By Dr. Bill Whitley, CPA
Faculty Member, School of Business, American Public University
When you are thinking of opening a business, picking the best business entity for reporting federal (and possibly state) taxable income may not be the top item on your agenda. But it should be for a number of reasons. First, you don’t want to pay a lot of taxes. Second, you don’t want to create a lot of personal liability if something happens.
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Starting a Business as a Sole Proprietorship
The simplest solution is to just buy a business license at the local courthouse, because most cities and counties will require a license if you are in business as a sole proprietor. The cost for that license might not be more than $100, which is a minimal business expense.
The disadvantages of starting a sole proprietorship are unlimited liability and your taxes. You can lose everything you own if a lawsuit award against you exceeds any liability insurance you may have purchased, and you will have to pay a lot of tax on your earnings.
This type of business entity files federal taxes by using a 1040 Schedule C. Schedule C income is subject to the usual tax rate schedule for individuals.
But a sole proprietor is considered to be self-employed. As a result, you pay the employer’s and the employee’s share of Social Security and Medicare tax in addition to income tax.
One other problem with this type of business is a limited ability to raise capital to expand your business. You have several options: use your earnings for growth, borrow money or invest all your savings.
Starting a Business as a Partnership
If you are thinking about going into a business with one or more partners, you have a few more resources for getting the capital you need to get started. Also, the startup cost is not too high. You still need a business license and an oral agreement (not recommended) to start up a partnership. You should seek professional help in drafting a written partnership agreement. An attorney of a CPA can help with that.
But a partnership might not be a good choice for you. For instance, you are taxed on your share of partnership income, whether you can withdraw cash or not.
Also, you are still considered to be self-employed, which means you pay Social Security and Medicare tax on that taxable income. In addition, partners are subject to unlimited liability. In addition to that, you cannot have tax free employee benefits. If the partnership pays for your health insurance, it is taxable to you as a partner.
It is possible to provide some liability protection if you register the business as a limited liability company (LLC), which can be done if you are a sole proprietor or a partnership. However, you should contact an attorney for legal advice about liability protection.
Starting a Business as a Corporation
Finally, there is the corporation to consider. Corporations provide liability protection for owners. If you handle corporate affairs correctly, the most you can lose is the amount you invested in it.
You may have heard that a corporation has a high startup cost. But the cost to start it up depends on how you go about it. It is possible to fill out the incorporation paperwork on your own using information provided by the state where you want to incorporate, or you could go a site like LegalZoom.com for help with incorporation.
Other choices include using a certified public accountant (CPA) firm or a lawyer for assistance with incorporation. You might want legal advice or accounting advice anyway, so getting help with it in your company’s initial stages is not a bad idea.
Unlike sole proprietorships and partnerships, corporations have an unlimited life. In addition to the longevity issue, you might be able to raise a lot of capital sometime in the future if it gets to the point where you can do an Initial Public Offering (IPO) and turn it into a publicly traded corporation.
But you will have to do payroll for your employees. Corporate officers who work for the corporation are employees and you will have to set up some type of payroll system.
The payroll issue is not a big hurdle now that online sites are available to handle an organization’s payroll. The corporation will file its own tax return and pay taxes. However, you will be responsible for filing the corporate return, and you will need to pay taxes on your personal return for the income you have received as an employee.
An added benefit of incorporation is an employee benefit plan, which provides benefits that are deductible by your corporation and not taxable to you. In other words, the corporation can pay for life insurance, health insurance, daycare and other benefits.
Before Creating A Business Entity, Think Carefully about Your Options and Long-Term Goals
Before you take the steps for your start-up business and create a business entity, think carefully about your options and your long-term goals. Get some legal and accounting advice from people you trust and make a wise choice.
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About the Author
Dr. Bill Whitley is a full-time professor in the School of Business at American Public University. He holds an M.B.A. in business administration from the University of Houston – Victoria and an Ed.D. in higher education administration from the University of Alabama. Dr. Whitley has a CPA with a license to practice in Alabama.
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