Have you given serious thought to how your business
is taxed (other than the fact that you believe it is taxed too much)? For many
business owners, this area is often overlooked until taxes are due, and by that
time many tax advantages available to business owners may have been missed. As
2012 comes to a close, and with the threat of the fiscal cliff and higher tax
rates looming, now is the time to plan for 2013.
There are a number of entity selections for your
business, and the most common types of business entities are Proprietorships, General
and Limited Partnerships, C and S Corporations, and Limited Liability Companies.
The two issues this post will focus on are how each type is treated from a
liability standpoint, and from a federal tax perspective. Think of this as a
broad overview of each entity type, and should you have more pointed questions,
don’t hesitate to email me at Josh@theHElawfirm.com.
Proprietorship
This is the simplest form in which you can organize
your business. There is only one owner, the Proprietorship is not considered a
separate entity from that owner and no separate federal income return is
required (you include the income on your Schedule C). A Proprietorship is a “flow-through”
tax entity which means that the net profit or loss flows through to you and is
accounted for on your return. You are taxed on all the net profit, even if you
leave some cash in the business, and you do not receive a tax deduction for
cash draws out of the business. Further, the net profit is subject to self-employment
taxes and losses from prior years cannot be carried forward or backward to
offset self-employment taxes in other years.
In my opinion, the greatest drawback of a Proprietorship
is that you, as the owner, are personally liable for all the debts and
liabilities of the Proprietorship. While this may be less of an issue for
owners engaged in lower-risk activities with adequate insurance coverage, I
believe by operating as a Proprietorship, you are subjecting yourself to
unnecessary risk in addition to missing out carrying forward losses to offset
future income.
Partnership
When two or more individuals or business entities
create a business without forming a Corporation or other legal entity, a Partnership
has been created (there are some minimal state requirements which must be met including
filing specific documents and paying the appropriate fees). A Partnership also receives
flow-through tax treatment. All income, loss, gains, deductions, and credits
flow through to the partners. Partnerships that operate a trade or business
will generally result in self-employment income or loss to general partners (but
not limited partners).
The liability structure differs from the Proprietorship
because a Partnership is considered separate from the partners. Therefore, the Partnership
is primarily responsible for its debts and liabilities. However, if the company
does not have sufficient assets to satisfy its debts and liabilities, the
partners become responsible. Note the distinction between General and Limited
Partnerships discussed below.
In a General Partnership, the partners share
liability and management. In a Limited Partnership, the general partner(s)
share liability and management, but limited partners are only liable for their
capital contributions to the Partnership, and any debts the limited partner(s)
personally guaranty. There are some circumstances where a limited partner could
be held personally liable, but that is a conversation for another day.
Corporation
You have likely heard about C-Corporations and
S-Corporations. Both types provide limited liability protection to owners
(known as “shareholders”) as a shareholder is generally only responsible for
Corporation debts and liabilities up to the amount of the shareholder’s capital
contributions and any personally guaranteed debts. But beware of Courts “piercing
the corporate veil” to render a shareholder personally responsible for
Corporation debts and liabilities. This can be avoided by, among other things,
complying with Ohio’s filing requirements.
A C-Corporation, considered a separate entity from
the shareholder, is subject to a “double tax” regime, meaning income is taxed
at both the Corporation level, and again at the shareholder level as dividends.
A C-Corporation is not a flow-through tax entity. Losses do not pass through to
the shareholders; rather they are either carried back to prior years or forward
to offset future Corporation income. See the benefit realized by GM discussed
at http://online.wsj.com/article/SB10001424052970203609204574314180298525294.html.
Finally, the dividend distributions to shareholders are not deductible by the
C-Corporation.
An S-Corporation is also considered a separate
entity from the shareholders, but is a flow-through tax entity. Generally, any
item of income, loss, gain, deduction and credit passes through to the
shareholders. Similar to the C-Corporation, shareholders are not subject to
self-employment tax on the company’s profits. An additional benefit of the S-Corporation
is that there is no second level of tax.
Limited Liability Companies
The LLC is perhaps the most popular entity selected
by business owners today. LLC’s offer the liability shield present with a Corporation,
but with the flexibility to be taxed as a Proprietorship, C-Corporation,
S-Corporation or Partnership. An LLC can have a single or multiple owners (called
“Members”), and if a Member is an active participant in management, he or she
will likely be subject to self-employment tax. Ohio’s filing requirements are
minimal for an LLC, but be sure to have your Company Minute Book properly
created and updated regularly to avoid problems with liability, Member-buyouts
and the other common pitfalls for LLCs.
I did not discuss it here, but there are some intriguing
ways to combine the business entities outlined above in order to benefit your business
even further. If you would like to find out more, or if you have questions you
need answered in more depth, I am available at Josh@theHElawfirm.com, or (614)
759-4603.
