So You Want To Go Into Business For Yourself?

By Caryn M. Feldman, CPA, MST

When starting any new business, there are many decisions you must make before you can even open your doors for business. The first choice you will need to make is the legal form in which you will operate as a business. Among the choices are an unincorporated sole proprietorship, a regular corporation, an S corporation, a partnership or a limited liability company. From a tax perspective, each of these forms have advantages and disadvantages that must be carefully weighed in conjunction with your own plans and personal objectives.

A sole proprietorship is perhaps the simplest and easiest form to set up and maintain. There are few legal formalities in this format. However, sole proprietorships cannot provide you with personal liability protection nor can they offer you many of the tax benefits available to corporate employees, such as medical coverage and life insurance. The business liabilities are your personal liabilities and you assume all the risks for the assets owned by the business. In addition, as a sole proprietor, you include all the income and expenses of the business on your personal income tax return and the net income from the business is subject to self-employment tax.

In contrast, a corporation generally is a legal entity which exists separately from its owners. The sale of stocks or bonds by the corporation can generate additional capital and unlike sole proprietorships, the longevity of the corporation can continue long past the death of its owners. As a regular corporation, known as a C corporation, your business income will be subject to double taxation. Double taxation means that your business profits will be taxed at both the corporate level, and then taxed again at the shareholder level if the income is distributed as dividends. A considerable advantage of the corporate format is that from a legal standpoint, your personal assets are fully protected from creditors of the business.

An S corporation offers liability protection as well, without an additional layer of corporate tax. Generally, S corporations are exempt from federal income tax. S corporation shareholders include their share of the corporation’s income and deductions on their personal income tax returns. One potential drawback to the S corporation format, however, results from limitations on the number and kind of permissible shareholders. These restrictions can hinder a corporation’s growth potential and in some instances, access to capital.

A partnership offers many of the same advantages and disadvantages of the sole proprietorship. A partnership, however, allows the business to be owned and managed by more than one person. In addition, the exposure to personal liability can be mitigated by the formation of either a limited partnership (LP) or a limited liability partnership (LLP). However, in an LP or an LLP, a partner whose liability is limited cannot be involved in actively managing the business. Like an S corporation, a partnership does not pay federal income tax. Income and deductions are passed through to the partners for inclusion on their personal income tax returns. However, in an LP or LLP, the deductibility of losses incurred can be restricted at the limited partner level due to the passive activity loss rules.

A newer form of business entity, known as the limited liability company (LLC), many see as the best alternative for the typical small business. LLCs combine the flexibility of partnership taxation with the liability protection of a corporation. LLC members do not have to limit their participation in the management of the business in order to protect their personal assets from creditors of the business, as they do in an LP. Yet the entity will be taxed as a partnership unless it elects otherwise. LLCs also have one distinct advantage over S corporations for many businesses. There are no limits on the number or kind of shareholders, giving an LLC greater access to capital. In addition, LLC members have greater flexibility to allocate income and loss items. LLCs also provide more estate planning flexibility than S corporations.

With all that going for them, should your business become an LLC? The answer depends on your particular set of circumstances. Established corporations with appreciated assets may find the tax cost of conversion to be too prohibitive, while most start-up ventures should at least consider operating as an LLC. Real estate partnerships are especially suitable candidates.

As you can see, there are a number of variables for you to consider before making the decision on what legal entity makes the most sense for you as a business owner. There is no right or wrong answer. Before making any final decisions, you should seek professional advice from your accountant and attorney about which form would be the most beneficial for you. Caryn M. Feldman, CPA, MST is a tax manager at Walter & Shuffain, P.C. located in Norwood, MA. For more information on starting a new business, please call Caryn at (781)769-5300 or email her at cfeldman@wscpa.com.