Starting a small business can be a daunting yet exciting task. It’s filled with many difficult decisions, and it is very important that your business planning begins even before your company does!
How important, you ask? Well, starting a small business is no walk in the park. Things must be done right and legally for your business to be successful. If you make the wrong choices, you and your business could face fines and even jail time.
One of the first things you need to do is choose your business entity type.
You may wonder which considerations are important when selecting your entity type. The answer depends on your intended purpose and goals for the business. The issues below are nearly universal, and should be considered by any new business owner.
Liability, and specifically its limitation, can play a large role in deciding whether to run your business as simply as possible, or to create a formal business entity.
Sole proprietorship’s and basic partnerships are perhaps the easiest business types to form. Simply start doing business and your entity exists. However, sole proprietors enjoy no protection from business liability. Owners are personally responsible for any debts the business incurs, in any amount.
While the rules can differ slightly for partnerships, at least one partner will risk unlimited exposure to business liability. The drawback is easy to see: most new business owners understand that their venture carries some risk, and understand that choosing these entities when starting a business place personal assets at risk. Other entities offer significantly more protection.
Corporation, Limited Liability Company, and Limited Liability Partnership:
The corporation, limited liability company (LLC), and limited liability partnership (LLP) all enjoy limitations on liability to the owners. Generally speaking, owners of a corporation or LLC are not personally liable for business debts as long as certain formalities are observed in running the business. The LLP form can protect a partner for incurring debt caused by the negligence of the other partner(s). To qualify for the protections afforded by the various business types, there are strict filing requirements with the state and rules on the methods for running your business.
Furthermore, it is highly recommended you consult with an attorney and an accountant to ensure your business is complying and maintaining protection.
While the tax code is extensive and confusing, every new business owner should understand the method of taxation on businesses. Remember, taxation can dictate your choice of entity.
Sole proprietorships are disregarded for purposes of income taxation. All income and expenses are reported directly on the owner’s individual tax return.
Generally, partnerships work in much the same way. There are a number of special rules dealing with participation in the partnership, and deduction of losses, that are best suited for an accountant’s advice.
C-corporations, on the other hand, are subject to what is popularly called double-taxation. This means the company files its own tax return and is taxed on its income before any distributions are made to owners. Upon distribution of corporate assets or dividends, the owners are taxed in their individual capacity, so tax is effectively “doubled.” The drawback to this form is obviously that in most cases, a net greater percentage of profits generated by the business will be paid to the government as tax. Pass-through taxation remedies the C-corporation tax treatment, and eliminates one of the levels of taxation.
S-Corporation, LLC, and LLP:
S-corporations, LLCs, and LLPs can elect to be disregarded for tax purposes so that instead of being taxed at the business level and again at the owner level, the business is treated more like a sole proprietorship or partnership. Owners are taxed only at the individual level, generally in proportion to their ownership interest in the business. Unlike sole proprietorships and partnerships however, the other entities retain their limited liability while taking advantage of the tax treatment.
Other Considerations When Starting a Business
Limitation of liability and tax treatment are but two factors to consider when choosing the type entity for your new business.
Other questions owners should consider include:
- how do you plan to transfer assets in and out of the business?
- Will certain owners be employed by the business and others merely hold a passive ownership interest?
- Will the business have employees that receive benefits?
- How will the business be transferred to the next generation, and does that fit with your current estate plan?
Exploring these questions with your advisers before making a selection will help you make the right choice, and whether in a literal or figurative sense, keep you from being handcuffed.
If you are thinking of starting a small business, or seeking ongoing counsel for your existing business, contact one of our Gerbers Law Business Attorneys today at (920)-499-5700 to help you make the right choices for your business.