Step 12: Consider A Legal Entity
The Concept:
One of the most important decisions you'll make is the legal form for your new business, which defines potential liability regarding business activities as well as a tax structure and which parties have controlling interest.
What you need to know:
Each of the various legal business entities has its advantages and drawbacks. It is important to consult with a knowledgeable attorney and tax advisor before making your choice. Don't automatically assume you need to incorporate because this may not be the most desirable form for your venture. The basic legal structures include:
Sole Proprietorship: You are the owner and maintain complete control of the business. As such, you are totally liable with personal assets at risk in any legal case against you. Income and expenses are reported on your personal tax return. The business terminates on your death or withdrawal from the business. The business can be sold but you are no longer the proprietor.
General Partnership: You and other parties co-own the business and have authority to establish contracts and make decisions. All partners share liability for debts and report income (or loss) on their personal returns. The business itself does not pay taxes. Cash distributions to partners generally are not taxed. The partnership dissolves upon death or withdrawal of a partner.
Limited Partnership: The business is controlled by a general partnership, with limited partners liable only for the amount of their investment. Limited partners do not participate in day-to-day operations. In this legal structure, both limited and general partners report their share of income or loss on their individual tax returns. Death of a limited partner does not dissolve the business. Tax treatment is similar (but not identical) to the general partnership form.
Limited Liability Company: A relatively new form in which an owner or "member" partners run the business, although members are not liable for debts. Members (an unlimited number of individuals or business entities) report income and income tax on their individual returns in the same manner as for partnerships. Continuity regarding death or withdrawal of members is different from state to state.
Corporation: A corporation is formed by filing Articles or a Certificate of Incorporation with the relevant state office. Here, shareholders in the business name a board of directors, who in turn appoint officers to run the business. Liability falls to the corporation, with shareholders responsible for the amount of investment. The corporation survives any death or withdrawal by owners, partners and shareholders. A corporation can file an election with the IRS to be treated as an S-Corporation. If no S selection is filed, the corporation is a C-Corporation.
C-Corporation: The entity pays its own taxes while shareholders report any actual dividends on their own returns.
S-Corporation: Similar to the C-Corporation, except the business entity generally does not pay taxes on its income, which is passed through to its shareholders. Shareholders will personally report their share of the income (whether or not distributed). Distributions of cash to shareholders are generally not taxed.
Points to consider:
How will you finance your new business?
How can you minimize taxes?
What risk (liabilities) are you undertaking?
How will control of the business be shared?
What are the costs in forming your business?
Will you retain profits (to grow the business) or distribute them to owners?
What entity is the best for your business given your financial, tax and liability issues? |
