Business Entities: A PrimerBy David McIntee, CPA®/CFF®, CVA
So you fulfilled a lifelong dream of starting your own business – to be an entrepreneur -- congratulations!
One of the most important tasks that should be undertaken at the beginning of the startup process is choice of entity.
So many times, the business owner’s first interaction with a CPA® is when it’s time to file their first income tax return. It pains me to see the chagrin on their face as we discover a critical mistake or oversight has occurred. The most common mistake at the beginning stages deals with the handling of their entity formation.
Limited liability Company (LLC)
Deciding on the choice of business entity is a very important event for this new business. Seeking an experienced CPA® and business attorney is imperative. There are many tax and legal issues to be discussed. Each professional will help the new business owner make the right choice.
In recent years, with the advent of the Limited Liability Company (LLC) and the ease of formation, the new business owner makes this choice without any professional counsel. This type of entity, formed under state law, provides the owners of an entity certain liability protections similar to those available to corporate shareholders. From a tax standpoint, a single owner reports their income from this business on their individual income tax return on Form Schedule C. There is no additional income tax return filing required. This often is the right choice for the business for its simplicity, but there are many other tax and legal considerations.
The choice becomes a bit more complicated when there is more than one owner. By default, the tax code treats a multiple member LLC as a partnership. The partnership files a separate income tax return and does not pay taxes at the entity level. The income tax is reported on the individual income tax returns of the respective members.
Depending on the nature of the business, and tax situations of the owner(s), or the need to raise capital, the Corporation form of business may be advisable. A Corporation need only have a single shareholder.
The managing of a corporate entity is more complicated than that of an LLC. First and foremost, the owners, known as shareholders, who work for the entity must receive compensation for their work by means of a “reasonable” salary payment. This means that the company must withhold taxes, and file quarterly and annual payroll tax returns including W-2’s.
By default, a new corporate entity is taxed as a regular Corporation, known as a C Corporation. In this type of entity structure, the Corporation itself is subject to income tax on its net profits. On the personal income tax returns of the shareholders, they report the income from the wages they earn and from any dividends paid by the corporation.
The shareholders may elect to be taxed as an S Corporation. In this case, the S Corporation pays no income tax with the tax filing, however the net profits from the Corporation flow to the individual income tax return(s) of the shareholder(s). This is similar to how partnerships are treated, except that the shareholders of an S corporation must take salary payments for their compensation. Therefore, the shareholder of an S Corporation will usually have at least two types of income on their individual income tax returns.
A common misconception is that the S Corporation shareholders simply take distributions and forgo salary. This tactic serves to avoid Social Security and Medicare tax. The Internal Revenue Code does provide guidance and sanctions for unreasonably low compensation.
The choice of entity is only one part of the startup phase of any business. There are many other tasks undertaken, such as applying for a federal tax ID number, setting up a banking relationship, obtaining insurance, having the required organizational documents prepared and having a bookkeeping system developed. In addition, there are many tax consequences that affect the startup business, some good and some that can be viewed as somewhat limiting. Good planning helps eliminate the unpleasant surprises.
This article is necessarily brief. Many other tax and legal issues need to be addressed in consultation with a qualified advisor.
About the Author
David McIntee, CPA®/CFF®, CVA has been working with entrepreneurial businesses for more than 30 years. In addition to being a CPA® he credentialed as a Certified Valuation Analyst. His firm has offices in Hillsborough, NC and Fairfield, NJ. He can be reached at (919) 918-7565 or www.mcintee.com.
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