Thoughts on starting a new business. Part 4


This article is part of a series. To read the previous article please click here. To read this series from the beginning please click here.

To Corp or Not To Corp… That is no longer the Question

articles-of-incorporation

Incorporating a business is a big deal. Your corporation is your baby in more ways than one. A corporation is recognized by law as a separate entity, it has its own tax identification number or EIN just like you have a social security number. As it grows and generates more and more income, so will be the associated expenses including salaries, benefits, and lest we forget; taxes. It also needs a bit of TLC every quarter with the remittances of appropriate corporate and employment taxes, unemployment insurance forms, and any other appropriate deductions and withholdings depending on your type of business.

In this post we will take a closer look at the different types of businesses entities and understand what they are all about. The following is taken from sba.gov:

1) Sole-Proprietorship: This is where you are the company. There is essentially no separate legal entity formed. You have no separate taxes to file, no termination forms to fill if you ever wish to stop doing business. It’s just you and the lemonade stand. The downside of this type of business is that it is incredibly difficult to raise money and because there isn’t a separate entity to take the blame should any losses occur, the sole-proprietor is liable for any and all damages incurred.

2) Limited Liability Company or LLC: An LLC is essentially a partnership. Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity but the members enjoy limited amount of liabilities just like a corporation would. All profits and losses are “passed through” the business to each member of the LLC to be reported on the personal federal tax returns. The other nice thing about LLCs is that you can apply for an S-Corporation status for your LLC and enjoy the tax benefits associated with it.  Filing taxes is a once-a-year affair on April 15: a single-member LLC files a 1040 and Schedule C like a sole proprietor; partners in an LLC file a 1065 partnership tax return like owners in a traditional partnership. Moreover, LLCs are not required to have formal meetings and keep minutes.

There are also fewer restrictions on profit-sharing within an LLC as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat-equity. Consequently, it’s up to them to decide who has earned what percentage of the profits or losses.

But LLCs are not the perfect entity for all businesses. First, an LLC has a limited life: when a member dies or undergoes bankruptcy the LLC is dissolved. Typically, you would determine in advance the length of the LLC’s duration when you file it with your state. If your plans include taking your company public or issuing shares to your employees, essentially prolonging its life, then you would need to convert to a corporate business structure.

Second, the owner of an LLC is considered to be self-employed and must pay the 15.3% self-employment tax contributions towards Medicare and social security. As such, the entire net income of the LLC is subject to this tax. It costs money to have some operational ease!

The IRS also limits the ‘characteristics’ of your company. An LLC may only have two of the four characteristics that define corporations:

1) Limited liability to the extent of assets

2) Continuity of life

3) Centralization of management

4) Free transferability of ownership interests.

Therefore, if you wish to have more than two of these characteristics, you’ll need to convert to a corporate business structure.

3) Cooperative: A cooperative is a business or organization owned by and operated for the benefit of those using its services. Profits and earnings generated by the cooperative are distributed among the members, also known as user-owners.

Typically, an elected board of directors and officers run the cooperative while regular members have voting power to control the direction of the cooperative. Members can become part of the cooperative by purchasing shares, though the amount of shares they hold does not affect the weight of their vote.

Cooperatives are common in the healthcare, retail, agriculture, art and restaurant industries.

Forming a cooperative is different from forming any other business entity. To start up, a group of potential members must agree on a common need and a strategy on how to meet that need. An organizing committee then conducts exploratory meetings, surveys, and cost and feasibility analyses before every member agrees with the business plan. Not all cooperatives are incorporated, though many choose to do so. If you decide to incorporate your cooperative, you must complete the following steps:
•File Articles of Incorporation. The articles of incorporation legitimizes your cooperative and includes information like the name of the cooperative, business location, purpose, duration of existence, and names of the incorporators, and capital structure. Once the charter members (also known as the incorporators) file with your state business entity registration office and the articles are approved, you should create bylaws for your cooperative.
•Create Bylaws. While the law does not require bylaws, they do need to comply with state law and are essential to the success of your cooperative. Bylaws list membership requirements, duties, responsibilities and other operational procedures that allow your cooperative to run smoothly. According to most state laws, the majority of your members must adopt articles of incorporation and bylaws. Consult an attorney to verify that your bylaws comply with state laws.
•Create a Membership Application. To recruit members and legally verify that they are part of the cooperative, you must create and issue a membership application. Membership applications include names, signatures from the board of directors and member rights and benefits.
•Conduct a Charter Member Meeting and Elect Directors. During this meeting, charter members discuss and amend the proposed bylaws. By the end of the meeting, all of the charter members should vote to adopt the bylaws. If the board of directors were not named in the articles of incorporation, you must designate them during the charter meeting.
•Obtain Licenses and Permits. You must obtain relevant business licenses and permits. Regulations vary by industry, state and locality. Use our Licensing & Permits tool to find a list of federal, state and local permits, licenses and registrations you’ll need to run a business.
•Hiring Employees. If you are hiring employees, read more about federal and state regulations for employers.

