Your First Business Decision
How to select the business structure that's right for you.
by John B. (Jay) Hoover, CPA
Recently, I had the uncomfortable task of informing a new client that he owed an additional $80,000 in state taxes solely due to the structure of his business. Once the client recovered from the shock of that news, I further informed him that he would owe this tax each and every year! Needless to say, the client is evaluating whether or not to start over with a new entity. Don't let this happen to you!
Entity structure is one of the first decisions every new business must make. The decision you make will have effects on your business throughout its existence and even after the business has been sold or closed. The good news is that businesses today have more entity choices to select from than ever before.
So what will it be? A proprietorship, partnership, LP, LLC, LLP, S Corp, PC, C Corp? Confused? You're not alone. Generally, the options can be summarized into one of four categories: proprietorship, partnership, corporation and limited liability company (LLC). Exhibit A summarizes the primary characteristics of each of these general categories.
Although management, capitalization, continuity of life and others are important factors to consider, small businesses generally are most concerned about the tax consequences and limiting liability exposure. In Tennessee, state taxes play an important role in entity selection, which is primarily due to the fact that Tennessee does not impose a tax on earned income from sole proprietorships and partnerships. Conversely, Tennessee imposes a franchise and excise taxes on corporations, limited partnerships, LLPs and LLCs. The franchise tax is based on assets and capital utilized by the business, while the excise tax is based on the profits of the business. Obviously, you should consider all states in which you will do business in making the choice of entity. Federal taxes are also important, and can make the difference between paying taxes once or twice on the same income.
In today's litigious environment, most entrepreneurs are keenly aware of what can go wrong in a business enterprise that could subject the owner to virtually unlimited liability exposure. There is a great desire among new business owners to limit their risk of loss to the actual amount invested into the business venture, thereby protecting the owners' home and other personal assets. Until recently, a small business owner desiring to limit his or her personal liability typically had to form a corporation to enjoy limited liability protection. In addition to the limited partnership alternative that has also been around for many years but is somewhat cumbersome, entrepreneurs now have two new options: limited liability company and limited liability partnership.
The proprietorship is by far the easiest to setup since there can only be one owner and there are no legal documents or filings with the secretary of state required. You simply hold yourself out for business and file for a business license in your local area. That's it, and you're in business. You aren't even required to maintain a formal set of books, although most CPAs highly recommend establishing a separate bank account and maintaining some form of recordkeeping. Sole proprietorships are not required to file a separate tax return, but simply attach a Schedule C to their Form 1040. Income from the business will be subject to the self-employment tax (Social Security and Medicare) and the individual federal income tax.
The primary disadvantages of a proprietorship are that there can only be one owner and that owner is typically subjected to all of the risks associated with the business. A proprietor can help minimize his or her liability exposure by obtaining adequate insurance to guard against insurable risks.
If the business has more than one owner, a general partnership is relatively simple to set up. A partnership is a little more complicated than a proprietorship in that you are only required to file a separate tax return and maintain a set of books. Again, there are no required filings other than a business license with the local authorities. The tax consequences would generally be the same as a proprietorship except that each partner's share of income and expenses would be reported on one's individual tax return. A partnership is also generally allowed to allocate income and losses among partners in any manner it chooses as long as it follows the economic substance of the partners' affiliation with each other.
The liability exposure is actually greatest in a general partnership structure, since each partner is typically liable for the actions of the other partners, whether authorized or not, in addition to general business liability. Insurance can be obtained to cover some situations but not all. So, pick your partners wisely.
A special type of partnership, known as a limited partnership (LP), can also be formed to limit the liability of some of the partners to that of their investment only. These limited liability partners, called limited partners, generally cannot have any voice in the management of the business. The partners that do have management responsibilities, called general partners, are subjected to all of the claims of the general creditors and any other potential claims. There must be at least one general partner in a limited partnership.
Another important factor to consider is a written partnership agreement. In the state of Tennessee, the presumption is that all income and expenses are to be allocated evenly unless the partnership has a duly executed agreement to the contrary. If you have disproportionate interests, be sure to take the time to draw up a partnership agreement. It may be wise to seek the help of a qualified attorney and certified public accountant (CPA) to make sure all of the bases are covered in the agreement.
