This is the second week of my series on Starting a Business 101. Last week, I talked about choosing a name. Now that you have chosen a name, this week, we are going to talk about choosing a business structure.
In this series, I cover the topics below that are central to starting a new business.
Introduction - Why make it complicated?
Week 1 – Choose a name for your business.
Week 2 – Determine the legal structure.
Week 3 – DBAs and business licenses.
Week 4 – Get a federal tax id number.
Week 5 – Determine your federal, state and local taxes.
Week 6 – Record Keeping.
Week 7 – Other good information.
When I first started looking into business structures, it felt a little like reading Greek. As new information, it can be overwhelming. And, talking to a CPA right out of the shoot (though you should later once you can formulate questions) can be confusing if they toss around industry terms.
A friend with a jewelry business put it this way – “The CPA was speaking in tax terms I don’t understand. It would be like me asking them do they know what crimp cover pliers are or pave beads and if they know what to do with a crimp cover, etc. I so badly wanted to ask them that!” Isn’t that the truth?
I hope to make this as simple as possible. So, let’s get started. The IRS, your state and local government will all need to know what sort of business entity your business is, and it will affect what all you need to fill out and do.
Main Types of Business Structures (or entities)
The main types are, listed from most basic to most complicated:
- Sole Proprietorship
- LLC (filing as sole proprietorship, partnership or s-corp)
There are also entities such as LLP but I want to keep this basic and easy to understand. Each business structure type has different tax ramifications, as well as what forms to fill out when getting started. We’ll discuss that below and hopefully by the end of the post, you’ll have an idea of which type of entity you should choose for your new business.
The choice should be something you think through. But, I will say upfront, that for a new design business (and most new businesses), either a sole proprietorship or LLC make the most sense.
This is the simplest form of business,. It is also the easiest to set up and easiest to do taxes on. And, in most cases, the least expensive. If your business has one owner, it’s a great way to start out.
A sole proprietorship is an unincorporated business that is owned by an individual (one person).
If you establish your business as a sole proprietorship, you won’t need to register your business at the state level other than filing your Doing Business As (DBA) name (aka assumed name or a fictitious name).
As a sole proprietor, you may need the following (which we will discuss later in the series):
- A DBA name (there is a fee involved).
- A sales tax identification number.
- An employer identification number.
- A business license.
A sole proprietorship has no existence apart from you, the owner. That means there is no protection for liability. If anything goes wrong, you have debts or get sued, you are personally liable. You undertake the risks of the business. And, as such, when you do taxes, you include the income and expenses of the business on your own personal tax return. You pay income taxes and self-employment (SE) taxes on all profits.
Business profits or losses of a sole proprietorship are reported on Schedule C, Schedule C-EZ, or Schedule F of Form 1040, U.S. Individual Income Tax Return.
A partnership simply has more than one owner. It can have two or more owners.
You can create a partnership without many formalities, but for your protection, it’s a good idea to have a Partnership Agreement that outlines the partners’ rights.
In general, you’ll want to avoid general partnerships, though. Why? Like with a sole proprietorship, you have personal liability for the debts and obligations. In other words, your personal assets are at risk if anything goes wrong. And, this time, you have a partner(s) that would share the liability. And, you must split profits and losses with your partner(s) as well. That could end a friendship, should there be issues. Why go through this if you can just start an LLC?
Like sole proprietorships, owners of general partnerships are taxed personally, not the business itself. This is called pass-through taxation. You pay income taxes and self-employment (SE) taxes on all business profits. Even when funding a retirement account, which reduces your income taxes, you’ll still pay SE taxes on those profits. That’s why people look at LLCs (filing as s-corps) and corporate structures.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is also an unincorporated (not a corporation) business structure. An LLC is allowed by state statute, which means it’s formed at the state level, typically by filing articles of organization as an LLC. An LLC is not a sole proprietorship, partnership or a corporation, but blends elements of a partnership (in the form of pass-through taxation) and elements of a corporation( in the form of limited liability.)
Limited liability means if anything goes bad, they can’t come after your personal bank accounts, home, etc. You are not personally liable.
LLC Statues Vary by State
However, it is wise to note that there are numerous differences among states’ LLC statutes. Check with your state and talk to a CPA or lawyer about exactly what an LLC may mean for you in your state. In addition to statute differences, different states also require different fees to start an LLC.
Fees for the initial start-up as well as renewal fees for LLC’s may be significant in some states. In Texas, for example, it costs $300 to start an LLC (but there is not a renewal fee.) Yet in Utah, it only costs around $30 to start an LLC. In Arizona, I believe it was $85. In addition to this fee, certain states, such as New York and Arizona, impose a publication requirement upon formation of the LLC which requires that the members of the LLC publish a notice in newspapers in the geographic region that the LLC will be located that it is being formed. That cost can be significant in some locales.
Another way LLC statutes may vary between states is that unlike most states, the District of Columbia considers LLCs to be taxable entities, which eliminates the benefit of pass-through taxes thereby subjecting members to double taxation.
LLC’s and Taxes
Depending on how the LLC is structured, the company may file taxes like a sole proprietorship, partnership (though it still has limited liability in those situations), or like an s-corporation.
