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, 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 weighed in conjunction with your own plans and personal situation.
Choice of Entity
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, and they allow the business to be owned and run by more than one person. Also, the liability problem can be overcome to a certain extent by forming a limited partnership, but a partner whose liability is limited, called a "limited partner," cannot be involved in actively managing the business. Management authority of a partnership is vested solely in the General Partner. Finally, the tax-deductibility of losses from partnerships is often restricted by the so-called passive activity and at-risk rules.
A limited liability company 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. Management of a limited liability could be the responsibility of the members, or could be placed in vested in a Manager, who may or may not be a member of the company. It is also possible for the company to elect to be taxed as corporation.
The other form of entity, and one of the most often used in businesses, is the corporation. A corporation offers limited liability protection to its owner/operator, but requires operation with a number of formalities.
Besides the question of choosing an entity for your new business, there are many other tax decisions to be made, and much planning to ensure that you meet your income and payroll tax reporting and compliance chores properly. For example:
You should seek experienced legal and financial advice to help you explore these important matters before deciding on the right entity for your new business, then you can concentrate on the success of your new venture.
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 new business often has losses in the early years. By operating as a partnership, you can use your share of the partnership's losses to offset income from other sources, such as investments and wages or compensation from other employment.
However, to be able to deduct losses currently, you must satisfy the so-called passive activity loss and at-risk rules. As a general rule, as long as you materially participate in the business conducted by the partnership, and have some financial risk in its activities, you will meet the rules.
Although a partner is not considered an employee of the partnership, the partnership may 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 payroll taxes like employees; however, partners pay the equivalent in the form of self-employment tax, which can be very steep. The self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security and 2.9% for Medicare. Only the first $200,000 ($250,000 for joint filers, for year 2021) of net income is subject to the 12.4% component, but all net earnings are subject to the 2.9% Medicare tax. Earnings over $200,000 ($250,000 for joint filers) are subject to an additional 0.9% Medicare tax. However, you get to deduct one-half of the total tax that you pay in figuring your gross income, so you do get a little break.
These taxes count just like regular social security taxes in determining benefits for which you or a family member may become eligible based on your earnings record.
One legal downside to operating as a partnership is that general partners are exposed to unlimited liability from lawsuits that arise in connection with the business even when they are not based on the acts or omissions of a partner. This is to be contrasted with operating a business as a corporation or a limited liability company where, as a general rule, only the funds invested in the business are at risk.
Fortunately, 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 or limited liability company to minimize your liability exposure and yet be taxed similarly to the way you would be taxed if you operated as a partnership.
Limited Liability Companies
Until the mid-1990s, hardly anyone had heard of limited liability companies, or "LLCs.” Now businesses can operate as LLCs in all 50 states. Generally, legal and financial analysts have nothing but good things to say about LLCs. LLCs offer an unprecedented combination of corporate-like liability protection and partnership pass-through taxation and LLC members don't have to limit their participation in the firm's management to protect their personal assets from the firm's creditors, as they do in a limited partnership.
Yet they can qualify for true partnership, pass-through taxation, although is some circumstances an LLC may be classified for federal income tax purposes as either a partnership or a corporation.
LLCs have a number of distinct advantages over S corporations for many businesses. There are no limits on the number or kind of shareholders, giving LLCs greater access to capital. They're not restricted to a single class of stock as S corporations are, so LLC members have a greater ability to allocate gains, losses, deductions, and credits. LLCs also have much more estate planning flexibility than S corporations and there are other technical advantages that can make a bottom-line tax difference.
With all that going for them, should your business become an LLC? The answer is maybe. Established corporations with appreciated assets might find the tax cost of conversion to be prohibitive. But most start-up ventures should at least consider operating as LLCs. And existing proprietorships and partnerships should definitely consider conversion--that way the owner's personal assets will b protected from any financial problems that arise in the business. Real estate partnerships are especially suitable candidates. Under Virginia law, in fact, it is quite simple to convert an existing partnership to a limited liability company.
Did You Know? Why are limited liability companies used so frequently? [This information is partially derived from the Virginia CLE deskbook, "Limited Liability Companies in Virginia." ]
Flexible Starting Date
Under the Virginia Limited Liability Company Act, an LLC is formed by filing articles of organization with the Virginia State Corporation Commission (SCC). Virginia Code Section 13.1-1010, permits one or more persons to file the articles of organization but does not require that these persons be members of the LLC after it is formed. Many attorneys who organize LLCs sign the articles of organization themselves. The Act does not require a Virginia LLC to have any members at the time of formation, so a Virginia LLC can be organized and kept “on the shelf” before beginning operations. While there is no express statutory provision in the Act providing for a “shelf” LLC, this conclusion is based on the absence from the Act of the requirement for members when forming an LLC; from the Act's definition; from the Act's dissolution provisions; and, the inclusion in the Act of a number of provisions addressing how action is taken in an LLC that has no members.
