June, 2003 Tax Newsletter

Tax Differences From Choice of Business Structure Revisited

A business can be structured as a sole proprietorship, a partnership (general or limited), a corporation (C or S), or a limited liability company (LLC).  Significant tax differences flow from each choice.  The following brief discussion of each entity may assist you in making that decision.

Sole proprietorship

For a sole owner of a business, the sole proprietorship form of ownership is simplest. Legally, all the business's assets and liabilities belong to the business owner.

Advantages: The owner receives all the profits and makes all the decisions. Net income of the business is taxed only once.

Disadvantages: The owner has unlimited liability for legal problems and debts and is limited in raising capital by his or her personal resources and ability to borrow money.  Also, the net income of the business is subject to self-employment tax, which can be costly.

Partnership

A partnership is an unincorporated business that allows two or more people to share liability and provide capital. There are two types: general partnerships and limited partnerships. In a general partnership, partners share in management and are each 100 percent responsible for the partnership's obligations.

In a limited partnership, there are general and limited partners.

General partners manage the partnership and are personally responsible for obligations, while the limited partners cannot participate in management, but share in the profits. Limited partners' liability is limited to the amount of their actual or required capital contribution.  Because of a partner's potential liability for actions of other partners, the partnership form of doing business is on the wane.

Advantages: Profits are taxed only once, at the partners' individual income tax rate. Limited partnerships have the ability to raise money without involving outside investors in day-to-day business decisions. Limited partners have limited personal liability.

Disadvantages: Each general partner is fully liable for partnership debts, transfer of ownership may be difficult, and the partnership legally and for tax purposes ends upon the death, disability or bankruptcy of any partner.

Corporation

As a corporation is a legal entity separate and apart from its owners, the exposure to loss is limited to the capital in the corporation.  There are formal requirements that must be satisfied (many dictated by government authorities and state statutes), such as board meetings and recording of minutes, opening a corporate bank account and certain non-tax filings.   Under corporate law, shareholders and officers can be individually sued if corporate formalities are not followed.

Corporations with fewer than 75 shareholders can elect to be taxed as an S corporation.  The S corporation has the advantage of being taxed only once, through a personal return. That can be helpful in the early years of start-up when there may be losses.

In a C corporation, the corporation pays income tax on corporate profits and shareholders must also pay taxes on these same profits when paid to them as dividends.  Recent tax law has provided some relief in the form of a lower tax rate on most dividend payments.

Corporations are established by filing Articles of Incorporation and bylaws with the appropriate state authorities.

Advantages: Liability is limited to one's investment, transferring business ownership is easier, the corporation's life is perpetual,  raising larger amounts of capital can be facilitated, and there are opportunities to provide combined tax savings to the corporation and its shareholders.

Disadvantages: As mentioned, there is double taxation with a C corporation.  In its early years one or more of the shareholders will, in all likelihood, be required to guarantee the corporation's financial obligations. Also, when acting in the capacity of an employee or officer, the owner still has unlimited liability for his personal actions.

Limited Liability Company

An LLC is a legal entity that offers the limited liability advantages of a corporation and, if desired, the pass-through tax advantages of a partnership.  As with corporations, an LLC is established by filing Articles of Organization with the appropriate state authorities.

The law protects an LLC member from being held personally liable.

Advantages: The benefits are similar to those for a corporation, except there are fewer formalities than with corporations.  Operations are governed more by the management agreement than corporate formalities.  LLC members enjoy limited personal liability.  Also, depending upon whether it is a single member or multiple member LLC, the owners can elect to be taxed as a sole proprietorship, a partnership, a C corporation or an S corporation.  For both a corporation and an LLC, there's a potential tax-saving benefit arising from the fact that, after paying a "reasonable compensation" to the active owners, the remainder of the profits taxed to the owners is not subject to social security tax or self employment tax.

Disadvantages: An LLC is somewhat more expensive to form than a corporation.  Since the LLC is still a relatively new entity, there are questions about which state's laws take precedence in legal matters if the LLC does conducts business in a state other than the one in which it was formed.

IMPORTANT!!  The above is a very cursory discussion of the differences between the various types of business entities.  The tax consequences of making the right choice can be very significant.  It is an area that almost always requires professional assistance, which must be based upon an analysis of all the pertinent facts and circumstances surrounding the proposed business operations.

I would welcome the opportunity to help you make the proper decision.