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How To Select the Right Legal Structure For Your Business
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Business New Haven
11/10/2003
By: Karen Singer
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When planning a new business, one of the first things to consider is what kind of business entity you wish to create.
There are several choices, with varying financial and legal implications. The type you choose hinges on several factors, including whether you are going into business on your own, or with a spouse, friend or associate.
The simplest form is a sole proprietorship. There's no cost to set it up, and no legal forms to fill out. You can open or close the business any time you choose, and any profits you earn appear on your personal income tax return as Schedule C income. The chief disadvantage is that an adverse legal judgment can wipe out your personal assets.
To help shield yourself from liability, you may wish to become a limited liability company, LLC. This offers several advantages over a sole proprietorship. Probably the biggest benefit is protection of your personal assets. A legal judgment against an LLC will place at risk only the amount of capital you've invested in the business.
Also, unlike a sole proprietorship, an LLC allows members to transfer ownership interest.
[Even with an LLC, many vendors may still demand personal guarantees for debt, and inadequate cash flow could cause problems if the vendor won't deliver the goods without some sort of payment.]
You can become an LLC relatively easily, by filing out a state of Connecticut application form (online, if you wish) requiring such information as name, address, type of business and agent for service. The annual fee is $300.
If you decide to go this route, it may also make sense to apply to the IRS for a tax identification number, which you can use to conduct business as an LLC. The IRS charges no fee for this process, and the application also can be filed online.
Both sole proprietorships and LLCs offer tax advantages, including deductions for office, property and commuting expenses.
If you intend to hire employees, be sure to thoroughly think about whether any will qualify as independent contractors. In recent years, the IRS has been cracking down on businesses for not withholding Social Security, pension and payroll taxes for company workers who are in fact real employees. An LLC does not shield you from personal liability for failure to pay such taxes. Check out IRS revenue ruling 87-41, which delineates criteria the agency uses to distinguish between independent contractors and bone fide employees.
An LLC with two or more principals may be treated as a partnership or a corporation. Most choose partnerships.
An LLC treated as a partnership by the state gets one level of federal income tax, where the entity is not taxed but the owners are taxed. This so-called pass-through entity has its pluses and minuses, the downside being the tax must be paid regardless of your cash flow.
If you choose to become a corporation there are two options, a Subchapter S Corporation (S Corp) or C Corporation (C Corp).
An S corp, probably the most common type of small-business entity, is similar to a partnership in that the owners are taxed rather than the entity. There are some restrictions, however, including a limit of 75 shareholders and an inability to make special allocations.
One possible advantage might be to reduce compensation subject to payroll taxes. S corp owners sometimes receive a small (but reasonable) salary and take the rest as non-salary distribution, but this practice has attracted more IRS scrutiny in recent years.
To become an S corp, you must file a state application as well as fill out a federal form.
Another drawback; S corps are typically hard to jettison. It's difficult to get out of them easily by liquidation, without triggering a capital gains tax.
The alternative, a C corp, is not the entity of choice for a small business because it is rife with deficiencies for the owner(s). C corps also include a tax structure where both entity and owner(s) are taxed.
For those interested in forming a non-profit or charitable business entity, apply for a 501 C(3) tax status, which exempts its principal(s) from federal income tax.
Although there are online sites where you can create a business entity, consulting a tax expert and attorney before making your decision will probably be money well spent.
Above all, remember careful contemplation in advance may well help you avoid or minimize problems later on.
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