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Taxes & Accounting

2002-02-01 16:35:00

Starting a business?

Question: When establishing a new business, what are the legal implications for the different entities such as, a Class C Corp, Sub Chapter S, Sole Proprietorship, or LLC?  What are the tax implications?  Why would you select one over the other?

Answer: Larry Sell, Accountant: Each new business situation is different, and each must be individually analyzed to determine the most appropriate business entity structure.  It is not an easy choice to make. John Gibson, Attorney: A few of the issues to be resolved are: is this a brand new business or a restructuring?  Is it a manufacturing business, retail sales, or a service business?  Will there be employees?  Larry Sell: How many owners will there be initially and in the future?  Is it anticipated to be profitable in the early years?  What are the working capital needs of the business and where are the funds coming from to start the business?John Gibson: Since the question is very general, and we don't have a specific situation to address about the above specific issues, we'll just discuss the various available business entities.  The most common business entity is the Sole Proprietorship.  As its name implies, this is simply one person going into business for him or herself.  No special filings with the Secretary of State or any other governmental regulator are needed nor are any agreements or incorporation papers required.  The individual bears all liability associated with the business.Larry Sell: This is the simplest form of entity.  The net income or loss is reflected on schedule C of the taxpayer's individual return, thus no other business income tax return is required.  Absent liability concerns, this type of entity is usually recommended for an individual business owner when profits are estimated to be below $100,000 and the working capital is relatively small.  A separate federal identification number is not required unless the business will have employees. John Gibson: A second common entity is the Partnership.  This is an association of two or more persons pursuing a business.  Kansas has adopted a Uniform Partnership Act which provides the rules for operation of the Partnership as well as the rights and duties of the partners.  A written partnership agreement, however, can provide all of these rights and duties, so long as they do not violate the law.  Since an association of people would typically like to provide many of its own rules, a written partnership agreement would be advisable.  In a general Partnership each partner is liable for all of the partnership debts and liabilities, and has equal rights in the management of the partnership.  The partners also share equally in the profits and losses, unless otherwise provided in the partnership agreement.Larry Sell: The Partnership is a fairly flexible entity format.  The net income is passed through to the partners based on their ownership percentages.  The partners pay the income tax on their share of income.  There are methods available to provide for special allocations or guaranteed payments to partners.  The partnership does not pay income tax but a return is normally required.  The partners are treated as self-employed individuals unless the business is a rental business.  Losses may be limited due to the passive activity rules, which are too extensive to discuss here.   John Gibson: A third entity, Limited Partnership, is a "hybrid" form of organization having some characteristics of a general partnership and some of a corporation.  In Kansas the Revised Uniform Limited Partnership Act covers the formation and operation of a Limited Partnership.  A Limited Partnership has both at least one general partner and at least one limited partner.  With respect to the general partner or partners, a Limited Partnership is very similar to that of a general partnership in that each general partner is liable for all of the partnership debts and liabilities, and has equal rights in the management of the limited partnership.  With respect to the limited partners, a Limited Partnership is more similar to a corporation in that each limited partner is typically at risk only to the extent of that limited partner's contribution to the Limited Partnership, the same as a stock holder in a corporation.  Larry Sell: We see this type of entity more often in a family situation or where the business needs capital infusion and does not want to share the control of the business.  The limited partner is typically not involved in the business and as such would not be subject to self-employment tax. In the family setting, this form of entity may allow parents to transfer the business to the children while maintaining control. John Gibson: Another very common form of organization is the Corporation.  Kansas has a very modern and up-to-date corporate law which sets forth the requirements with respect to the formation and operation of a for-profit Corporation.  One of the main reasons for forming a Corporation is that the stockholders of a Corporation generally will not be liable for the debts and liabilities of the Corporation.  Therefore, stockholders' losses will generally be limited to his or her individual investment in the corporation stock.Larry Sell: The corporation is a tax paying entity unless an S election is made.  The S election must be made timely or the corporation will be taxed as a C corporation until the following year.  There are limitations on who may own stock in an S corporation as well as the number of stockholders. The C corporation may elect a fiscal year end in most cases while an S corporation is generally limited to a calendar year. The C corporation pays income tax on the net income of the business.  The federal tax rates of the C corporation are generally lower than individual rates unless the corporation business involves personal service, in which case the corporate rate may be higher than individual tax rate.  Double taxation can occur in the C corporation that pays income tax and distributes dividends that are not deductible by the corporation, but are taxed again by the shareholder.  The C corporation generally provides for more liberal rules in deducting fringe benefits than an S corporation, sole proprietor or partnership.  The S corporation operates much like a partnership with stricter rules on distributions and limitations on loss deductibility.  John Gibson: A couple of fairly new business entities are the Limited Liability Company and the Limited Liability Partnership.  A Limited Liability Company (LLC) is an entity that can have the tax and management characteristics of a general partnership as well as the limited liability advantage of a corporation.  Kansas has provided for LLCs in the Kansas Limited Liability Company Act.  In order to set up a Limited Liability Company, Articles of Organization must be filed with the Secretary of State.  These are similar to the Articles of Incorporation for a corporation.  These are very simple organizational documents setting forth who the members of the LLC are, its business purpose, and who the registered agent will be. An operating agreement, which is in certain respects like the by-laws of a corporation, is required.  An operating agreement is like a partnership agreement in that it sets forth the duties and rights of the members of the LLC and also can be used to set forth allocation of profits and losses.Larry Sell: The LLC is taxed like a partnership unless the members elect to be treated like a corporation.  As in the partnership, the LLC pays no income tax and the income is passed through to the members.  When comparing pass through entities, we find the LLC to be favored over the S corporation because of the flexibility of the partnership rules over the corporate rules.  The advantage of the S corporation is the ability to limit the self-employment tax in the appropriate circumstances.  The member of an LLC in most cases will be subject to self-employment tax on their entire share of earnings from the LLC.  Like the S corporation but unlike the partnership, the LLC may be formed with one member. A single member LLC will generally report the income as a sole proprietor on schedule C of their individual income tax return and a separate partnership return will not be required.  John Gibson: Generally, a Limited Liability Partnership (LLP) is a modification of a general partnership in that it limits the liability of each of its partners arising from the negligence, malpractice, wrongful acts and omissions or misconduct of other partners or any person not under the direct supervision and control of the partner.  Unlike an LLC, an LLP does not limit the liability of its partners for other debts and liabilities of the LLP or for the acts and omissions of a partner.  The business people most likely to use an LLP are professionals, usually attorneys, doctors, and accountants.Larry Sell:  The major accounting firms were primarily responsible for pushing this legislation through state by state.  Many states did not have LLC legislation or were not appropriate for personal service organizations.  Today you will note that most large accounting and law firms operate as a Limited Liability Partnership.  The income tax treatment is the same as a general partnership. John Gibson:  That pretty well covers the waterfront on business entities that are usually used for a new business.Larry Sell: As an overview, the determination of the most appropriate entity for a new business to form will be unique to that business.   The advantages and disadvantages should be explored and an informed decision be made with the assistance of qualified advisors from both the legal and accounting professions.