Qualifications of Members
The Act does not impose any qualifications on becoming a member of an LLC. Under the Act, an
individual, estate, corporation, unincorporated association, business trust, partnership, other trust, or governmental entity may become an LLC member. Section 13.1-1002 of the Virginia Code contains the definition of a “member” and a “person” for purposes of the Act. The LLC in this respect contrasts with another popular entity that enjoys pass-through treatment for income tax purposes, the Subchapter S corporation. Corporations (other than 100-percent S corporation parents), partnerships, other entities, most trusts, and nonresident aliens cannot be shareholders of an S corporation. See IRC Section 1361. Because it allows ownership by business and other entities, the LLC is often used in joint ventures among businesses, as well as by investment entities such as private equity and hedge funds.
Contributions and Interests
The Limited Liability Company Act has very flexible rules about contributions by members in exchange for their membership interests. Contributions may be in cash, property, or services rendered. In addition, a promissory note or any other binding obligation to contribute cash or property or to perform services is recognized as a valid contribution. A contribution can be conditioned on the happening of a future event. For example, a required capital contribution could be conditional on the LLC obtaining a commitment for bank financing or identifying an acquisition target.
An LLC may admit a person as a member and issue a membership interest to that person without that person either making a contribution or being obligated to do so. The Act also does not prohibit an LLC from establishing through its articles of organization or operating agreement one or more classes of membership interests with different economic rights, such as distribution rights and rights to net assets on liquidation of the LLC. For example, venture capital and “angel” investors often require they be issued “preferred” membership interests with distribution and liquidation rights to the founders' “common” membership interests.
As a general proposition corporations come in many forms, stock and non-stock, profit and nonprofit, public and private, to name a few. For the purposes of starting a business, the basis decision which you will face is a tax question, that is, whether to use the small business form of corporation, commonly referred to as an "S" corporation, or the regular corporation, commonly referred to as a "C" corporation.
Small businesses typically begin as S corporations, and often later change to C corporations. Both forms offer liability protection. The primary distinctions in the two are tax-based.
The S corporation is essentially a pass-through entity for income tax purposes, that is, all profits and losses "pass-through" the corporation and are reported on the individual tax returns of the shareholders. Like partners and sole proprietors, however, more-than 2% S corporation shareholders are ineligible for some tax-favored fringe benefits. There are also limitations on the number and kind of permissible shareholders for S corporations. These restrictions tend to limit an S corporation's growth potential and access to
capital. C corporations 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.
But if profits are to be plowed back into the business to foster the company's growth, the tax bite is usually lower than with an S corporation. And there are many situations in which the double tax can be substantially minimized.
An additional, and often very important, advantage of using a C corporation is that shareholder-employees are entitled to greater tax-advantaged corporate-type fringe benefits, such as medical coverage, disability insurance, group-term life and medical/dental reimbursement plans.
Characteristics of S Corporations
Most new small businesses begin as S corporations. The reasons that the S corporation is the preferred entity become evident when reviewing the relative advantages and disadvantages of the S corporation form. Some of these advantages/disadvantages will be more important than others, depending upon the particular circumstances of the business owner.
You must be aware, however, that S corporation reform measures are almost constantly being considered by Congress, any of which could make the S corporation more or less attractive and eliminate, lessen, or even add to, some of the listed disadvantages.
Advantages of S Corporations:
Disadvantages of S Corporations:
Maximize Benefits of Start-up Costs
Planning to get the most out of any new business venture begins with making sure you get the greatest possible tax advantages for your investigation costs, start-up expenses, and other organization costs. These include costs such as advertising, salaries and wages of employees-in-training, travel and other expenses of lining up customers, suppliers, and distributors, and fees paid for consultants and professional services.
You may assume that all of these start-up expenses are deductible as business expenses in the year you pay them, but that's not the case!
Such expenses are not considered to be business expenses because they are not incurred in a going business. Instead they must be capitalized unless you make a proper election to amortize them ratably over the appropriate period. The costs of organizing a corporation can also be amortized, if the corporation properly elects to do so. Another complication with start-up expenses is that they may be amortizable only by the person who incurs them.
If your new business is going to be a sole proprietorship, that won't be a problem. However, if the venture is to be a corporation, you can't personally deduct the costs you incur before incorporation. Those costs are part of your investment in the corporation's stock--you may want to contribute the funds to the corporation and let the corporation incur the expenses so that it can amortize them.
It's also important to know that some expenses are treated more favorably than the regular start-up costs we have been talking about, and some less favorably.
Start-up expenses for interest, taxes, and research costs usually can be deducted in the year paid. The cost of tangible and intangible property purchased for use in the business can be recovered by way of depreciation deductions (or expensed) over various periods, depending upon the type of asset.
Finally, You want to be sure that you get whatever tax benefit you can from all of these expenses. To do so, you need to coordinate the expenses with the business's starting date, and properly make the necessary elections.
If you are expanding an existing business, rather than starting a new one, you may be able to deduct the expansion costs currently. You should explore these possibilities further with your accountant to be sure that you avoid any costly pitfalls.
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