Generally, the first step in setting up a business is the choice of entity. While state laws govern the formation of entities, Federal law dictates the treatment of entities for Federal tax purposes. Additional considerations should be liability, control, and exit strategy.
The most common entity types are:
- Sole Proprietorship – An entity owned and operated by a single individual, with its net income reported on the tax return of the individual owner.
- Partnership – An entity owned and operated by two or more individuals or entities (“partners”), with its net income reported on the income tax return of the entity, but passed through to the partners’ tax returns. Thus, the partnership itself is not a taxable entity; instead, it is a flow-through entity. The profits and losses flow through to the partners.
- Corporation – An entity owned by one or more individuals or entities (“shareholders”), with its net income reported on the income tax return of the entity, and potentially, the shareholders as well, in the event that taxable distributions are made to the shareholders. The income of a corporation can be taxed at both levels, thus the common expression, “double taxation.”
- S Corporation – A corporation is an entity owned by one or more individuals or entities and may elect to be treated as an S-corporation for Federal income tax purposes, in which case, its net income is reported on the income tax return of the entity, but passed through to the tax returns of the shareholders. The S corporation is another flow-through entity where all profits and losses flow through to the shareholders.
- Limited Liability Company (LLC) – An LLC is an entity owned and operated by one or more individuals or entities (“members”). An LLC must determine whether it intends to be treated as a corporation or a partnership for Federal tax purposes. If it chooses to be treated as a partnership for Federal income tax purposes, its net income is reported on the income tax return of the entity, but passed through to the members’ tax returns, or, if there is only one member, the entity’s income is reported directly on the tax return of the member. Otherwise, if no election for partnership treatment is filed, it will be treated as a corporation.
Liability is a common, and important consideration in forming an entity to transact business. Based on the type of business in which the entity will be operating, there are also Federal and state restrictions. For example, a few types of businesses generally may not form as an LLC based on Federal guidelines, such as banks and insurance companies.
For any entity in which more than one owner/shareholder/member will own the business, it is important to consider contributions, responsibilities, compensation, distributions, and decision making, via appropriate documents specific to the entity type. Decision making is particularly important with regard to establishing a control mechanism in the event that owners cannot agree on an entity issue.
Finally, a frequently overlooked consideration is the exit strategy for entities owned by multiple individuals or entities. Much like a prenuptial agreement, most new business owners are excited about their venture, and can’t imagine a day when the entity may no longer be sustainable. While it need not be a negative aspect of a business relationship that leads to termination (not all entity owners “part” for negative or controversial reasons), it is vital to plan for contingencies.
Contact Frost & Associates today if you have questions about your business formation or termination, document preparation, or tax issues.