When starting a business, this is often one of the first legal questions that comes up. If you as the owner have gotten to this point, then you’ve probably already figured out that you have a market, and how to target that market. You turn to your lawyer to help with the legal side of making your business a reality.
When your attorney talks about an “entity” they are usually asking whether your business assets should be held in some sort of formal business. Depending on your needs, this could be a partnership, LLC (limited liability company), or a corporation. There are two basic considerations to look at when determining whether you need a business entity: taxes and liability.
If you have gotten to the point of needing to worry about a business entity, one of the first people you should talk with is a licensed CPA or accountant. Do not skip this step or decide that you can figure it out as you go along. There are definite and major differences between how partnerships and corporations are taxed, and while LLCs can choose to be taxed as partnership or as corporations, there are still nuances that could trip you up. Get the tax planning advice up front so that you’re not unpleasantly surprised later on.
In addition, keep in mind that this is just an overview. It’s looking somewhat more likely that a major tax bill will pass either this month or next. If that happens, large changes are likely to impact the tax effects of each entity. In particular, pass-through entities like LLCs may actually become more favorable.
The entity most people are aware of is the “C Corporation” which is generally taxed on income at the entity level. At the state level, California requires at least an $800 per year franchise tax, which may mean that a corporation is a poor choice for particularly small businesses. California also levies taxes on corporate net income at 8.84%. On the other hand, Washington levies a gross receipts tax on business activities, meaning no deductions for expenses. The rate depends on the type of business conducted.
After the corporation has paid its income or gross receipts tax, it will pay its shareholders or employees, who are then taxed on that income on their personal tax return. In general, shareholders are taxed at the capital gains rate, and employees are taxed on their wages based on their income brackets. This one-two punch of taxes is referred to as “double taxation” and depending on the size of your business and what you can deduct can be very expensive. Many smaller businesses choose to organize as something else to avoid double taxation and only make the switch to a C corporation later on when it makes more sense.
Alternatively, a corporation can make a filing at the federal level to be recognized as an “S corporation” which means that the income of the corporation is not taxed federally, but instead the shareholders pay tax at their regular income tax rate on their personal returns. California does still tax S corporation income, but Washington’s tax is unaffected by corporate form or tax filing since it is actually a tax on business activity, not an income tax.
Limited Liability Company (LLC) and Partnership
In general, taxes on LLC or partnership income are paid by the owners on their personal income tax returns. The company itself does not pay an income tax, instead the tax liability is split among the owners. This style of tax is called “pass through” taxation, and can be more or less expensive than corporate taxation depending on the owner’s’ tax liability. LLCs and limited partnerships are still required to pay the $800 minimum California franchise fee, as well as a fee based on income over $250,000. Washington LLCs and partnerships are still subject to the gross receipts tax on business activity. Owners who take an active role in the business may be required to pay self-employment tax on their earnings from the LLC as well.
LLCs can also elect to be taxed as corporations or as S corporations if that makes sense, but be sure to get advice before making the election.
One of the main purposes of forming an entity is to limit the owner’s personal risk for business issues. The general concept is that the owner puts a certain amount of money or valuable things into the business and if something goes wrong, only the business money or assets are at risk. This theoretically allows a business owner to take on a certain amount of risk in starting a new venture, without risking necessities of life, such as the primary residence. Sole proprietor businesses offer no distinction between the personal assets of the owner and the business assets, so everything is potentially at risk. This may not be a problem for certain business owners who have low risk exposure, but a realistic look at the potential risks of the business is very important here.
For example, an employee of a widget manufacturer is injured in the widget-pressing machine. With no business entity between the employee and the owner, the employee could sue the owner and if the employee wins they could put a lien on the owner’s house, attempt to clear personal bank accounts, etc. If the owner has created a business entity ahead of time that holds the assets and earnings from producing widgets, the employee cannot reach the owner’s personal bank accounts or house, although business assets would still be at risk.
Different entities may behave slightly differently in providing limited liability to its owners. However, owners should note that limited liability is not necessarily permanent or guaranteed. Owners that commit fraud or other bad acts using the business entity, or who take money from the entity improperly may be personally liable for those losses. In addition, owners that provide a personal guarantee (usually for leases or business loans) are personally liable to the creditor if the business can’t repay the debt.
Corporations and LLCs
Although there are some differences around the edges, in general LLCs and corporations provide comparable and classic limited liability as described above. Absent a personal guarantee or some wrongdoing, owners can limit their risk of loss to whatever they contributed to the company, and their personal assets should not be at risk.
There are multiple types of partnerships, but in the broad overview they can be broken down into “general” and “limited.” General partners remain personally liable for business losses, so there is little to no liability protection. Limited partners may have less authority within a partnership, but they do get liability protection up to the amount contributed to the partnership. Limited partners are similar to members of LLCs in their liability protection.
Deciding whether you need an entity or not is a big decision that can have an impact on profitability, ease of administration, tax liability, and the level of risk in the business. It is best to talk over the impact of the decision with both an attorney and a CPA before deciding what is best for the business.
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