Each state will have slightly different laws that govern a cooperative. Consult an attorney, your Secretary of State or State Corporation Commissioner for more information regarding your state’s specific laws.

Most businesses need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit. A cooperative operates as a corporation and receives a “pass-through” designation from the IRS. More specifically, cooperatives do not pay federal income taxes as a business entity.

Instead, the cooperative’s members pay federal taxes when they file their personal income tax. Members pay federal and state income tax on the margins earned by the cooperative, though the amount of taxation varies slightly by state. Cooperatives must follow the rules and regulations of the IRS’s Subchapter T Cooperatives tax code to receive this type of tax treatment.

Advantages of a Cooperative
• Less Taxation. Similar to an LLC, cooperatives that are incorporated normally are not taxed on surplus earnings (or patronage dividends) refunded to members. Therefore, members of a cooperative are only taxed once on their income from the cooperative and not on both the individual and the cooperative level.
• Funding Opportunities. Depending on the type of cooperative you own or participate in, there are a variety of government-sponsored grant programs to help you start. For example, the USDA Rural Development program offers grants to those establishing and operating new and existing rural development cooperatives.
• Reduce Costs and Improve Products and Services. By leveraging their size, cooperatives can more easily obtain discounts on supplies and other materials and services. Suppliers are more likely to give better products and services because they are working with a customer of more substantial size. Consequently, the members of the cooperative can focus on improving products and services.
• Perpetual Existence. A cooperative structure brings less disruption and more continuity to the business. Unlike other business structures, members in a cooperative can routinely join or leave the business without causing dissolution.
• Democratic Organization. Democracy is a defining element of cooperatives. The democratic structure of a cooperative ensures that it serves its members’ needs. The amount of a member’s monetary investment in the cooperative does not affect the weight of each vote, so no member-owner can dominate the decision-making process. The “one member-one vote” philosophy particularly appeals to smaller investors because they have as much say in the organization as does a larger investor.

Disadvantages of a Cooperative
• Obtaining Capital through Investors. Cooperatives may suffer from slower cash flow since a member’s incentive to contribute depends on how much they use the cooperative’s services and products. While the “one member-one vote” philosophy is appealing to small investors, larger investors may choose to invest their money elsewhere because a larger share investment in the cooperative does not translate to greater decision-making power.
• Lack of Membership and Participation. If members do not fully participate and perform their duties, whether it be voting or carrying out daily operations, then the business cannot operate at full capacity. If a lack of participation becomes an ongoing issue for a cooperative, it could risk losing members.

4) Corporation:

A corporation (sometimes referred to as a C corporation) is an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.

Corporations are more complex than other business structures because they tend to have costly administrative fees and complex tax and legal requirements. Because of these issues, corporations are generally suggested for established, larger companies with multiple employees.

For businesses in that position, corporations offer the ability to sell ownership shares in the business through stock offerings. “Going public” through an initial public offering (IPO) is a major selling point in attracting investment capital and high quality employees.

Forming a Corporation

A corporation is formed under the laws of the state in which it is registered. To form a corporation you’ll need to establish your business name and register your legal name with your state government. If you choose to operate under a name different than the officially registered name, you’ll most likely have to file a fictitious name (also known as an assumed name, trade name, or DBA name, short for “doing business as”). State laws vary, but generally corporations must include a corporate designation (Corporation, Incorporated, Limited) at the end of the business name.

To register your business as a corporation, you need to file certain documents, typically articles of incorporation, with your state’s Secretary of State office. Some states require corporations to establish directors and issue stock certificates to initial shareholders in the registration process. Contact your state business entity registration office to find out about specific filing requirements in the state where you form your business.

Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state and locality. Use our Licensing & Permits tool to find a listing of federal, state and local permits, licenses and registrations you’ll need to run a business.

