Choose Your Business Structure, Part 2

Good morning. My name is Brian Hodak. I am a CPA and I work for Wamhoff Financial and Accounting. Thank you for joining us.

This session is the second in a series of seven (7) sessions that will track the developments in pursuit of opening the doors for a new business venture.

DJ, my client, is resolved to start his own bar business. So without mentioning real names and places, this and my following discussions will be something of a case study. I invite you to follow DJ and me as we work toward opening day.

In review, DJ has over 20 years’ experience in the bar and restaurant business and knows virtually every aspect of service operations meaning, he can price and prepare food and drinks, he can attract and entertain customers and he can staff and manage the kitchen and front floor operations.

In the previous session, I addressed some of the preliminary considerations I was advising DJ to assess.

I also prepared a not-all-inclusive checklist of forty-seven (47) steps that DJ will have to take before he can open the doors on his business. The checklist is published below.

And I ended by referencing legal and tax consequences of business formations. So that discussion begins here:

[Since the following subject matters involves legal implications, I should include the following disclaimer: I am not an attorney and I am not dispensing legal advice. The legal areas I will be discussing involve subject matters that frequently surface in client conversations. If you are contemplating starting a business, you should seek legal advice from legal counsel.]

To proceed, of all the choices you make when starting a business, one of the most important is the type of legal structure you select for your company. There are primarily four (4) types of legal business entities –

Types of Business Entities:

  • sole proprietorship
  • partnership
  • corporation
  • limited liability company (LLC)

A sole proprietorship is a common form of business organization. It is the simplest structure and usually involves just one individual who owns and operates the enterprise. However, the owner is also personally liable for all financial obligations of the business and the actions of employees that work for the business. As a result, the sole proprietor is placing his or her own personal assets at risk, and they could be seized to satisfy a business debt or legal verdict.

Income and expenses from the business are included on the personal income tax return (Form 1040). Income and deductions are first recorded on Form Schedule C, which is filed along with Form 1040. A sole proprietor must also file a Schedule SE with Form 1040 and use Schedule SE to calculate how much self-employment tax is owed. In addition to paying annual self-employment taxes, the sole proprietor must also make quarterly estimated tax payments on future income.

A partnership involves two or more people who agree to share in the profits or losses of a business. In a general partnership, a primary disadvantage is legal liability. Each partner is personally liable for the financial obligations of the business. A second type of partnerships is a limited partnership. In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners. A document known as a “partnership agreement” is essential to establishing the framework which guides the partners’ activities.

The partners in a general partnerships are taxed much like the sole proprietor is taxed.

Income and expenses from the business are allocated and included on the personal income tax returns (Forms 1040) of the partners. Income and deductions are first recorded on Form Schedule E, which is filed along with Form 1040. A partner must also file a Schedule SE with Form 1040 and use Schedule SE to calculate how much self-employment tax is owed. In addition to paying annual self-employment taxes, the partner must also make quarterly estimated tax payments on future income.

A corporation is another form of legal entity that is created to conduct business. The corporation becomes an entity separate from those who created it. A key benefit of a corporation is the avoidance of personal liability. Shareholders in a corporation are generally not held personally liable for the financial obligations of the business, or acts of employees and fellow shareholders.

While not a legal description, for tax purposes, corporations are often referenced as “C Corporations” or “S Corporations.” The “C” designation only means that the corporation is taxed under Subchapter C of the Internal Revenue Code (IRC). The “S” designation only means that the corporation is taxed under Subchapter S of the IRC.

Under Subchapter C of the IRC, profits can be subject to double taxation, whereas under Subchapter S, double taxation is avoided as the corporation income or losses are passed through and reported on individual shareholders’ tax returns, similar to a partnership, but unlike a partnership, there is no self-employment tax on the profits.

C Corporation owners/shareholders can pay a double tax on the business’s earnings because not only are corporations subject to corporate income tax, any after tax earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns. However, reasonable compensation for services rendered and paid to owners/shareholders of a C Corporation avoid double taxation.

The S Corporation may be more attractive to small-business owners than a C Corporation. The S Corporation is not a different type of legal entity from a C Corporation. But, it does have a different “tax status.” The S Corporation status is “elective” and is made by filing Form 2553 with the IRS. However, there are qualifying limitations and restrictions placed on corporations that are eligible to make the S Election.

The limited liability company (LLC) has grown in use because it allows owners to take advantage of the tax benefits of individual, partnerships, C Corporations or S Corporation tax statuses while providing owners a shield from personal liability.

And, I am out of time for now. Next session, I will pick up with more information on the limited liability company. Stay tuned.

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