The Business Side

with Kevin Hedley, CPA

Category: Business
Published: October 2007

Before you start a new business, there are a number of preliminary decisions to be made. One of the first choices you will face is the legal form in which you will operate the business. Should it be an unincorporated sole proprietorship (commonly called a DBA or a Schedule C business), a partnership, a limited liability company, a regular corporation, or an S corporation?

Each of these forms has both tax and non-tax advantages and disadvantages that must be investigated in conjunction with your own plans and personal tax situation. No one-business form is correct in all circumstances.

Sole proprietorships, for example, are the easiest and cheapest business form to set up, and they can be operated with few formalities. However, they offer no personal liability protection and don't allow you to get many of the tax benefits that are available to corporate employees.

Partnerships offer many of the same advantages and disadvantages as the sole proprietorship in that that they may be easily and inexpensively formed, but they allow the business to be owned and run by more than one person. They generally do not provide liability protection for the partners. The liability problem can be overcome to a certain extent by forming a limited partnership, but partners whose liability is limited cannot be involved in actively managing the business, therefore this is not an adequate solution for most smaller businesses.

Unlike a corporation, a partnership is not a taxable entity. Rather, each partner is taxed directly on his or her share of partnership profits or losses. This is an advantage over operating as a corporation where profits could be taxed twice, once at the corporate level and again at the owner level when dividends are distributed to shareholders.

A partner is not considered an employee of the partnership. However, the partnership can set up a qualified retirement plan and other types of benefit plans that cover partners as well as employees. Since a partner is not an employee, a partner does not pay social security taxes like employees do. However, partners pay the equivalent of social security taxes in the form of two components of self-employment tax, which can be very steep. One component is 12.4% of net earnings up to $97,500 (inflation-adjusted figure for 2007) and the other is 2.9% of all net earnings.

A newer form of entity, known as the limited liability company, which is approved for use in almost every state, offers what many see as the best alternative for the typical small business. These entities can be set up to be taxed as partnerships, avoiding the corporate income tax, while the managing members' personal assets remain fully protected from business creditors.

S corporations also offer liability protection without a separate corporate tax. Like partners and sole proprietors, however, more-than 2% of S corporation shareholders are ineligible for tax-favored fringe benefits. Another potential drawback of S corporations results from limitations on the number and kind of permissible shareholders. These restrictions can limit an S corporation's growth potential and access to capital in some businesses. In others, however, an S corporation can be a key ingredient toward success.

Some (but not all) of the advantages of operating a business as an S corporation are:

Your personal assets will not be at risk because of the activities or liabilities of the S corporation (unless, of course, you pledge assets or personally guarantee the corporation's debt).
Your S corporation generally will not have to pay corporate-level income tax.
The S corporation has no corporate alternative minimum tax (AMT) liability.
FICA tax is not owed on the regular business earnings of the corporation, only on salaries paid to employees. This is a potential advantage over sole proprietorships, partnerships, and limited-liability companies.

Some (but not all) of the disadvantages are:

S corporations cannot have more than 100 shareholders.
There are limitations on who may be a shareholder in an S corporation.
S corporations can have only one class of stock.
A shareholder's basis in the corporation does not include any of the corporation's debt, even if the shareholder has personally guaranteed it.

What about regular corporations, known as C corporations? They do not have the shareholder restrictions that apply to S corporations, but they are subject to a double system of taxation. That is, their profits are subject to income tax at the corporate level, and are also taxed to the shareholders if distributed as dividends. An advantage to this form of operation is that shareholder-employees are entitled to tax-advantaged corporate-type fringe benefits, such as medical coverage, disability insurance, and group-term life.

Fortunately there are many choices. You do not have to forgo the tax advantages of operating as a partnership to limit your potential liability. You can operate as an S corporation to minimize your liability exposure and yet be taxed similarly (but not identically) to the way you would be taxed if you operated as a partnership. Another option is the limited-liability company. With this choice, your liability exposure also would be reduced and you would be taxed even more like a partnership than if you operated as an S corporation.