed as a corporation (C or S). Do you see the beauty of this structure? You get liability protection akin to a corporation, but you don't have all the nit picky paperwork to do and the "corporate book" to maintain. At the same time, you get to choose how you're treated for tax purposes! That's enough to make a tax accountant's heart flutter!

As you can probably tell, I really like the LLC structure. My own business, Thomas Norton & Company, LLC, is obviously structured this way. I have also elected to be taxed as an S corporation, since it gives me certain advantages in my circumstances. It should be noted that you can start an LLC and be taxed as a sole proprietorship at first, and elect to be treated as an S corporation at some future date.

Though the S corporation still rules the roost among small businesses, the LLC is fast making inroads as more and more business owners discover its simplicity, flexibility and effectiveness.

Which Structure is Best for You?

Since your circumstances might be different, you should consult a qualified tax advisor before making this important decision. That said, most small businesses are and should be structured as either an S corporation or an LLC. Whether your LLC should be taxed as a sole proprietorship, partnership, C corporation or S corporation is very situation dependent, so ask that tax advisor what he or she thinks.

No matter what form of business you choose, make sure it is a conscious choice, made after carefully considering the legal and tax ramifications involved. While it may seem mundane, it is one of the most important business choices you will ever make.

Tom Norton is the St. Louis based founder and owner his own CPA firm, Thomas Norton & Company, LLC. Tom specializes in business valuations, forensic accounting, and complex divorce litigation support. For more information and hundreds of free tax and financial reports, go to [http://thomasnortoncpa.com].

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