If you are hiring employees, read more about federal and state regulations for employers.

Corporation Taxes

Corporations are required to pay federal, state, and in some cases, local taxes. Most businesses must register with the IRS and state and local revenue agencies, and receive a tax ID number or permit.

When you form a corporation, you create a separate tax-paying entity. Regular corporations are called “C corporations” because Subchapter C of Chapter 1 of the Internal Revenue Code is where you find general tax rules affecting corporations and their shareholders.

Unlike sole proprietors and partnerships, corporations pay income tax on their profits. In some cases, corporations are taxed twice – first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns. Corporations use IRS Form 1120 or 1120-A, U.S. Corporation Income Tax Return to report revenue to the federal government.

Shareholders who are also employees pay income tax on their wages. The corporation and the employee each pay one half of the Social Security and Medicare taxes, but this is usually a deductible business expense.

Read more about tax requirements for Corporations on IRS.gov.

Advantages of a Corporation
• Limited Liability. When it comes to taking responsibility for business debts and actions of a corporation, shareholders’ personal assets are protected. Shareholders can generally only be held accountable for their investment in stock of the company.
• Ability to Generate Capital. Corporations have an advantage when it comes to raising capital for their business – the ability to raise funds through the sale of stock.
• Corporate Tax Treatment. Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits are awarded a corporate tax rate, which is usually lower than a personal income tax rate.
• Attractive to Potential Employees. Corporations are generally able to attract and hire high-quality and motivated employees because they offer competitive benefits and the potential for partial ownership through stock options.

Disadvantages of a Corporation
• Time and Money. Corporations are costly and time-consuming ventures to start and operate. Incorporating requires start-up, operating and tax costs that most other structures do not require.
• Double Taxing. In some cases, corporations are taxed twice – first, when the company makes a profit, and again when dividends are paid to shareholders.
• Additional Paperwork. Because corporations are highly regulated by federal, state, and in some cases local agencies, there are increased paperwork and recordkeeping burdens associated with this entity.

5) Partnerships:

A partnership is a single business where two or more people share ownership.

Each partner contributes to all aspects of the business, including money, property, labor or skill. In return, each partner shares in the profits and losses of the business.

Because partnerships entail more than one person in the decision-making process, it’s important to discuss a wide variety of issues up front and develop a legal partnership agreement. This agreement should document how future business decisions will be made, including how the partners will divide profits, resolve disputes, change ownership (bring in new partners or buy out current partners) and how to dissolve the partnership. Although partnership agreements are not legally required, they are strongly recommended and it is considered extremely risky to operate without one.

Types of Partnerships        

There are three general types of partnership arrangements:
1) General Partnerships assume that profits, liability and management duties are divided equally among partners. If you opt for an unequal distribution, the percentages assigned to each partner must be documented in the partnership agreement.
2) Limited Partnerships (also known as a partnership with limited liability) are more complex than general partnerships. Limited partnerships allow partners to have limited liability as well as limited input with management decisions. These limits depend on the extent of each partner’s investment percentage. Limited partnerships are attractive to investors of short-term projects.
3) Joint Ventures act as general partnership, but for only a limited period of time or for a single project. Partners in a joint venture can be recognized as an ongoing partnership if they continue the venture, but they must file as such.

Forming a Partnership

To form a partnership, you must register your business with your state, a process generally done through your Secretary of State’s office.

You’ll also need to establish your business name. For partnerships, your legal name is the name given in your partnership agreement or the last names of the partners. If you choose to operate under a name different than the officially registered name, you will most likely have to file a fictitious name (also known as an assumed name, trade name, or DBA name, short for “doing business as”).

Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state and locality. Use our Licensing & Permits tool to find a listing of federal, state and local permits, licenses and registrations you’ll need to run a business.

If you are hiring employees, read more about federal and state regulations for employers.

Partnership Taxes            

Most businesses will need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit.

A partnership must file an “annual information return” to report the income, deductions, gains and losses from the business’s operations, but the business itself does not pay income tax. Instead, the business “passes through” any profits or losses to its partners. Partners include their respective share of the partnership’s income or loss on their personal tax returns.

