By Jean Kruse / Guest Editorial
Determining the legal structure of a small business is among the most frequently asked questions when planning a new small business startup. It’s also one of the most important ones to answer. The structure you choose will affect everything from paying taxes to assigning liability, from raising capital to sharing profits.
Each type of structure has trade-offs that should be fully understood. Here’s a quick comparison of those most frequently used by small businesses:
A sole proprietorship is an unincorporated business owned by one person. Paying taxes is relatively simple, as the owner reports income/losses along with personal taxes. The business income and expenses are reported on a Schedule C that is attached to the owner’s personal income tax returns. The owner pays income tax, as well as Social Security and Medicare taxes on the profits of the business. The owner is personally responsible for any business-related expenses or liabilities. While there are no corporate registration requirements, sole proprietors may still have to comply with local registration and licensing laws, depending on the type of business.
In a partnership, two or more people share ownership. Each contributes time, resources, expertise and/or money to the business in return for a share of the profits/losses. Each partner is also responsible for his/her own actions, as well as business debts and decisions made by other partners. That’s why a partnership agreement is a must. It should detail each participant’s contributions and responsibilities, division of profits, resolution of disputes and the handling of other major business decisions.
Then there’s the corporation, an independent legal entity owned by shareholders. Corporations inherently have complex administrative, tax and legal requirements. On the other hand, selling various types of shares in an established business can make it easier to raise capital. Plus, shareholders are not legally liable for the business’s actions and debts. A word of warning, however, if you sign documents as an individual and not as an officer of the corporation, then, of course, you may be personally liable. For example, a lending institution is most certainly going to require the corporate shareholders to personally guaranty any loans made, especially when the entity is new with no track record of being able to repay debts.
A variation of this structure is the “S corporation,” named for the Internal Revenue Service subchapter that defines it, and often used in situations where the shareholders are also employees. An S corporation distinguishes between shareholder/employee wages and other profit distributions, which are taxed at different rates. However, S corporations carry the same legal and administrative requirements of “regular” corporations.
The limited liability company (LLC) has become a popular structure for small businesses in recent years. LLCs offer a corporation’s limited liability with a partnership’s flexibility and simplified taxation. There are also fewer recordkeeping requirements, and it’s entirely up to the LLC’s owners (known officially as “members”) to determine profit distribution. Like the sole proprietor, the LLC owners pay income tax, as well as Social Security and Medicare taxes (called self-employment taxes) on the profits of the business. And when a member leaves, the LLC must be dissolved. If the LLC is owned by only one person, then that person files income taxes on a Schedule C attached to the person’s individual income tax return. If the LLC is owned by more than one person, then a partnership tax return must be filed for the LLC.
One thing to note is that many small businesses start out as a sole proprietorship, the simplest type of entity, and then, as their business becomes successful, they can change their entity type, so the entity type is not carved in stone forever.
Each structure has provisions and options that require exploration before finding the right match for a small business.
A local resource is SCORE, formerly Service Corps of Retired Executives. For more information, visit www.scorecr.org and sign up for free and confidential mentoring sessions.
In addition, the above topic is covered in great detail at the “How to Really Start Your Own Business” (HTRSYOB) seminar which is repeated every other month. Go to www.scorecr.org, click on “Local Workshops” to view upcoming workshops, then on the lower right side of that screen click on “View Event Calendar.” The next HTRSYOB seminar begins Jan. 7 for three consecutive Tuesday evenings. Most SCORE workshops are free, but there is a small fee for this seminar.
Jean Kruse is a SCORE counselor and SCORE Iowa district president. She operated her own CPA firm for 13 years and in 1988, joined RSM McGladrey, a national firm, where she provided accounting and tax services to small businesses.
