Entrepreneurs are changing the world one innovation and one solution at a time. Think about Uber. Two guys couldn’t get a cab one night and they have now changed the entire industry. Or Tesla. Elon Musk and friends decided that people shouldn’t need to compromise looks and performance if they want an electric car. There are people all over with a passion to solve the world’s biggest problems. This is one reason I always try to provide services to small business owners that allow them to focus on the core function of their business. I can’t imagine Elon Musk stopping his work so he can go categorize his expenses at the end of the day.
One of these items that all business owners must deal with is setting up their business structure. All new businesses must choose the type of entity they would like to be. The decision will have a significant impact on your taxes, ownership options, legal liability, and the amount of paperwork needed. There are a variety of questions that business owners ask during the process. So let’s do a Q&A so I can try to help answer some right now!
Note: This post is meant to gain a basic understanding. There are many variables to consider when choosing your business entity.
What types of entities can be formed? Sole Proprietorship, Partnership, Limited Liability Company, and Corporation
There are four different types of business entities. Some of these types have subtypes as well. For instance, a corporation can be an S Corp or a C Corp. There are also default entities that form if you don’t choose on your own. If you are the sole owner of a new business, you will be considered a sole proprietorship. If you and someone else form a business, the IRS will consider it a general partnership. The default may work for you but is most likely not the best option available.
What aspects of the business should I be concerned about? Business Taxation, Legal Liability, Ownership Options, Cost of Operating, Future Needs
There are countless items that will factor into your business entity decision. Taxation and legal liability tend to be atop everyone’s list. Ideally, your business will be set up for you to minimize each of those two items. However, you also want to understand the ownership options and think about where you see the business going in the future. Do you want to be the sole owner of the business forever? Do you want to take it public someday? How much do administrative paperwork and state filings do you want to deal with? Start by listing your preferences in order of importance. That will allow you to figure out what entity fits the most important aspects for you.
How is my business taxed? Flow through or Entity Level. Schedule C, E, or F. Forms 1065, 1120-S, or 1120.
This question can be real fun for the tax nerds out there like me! In general, you will either pay income taxes at your personal tax rate unless you form a C-Corp. That is what is meant when someone refers to a “flow through entity”. Which form would from the list above to file your taxes? That depends on the type of business entity that you establish. The tax return preparation is one administrative area that can result in higher annual costs for the more complicated business entities.
Which makes most sense for your business? What are you most concerned with?
I hate to answer a question with another question, but it all depends. For instance, of you want the business to be passed on to someone when you die, a sole proprietorship would not work under any circumstance. I would strongly advise you to keep it simple. You can almost always change your business entity in the future. Don’t form a C Corp just because you may want to go public someday. It isn’t worth the hassle in your first few years of business.
How do I register? Find more info on your state government website.
Once you have determined the best entity for your business, you are ready to file the paperwork. Other than a sole proprietorship, which does not require state registration, you can find out more info about how to form your business entity from your state government. You should also research any business licenses you may need from your local municipality. You can do the forms on your own, or you could use a lawyer or legal website. Most won’t charge too much for the business filings.
Each one of us has strengths and weaknesses. Most small business owners should focus their time and talent on creative ideas and growing their business. This is one of those items that is much easier to discuss with a lawyer or CPA to let them figure out the best option for your business. The tax savings alone will probably cover the expense to work with them. Just make sure to have your priorities straight…kind of like everything else in life!
Mike Zeiter, CPA/PFS
P.S. – Check out the article below to see my comments about forming a business for ordinary and passive income!