Corporations are sometimes thought of as the structure for larger businesses. That is a misconception since many small businesses operate under the corporate structure. A corporation can be set up by most attorneys at a cost of between $500 and $1,500 based upon the complexity of the incorporation. Corporations are required to maintain a formal set of books and file a separate income tax return.
Limited liability is probably the single greatest advantage of the corporate form. A shareholder's liability is generally limited to his or her investment in the corporation. Stockholders who are also employees of the corporation can enjoy a few tax breaks related to the deductibility of certain fringe benefits such as group health and life insurance and dependent care assistance programs. These tax breaks are only available to regular corporations, sometimes called C corporations. The maximum corporate tax rate is also lower than the current individual tax rate by about 6 percent, which can help pay for the increased state tax costs. A corporation also has an indefinite life span since its stock can typically be transferred to new owners upon death, merger or sale of the business.
Unfortunately, there is a multitude of tax disadvantages associated with corporations. First of all, in Tennessee there is a six percent excise tax on all corporate earnings in addition to a franchise tax of $25 per $10,000 in assets and/or capital utilized by the corporation in Tennessee. If state taxes weren't enough of a deterrent, the federal government imposes a corporate level tax on all corporate earnings and a second tax upon the distribution of those same earnings to its shareholders in the form of a dividend or liquidating payment. C corporations also face numerous tax traps such as corporate alternative minimum tax, accumulated earnings tax, personal holding company tax and a personal service corporation tax. All of these tax issues should be thoroughly discussed with a CPA before forming a C corporation to determine which of these potential traps may catch your particular business.
A popular way to avoid many of the tax disadvantages of regular C corporations is to file an election with the Internal Revenue Service to be taxed as an S corporation. This federal election allows S corporations to be taxed in a manner similar to that of a partnership, which means that the profits and losses are allocated to its shareholders in proportion to their stock ownership. However, for state tax purposes, S corporations are taxed the same as C corporations in Tennessee. There are several restrictions and requirements to be met in order to qualify for this special election, which may require consultation with a CPA.
The limited liability company (LLC) is the new kid on the block, passing the Tennessee Legislature in June 1994, and has quickly become one of the most popular entity choices for small businesses in Tennessee. An LLC combines some of the best features of a corporation, S corporation and partnership. An LLC provides its members (similar to partners or stockholders) with essentially the same liability protection afforded to stockholders of a corporation and limited partners of an LP. Additionally, LLCs enjoy the tax benefits of a partnership, including: 1) a single layer of taxation and 2) the ability to specially allocate income and losses. The LLCs greatest drawback is its potential complexity and annual secretary of state filing fees ($100 per member with a $300 minimum and a $3,000 maximum). Most attorneys charge between $500 and $2,500 to setup an LLC depending on its complexity. Remember, an LLC is now subject to the franchise and excise taxes as a corporation.
Similar to a partnership agreement, all LLCs should have a written operating agreement. Without such an agreement among the members, the state of Tennessee presumes that all income and expenses are to be allocated evenly among the members. Once again, it may be wise to seek the help of a qualified attorney and CPA to properly draw up this agreement.
The Tennessee Tax Revision and Reform Act of 1999, expands the types of businesses subject to Tennessee franchise and excise tax by including every limited liability company, professional limited liability company, registered limited liability partnership, professional registered limited liability partnership and limited partnership. General partnerships and sole proprietorships are still not subject to the tax. The effective dates vary depending on the business entity and the provision of the act. The general rule is the new franchise and excise taxes go into effect for tax years beginning on or after July 1, 1999. This new law attempts to level the state tax playing field between corporations and other limited liability entities such as LPs and LLCs.
There is a lot to consider in evaluating your new business' entity structure. No two entity structures are the same, and the implications of choosing one will span the life of your new business. Ultimately, you need to balance the needs for simplicity, flexibility, protection and control. Avoid being like my small business client who is struggling to start with a new entity choice. Evaluate your options fully on the front end!
About the Author
John B. (Jay) Hoover, CPA, is the managing partner of Baker, Sullivan & Hoover, PLC, a certified public accounting firm in Nashville, Tenn.
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