Q: Tax Playa, what are the different ways that a business can be organized?
Darren, Falls Church VA
A: There are three basic models of business organization, each with their own advantages and disadvantages: the sole proprietorship/partnership, the corporation, and the S-corporation
First, a few misconceptions to clear up:
1. Forming an LLC (limited liability company) does not do anything for tax purposes. An LLC merely creates a legal distinction between you the person's assets and activities and you the business owner's. An LLC is a disregarded entity for tax purposes, so forming it and nothing else defaults to a sole proprietorship.
2. That being said, an LLC is the stem cell of legal business entities. It can morph into any shape you want it to simply by electing as such (for instance, an LLC formed by a person can elect to be taxed as if it were a corporation). For practical purposes, forming a corporate structure using this "check the box" method is far simpler and cheaper than getting legally incorporated. There is almost no good reason for a small business owner to legally incorporate.
3. There is no advantage from a tax point of view of forming a business in Delaware, Nevada or anywhere else. The advantages of those states get back to the "corporate veil" advantages of an LLC. They make it easy for key executives to be distinct from the business. Business activities are taxed in the state where the business takes place, not where it was founded.
There are three basic forms of business entities. I will go through each one separately, describing its nature, listing its advantages and disadvantages, and giving examples of the types of businesses that should consider this form.
1. Sole Proprietorship/Partnership
- Description: One or more owners of the business report their business income and expenses on their personal tax returns. They then pay taxes at whatever rate they happen to be in.
- Advantages: No double taxation. Business activity defaults into this form without any action being taken. No need to pay a salary.
- Disadvantages: These business owners must pay both their regular income tax on their profits and self-employment tax to account for both halves of Social Security and Medicare. This latter (SECA) tax is 15.3%, which really raises the marginal tax rate on business activity. Also, retirement and health benefits for owners are not as advantaged as other forms.
- This business model is good for: Startup companies and any company with less than $20,000 or so in gross receipts. Taxpayers who have already earned enough income to not have to pay most payroll taxes anymore.
- Description: A separate tax entity that conducts business. It reports its own business income and expenses, and pays its own corporate income taxes.
- Advantages: First $50,000 of profit is only taxed at 15%. Maximum retirement, health, and fringe benefit perks for executives. Separation between business owner and business activities.
- Disadvantages: Potential for double-taxation in the form of distributed corporate dividends. Need to have a payroll in order to qualify for pension and fringe benefits.
- This business model is good for: Mature businesses that have an excellent record-keeping system. Business owners must also be able to keep their hands out of the cookie jar, triggering double taxation of dividends
- Description: A separate tax entity that conducts business. It reports its own business income and expenses, and passes through any profit or loss to the business owner's personal tax return.
- Advantages: No potential for double taxation. Owner can take "draws" from corporate profits, and all he is doing is reducing his cash basis in the business. Social Security and Medicare taxes are minimized.
- Disadvantages: Requirement that owner pay self a "reasonable salary" is often ignored at the taxpayer's peril. Owners are generally ineligible for fringe benefits, except for retirement (tied to reasonable salary) and health care (which is done in a very confusing manner).
- This business model is good for: Mature businesses that have spotty record-keeping. If a business owner cannot be bothered keeping a very clean set of books, and often intermingles personal and business assets, this might be for him.
My recommendation to clients when they get a business to a certain size is to use an LLC taxed as a regular corporation. It has the best tax advantages, presuming the client is disciplined enough to keep the business's financial house in order.