If there is only one member in the company, the LLC is treated as a sole proprietorship for tax purposes. In that case, the individual owner would report the LLC’s income or loss on Schedule C of his or her individual tax return.
The default tax statutes for LLCs with multiple members is as a partnership. Since an LLC is created at the state level, federally there isn’t a distinct way of taxing that entity, so by default you are taxed as a partnership.
With this default tax treatment, the owners report income and loss on IRS Form 1065. Under partnership tax treatment, each member of the LLC, annually receives a Form K-1 reporting the member’s distributive share of the LLC’s income or loss that is then reported on the member’s individual income tax return.
An LLC may elect to be taxed as a corporation by filing IRS Form 8832. Then you can also file form 2553 to choose to specifically be taxed as an s-corp.
Some have said an LLC taxed as an s-corporation is the best possible small business structure. It combines the simplicity and flexibility of an LLC with the tax benefits of an s-corporation (self-employment tax savings). This is the structure we use at Hyphen Interiors.
In an LLC that is taxed as an s-corp, only salaries paid to employees via payroll (another thing you’d need to learn to do or pay someone to do) are subject to employment taxes. Profits outside of payroll (shareholder distributions) are not subject to employment taxes, just income taxes. This is in contrast to an LLC that does not make an election to be taxed as an s-corp. In that case, the owner of the (non s-corp) LLC is considered to be “self-employed” and, in addition to the usual income tax, those owners must also pay a self-employment tax equal to 15.3% on ALL profit, not just the payroll portion.
Self-employment tax is made up of Social security tax and Medicare tax.
Another thing to note when it comes to expenses that LLCs face is that many jurisdictions, including Alabama, California, Kentucky, New York, Pennsylvania, Tennessee, and Texas, have a franchise tax for LLCs. This may factor into your decision. In Texas, they waive this tax until you make over a million dollars, yet in California, there is a minimum tax of $800 for all LLCs. In essence, this franchise or business privilege tax is the fee the LLC pays the state for the benefit of limited liability.
Other LLC Information
An LLC does carry more formal requirements for its formation than a sole proprietorship or partnership. For example, in Texas, an LLC is created by filing a certificate of formation with the Texas Secretary of State.
The owners of an LLC are called “members.” A member can be an individual, partnership, corporation, trust, and any other legal or commercial entity.
LLCs in most states are treated as entities separate from their members, whereas in other jurisdictions case law has developed deciding LLCs are not considered to have separate legal standing from their members (such as D.C.).
Note that some states, such as California, do not permit LLCs to engage in the practice of a licensed profession. Instead, in that case, you’d need to start a professional LLC (a special type of LLC).
Brief History on LLC’s from Wikipedia
In the United States, the first limited liability company act appeared in Wyoming in 1977 as special interest legislation for an oil company. In 1980, the Internal Revenue Service issued a private letter ruling to an LLC formed under Wyoming LLC Act indicating that the IRS would treat the LLC as a partnership for federal tax purposes. However, later that year, the IRS proposed regulations that would deny partnership classification to any business entity in which no member bore personal responsibility for the entity’s liabilities. In 1982, Florida adopted an LLC act modeled on Wyoming’s LLC Act. Due to uncertainty over the tax treatment of LLCs, no other states introduced LLC legislation until after 1988. In 1988, the IRS issued a revenue ruling stating that it would treat a Wyoming-style LLC as a partnership for tax purposes. By 1996, nearly every state had enacted an LLC statute.
A corporation is legal entity that, like an LLC, is established under state law. It has the characteristics of limited liability and centralization of management. The owners of a corporation are called shareholders. The person(s) who manage the business and affairs of a corporation are called directors.
The advantage of a corporation is that, if properly formed, the shareholders are shielded from the corporations liabilities. However, note, the corporate business entity does not protect professionals, such as doctors, from personal liability during lawsuits.
The two main kinds of corporations are C corporations and S corporations. I won’t go into a lot of detail on these since it will be rare to use them for a start-up business.
Corporations do require that you follow a fair amount of formalities.
Below is a chart from Small Business Kit for Dummies. It summarizes the basics of each entity. Hopefully you can read it alright.
The list below is from the SBA.gov website. Click on a state to find out about specific filing requirements there.
It is always wise to consult your CPA and/or attorney before you make a decision on a business structure. If you do not have a CPA, be aware that most charge by the hour ($150-300/hr). However, if you just have a few questions, call around. Many times someone will answer them without charging. If you are truly short on cash you can see if your local H&R Block has anyone on staff that is knowledgeable in this area.
Once you figure out what entity you want your business to be, make sure you do the proper paperwork to get it started. A CPA can help with this, as LLC and Corporations will vary by state. But, a start is to refer to the charts above and to check your state link provided in the list above.
(By the way, on a side note, in case you were wondering, your business is not a hobby if you intend to make a profit.)
Next week we will talk about DBAs and business licenses.
I hope you enjoyed Week 2 and that the information is already helpful. Please add your own insights into this step in the comments. I’d love to hear what entity you chose and why, if you have a business.
As a disclaimer, I am not a CPA, lawyer or business expert. I am simply sharing what I’ve learned in case you have no idea where to start.