December 2004

ABCs of Accounting: Choosing the correct business form for your company

Choosing the correct business form for your company can be a complicated decision. The choice is dependent on many factors and can affect you for a long time. For that reason, it is best to consult with your personal legal and tax professionals before you make a final decision. But in the mean time, here are some things that you need to consider.

In general, your choices of business form are sole proprietorship, partnership if more than one owner, C corp., S corp., or Limited Liability Corporation (LLC).

A sole proprietorship is the simplest form of business to maintain. It does not require an additional tax return since the results of the business are reported on Schedule C of your personal Form 1040. If you are personally maintaining your business’ books and records, this may be your best choice.

The next business forms to consider are more complex from a tax and accounting standpoint. For most micro-businesses, there are no significant tax advantages if you incorporate and then make an S election or if you form an LLC. The costs of incorporating, maintaining the books and records, and preparing an additional tax return, (in addition to your personal return), out weigh the tax benefits of the corporation. You will also have the additional payroll tax filings necessary to process payroll to yourself if you incorporate.

There may be non-tax reasons to incorporate. Among those, the most significant would be taking on a partner or other owner, and limiting liability. If you are in a “high risk” business (roofing contractor, toxic waste, certain medical fields, for example) then, I would suggest you contact an attorney and discuss the personal liability you may have for business activity. The corporation is a method (other than insurance) to mitigate personal liability.

C corporations are the form most commonly used for large businesses. It has liability protection for its owners but has the disadvantage of potential double taxation. The earnings of the corporation are taxed at the corporate level and then again when the earnings are paid to the owners as dividends. This double taxation can be avoided in a small business with tax planning, but the decisions made to avoid the taxes may mean that you make less than optimal business decisions.

S corporations are corporations that make a special election. The S corp. is taxed like a partnership and provides liability protection for its owners. Sounds pretty good, huh? The problem is that to maintain the S corp. status, the owners must meet a number of restrictions. This situation may once again force you to make decisions that are not the best for the business to maintain the tax filing status of the S corp.

Partnerships are often the first step taken after a sole proprietorship when your business grows to the point that more ownership is needed for funding or expertise. Many businesses begin as a partnership. The income of the partnership must be reported on special tax forms but the income of the partnership “flows through” to the tax return of the owners so that there is no double taxation. The main disadvantage of a limited partnership is that there must be a general partner in addition to the limited partners. The general partner is liable for all of the liabilities of the partnership if the partnership defaults. There are ways to limit this liability by setting up corporations to be the general partner, but the organizational structure becomes more than you can generally keep up with without professional help.

The last choice, a limited liability corporation or LLC, is my personal preference if a sole proprietorship is not meeting your needs. It has the liability protection of a corporation but the flow-through taxation of a partnership. This is because your state recognizes it as a corporation, but the IRS views it as a partnership. It does not have complicated requirements to maintain its status as does an S corp. LLCs do have a limited life when established, but generally you can elect a life of 99 years and, after that, who cares?

Take a good hard look at the issue before you make a decision. Visit the business section of bookstores and read about the pros and cons of incorporating then go over the specific facts and circumstances of your business with your personal tax and legal advisors. This decision is not unchangeable, but making a good choice to begin with will make your life easier.