Partnership taxes generally include:
• Annual Return of Income
• Employment Taxes
• Excise Taxes

Partners in the partnership are responsible for several additional taxes, including:
• Income Tax
• Self-Employment Tax
• Estimated Tax

Filing information for partnerships:
• Partnerships must furnish copies of their Schedule K-1 (Form 1065)Download Adobe Reader to read this link content to all partners by the date Form 1065 is required to be filed, including extensions.
• Partners are not employees and should not be issued a Form W-2.

The IRS guide to Partnerships provides all relevant tax forms and additional information regarding their purpose and use.

Advantages of a Partnership
• Easy and Inexpensive. Partnerships are generally an inexpensive and easily formed business structure. The majority of time spent starting a partnership often focuses on developing the partnership agreement.
• Shared Financial Commitment. In a partnership, each partner is equally invested in the success of the business. Partnerships have the advantage of pooling resources to obtain capital. This could be beneficial in terms of securing credit, or by simply doubling your seed money.
• Complementary Skills. A good partnership should reap the benefits of being able to utilize the strengths, resources and expertise of each partner.
• Partnership Incentives for Employees. Partnerships have an employment advantage over other entities if they offer employees the opportunity to become a partner. Partnership incentives often attract highly motivated and qualified employees.

Disadvantages of a Partnership       
• Joint and Individual Liability. Similar to sole proprietorships, partnerships retain full, shared liability among the owners. Partners are not only liable for their own actions, but also for the business debts and decisions made by other partners. In addition, the personal assets of all partners can be used to satisfy the partnership’s debt.
• Disagreements Among Partners. With multiple partners, there are bound to be disagreements Partners should consult each other on all decisions, make compromises, and resolve disputes as amicably as possible.
• Shared Profits. Because partnerships are jointly owned, each partner must share the successes and profits of their business with the other partners. An unequal contribution of time, effort, or resources can cause discord among partners.

6) S-Corporation:

An S corporation (sometimes referred to as an S Corp) is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.

An S corp is a corporation with the Subchapter S designation from the IRS. To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits the financial liability for which you (the owner, or “shareholder”) are responsible. Nevertheless, liability protection is limited – S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident.

What makes the S corp different from a traditional corporation (C corp) is that profits and losses can pass through to your personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. There is an important caveat, however: any shareholder who works for the company must pay him or herself “reasonable compensation.” Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as “wages.”

Forming an S Corporation

Before you form an S Corporation, determine if your business will qualify under the IRS stipulationsDownload Adobe Reader to read this link content.

To file as an S Corporation, you must first file as a corporation. After you are considered a corporation, all shareholders must sign and file Form 2553Download Adobe Reader to read this link content to elect your corporation to become an S Corporation.

Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state and locality. Use the Licensing & Permits tool to find a listing of federal, state and local permits, licenses, and registrations you’ll need to run a business.

If you are hiring employees, read more about federal and state regulations for employers.

Combining the Benefits of an LLC with an S Corp

There is always the possibility of requesting S Corp status for your LLC. Your attorney can advise you on the pros and cons. You’ll have to make a special election with the IRS to have the LLC taxed as an S corp using Form 2553. And you must file it before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect.

The LLC remains a limited liability company from a legal standpoint, but for tax purposes it’s treated as an S corp. Be sure to contact your state’s income tax agency where you will file the election form to learn about tax requirements.

Taxes

Most businesses need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit.

All states do not tax S corps equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. However, some states (like Massachusetts) tax S corps on profits above a specified limit. Other states don’t recognize the S corp election and treat the business as a C corp with all of the tax ramifications. Some states (like New York and New Jersey) tax both the S corps profits and the shareholder’s proportional shares of the profits.

Your corporation must file the Form 2553 to elect “S” status within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect.

Read more about IRS filing requirements for S Corporations.

Advantages of an S Corporation
•Tax Savings. One of the best features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.
•Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, then benefits like health and life insurance are deemed taxable income.
•Independent Life. An S corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.

Disadvantages of an S Corporation
•Stricter Operational Processes. As a separate structure, S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.
•Shareholder Compensation Requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results.

We are here to help

At Encure, we understand that it can be difficult to choose what kind of business structure is the best for your organizational/personal needs and that is why we have partnered with one of the top accounting and tax services firm in New York to serve our customers when it comes to this very specific task. Our partnership allows us to provide you with the most accurate and up to date information when it comes to new company incorporations or questions pertaining to personal and corporate taxes. Most consultations are free, just use the form below to contact us and we will be in touch with you as soon as possible.

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