Benefits of S corporations, C Corporations and LLCs. Advantage of forming a limited liability structure over a sole proprietor or partnership. New business should make a choice between limited liability company, corporations, or S Corporation. Step by step guide to setting up a new business.
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Forming a Limited Liability Company or Corporation

for Small Business Start ups
and QuickBooks users.
 

 

Books that will guide you through new business set up,  incorporating, LLC formation and liability issues


  
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An important step to learning how to start a new small business is understanding the differences between incorporating or forming an LLC (limited liability company).  If you form a corporation, take a look at S corporations which allow the owner to avoid double taxation. If you begin operations and choose to put off the decision to form a corporation or form an limited liability company, the business defaults to operating as a sole proprietor (one owner) or partnership (if you have multiple owners) without liability protection.  If you are currently operating a business as a sole proprietorship or a partnership, you are personally responsible for the total liability of your business.  This article offers definitions, benefits and detriments, pros and cons of  each type of new business entity and what you should consider when making the choice between a corporation or a limited liability company (LLC) for your company.

Another step in getting your business off to a profitable start is finding the right tools to  monitor business performance and cash flow. This website offers many suggestions on how to make QuickBooks accounting software produce the reports you need and how to use these reports as a tool to manage your business.  But first lets see if you are ready to open your own small business.

What are the key advantages of each type of company?
Links to more information
Books that will guide you through new business set up,  incorporating, LLC formation and liability issues

Liability Protection

By choosing a corporation (and  S corporation) or a limited liability company as the legal formation of your business, you will be personally protected from the debts and claims of the business. That means you cannot lose your personal assets such as your car, home, retirement accounts or other businesses.

Take a look at how your business operates and assess where the risk from lawsuits come from. Do you need personal protection from liability claims created by your new business?  Risk protection is expensive.  Compare the additional costs of operating as a limited liability company / corporation  to the costs of  purchasing adequate liability insurance.  Both insurance and forming a limited liability entity may be necessary.  Find out what the legal fees would be to protect your business from one lawsuit.  In most cases, an insurance policy would cover the cost of legal counsel and pay for itself with one lawsuit.

Research the costs in your area for:

  1. the licensing cost of  incorporation or forming an LLC
  2. legal and accounting fees to set up the company as an LLC or a corporation
  3. legal and accounting fees to set up the S corporation if applicable
  4. Annual filing fees for the corporation or LLC to the state and local government
  5. Cost of tax preparation for the additional tax returns (corporate or partnership -if applicable)
  6. Cost of  liability insurance for the business
  7. Cost of time and money to conduct business in a way that demonstrates  intent to clearly separate the business conduct from personal conduct or in other words - tell the court system that your business is totally independent from your personal assets.
    1. Corporate Documents and Records  -maintain complete records of Bylaws or Operating Agreement, written minutes of all meetings, accounting and bookkeeping records, and all statements and receipts.
    2. Financing - Undercapitalize the business- starting the business with $1? It is unreasonable to assume that the creditors of the business should accept all the risk of running your business. The courts will think so. In a new company, invest enough for  down payments on new equipment, some inventory and a bit for operating costs,  for ongoing business, don't pay yourself 100% of the earnings. Keep some earnings within the company for growth. 
    3. Related Party Transactions - are you selling for a profit to related parties? Loaning money at fair market value interest rates?
    4. Keeping personal expenses out of the business?
    5. Protecting business assets with a proper set of Internal Controls  also see more
    6. Employing competent managers
    7. Dropping the word "Inc.", "Ltd.", or "Corp.", LLC  from the company name is an improper use of the company business name because it does inform the other party  that it is dealing with an entity that is limiting the liability to the assets of the business.  Be sure to  include company's full name on all business documents  ( checks, business cards, letterhead, fax cover pages, web site, e-mail, purchase orders, business contracts and other external communications)
    8. Fraudulent Representations by Shareholders, Directors, Members or Managers - employees, agents and owners can be sued if there was an indent to deceive.

Liability risk comes not only from customers who use your service and products but also from the acts of your employees or agents working for the business. Look at what risk may also exist from using certain vendors, selling to customers who do not use your products or services as intended, safety hazards existing on your property, risks that exist during bad weather, injuries that could occur on your premises due to no negligence on your part, but folly by others. And what are the risks of your new business incurring expenses and loan debt that it cannot pay (can your business become insolvent- go bankrupt)?   

Forming a corporation (s corporation) or limited liability company (LLC) provides "personal protection" from financial risk. This only occurs if the business has been operated with the proper management and supervision of a prudent business owner.  And  if the owners have kept their personal finances independent from the business assets.   If you do not want a debtor or claimant attaching your house or car, run a business with ethics and professional care and  incorporate or form a limited liability company.  Run a business with negligence and deceit your personal assets are at risk no matter what type of organization you form.   If the pockets of the corporation or liability company are not deep enough for the attorney and plaintiff, rest assured they will attempt to bring  you (and your assets)  into the suit as a defendant.  The easier you can establish support for item 7 above, the more likely the opposing attorney will cease the chase.    There are some instances where your legal form of business will not protect you from personal liability.  Find out more

Visit  the sites listed at the bottom of this article for a more in depth discussion of  the legal and tax issues to be considered..

At a minimum, consider the LLC for protection against legal claims. It is fairly inexpensive to set-up and it is possible to do without an attorney.  Make sure to produce an operating agreement which includes all the key characteristics of an LLC to avoid the pitfalls of being taxed as a corporation. 

Keeping costs to a minimum:

  • learn all you can,
  • make preliminary decisions
  • then sit with an attorney and a CPA to make sure you are on the right track then.
  • complete forms and have your advisor review before filing
  • mistakes are costly and the knowledge of professionals generate years of savings

 

Liability considerations:
Are you seeking liability protection from creditors?  Before you choose an entity form because of liability considerations:

  • Business owners of new businesses are generally required to sign a personal guarantee for bank loans and large vendors. 
  • The IRS may seek payment of unpaid payroll taxes from the owners of a business or anyone signing the payroll tax returns.
  • Businesses including corporations that have its books commingled with personal payments/transactions of the owners/officers can have a problem if it is ever necessary to defend itself  in court.  The court may decide that both entities (individual and business) are behaving as one, therefore, exposing the owners assets to plaintiffs.  Corporations should follow the legal requirements for running the corporation (keeping the corporate book with meeting minutes and  keeping the corporation's money and accounts strictly separated from personal assets).
  • Involve an attorney if your industry has a tendency to be sued.
  • Periodically consult with your CPA to make sure you are complying with federal state & local tax regulations and are implementing sound business policies.

 

How to's for the "do it yourself route"

1 Set up set up an LLC or an S Corporation without an attorney
      

2. Apply for a Federal EIN number
http://www.irs.gov/pub/irs-pdf/fss4.pdf

(firefox users - if the link does not work paste into IE)

3. If you incorporate, Elect S Status with Form 2553  download at www.irs.gov

Many states require you to elect S Status with the State too. http://taxsites.com/state.html

4 Register your LLC or  Corporation with your state  http://taxsites.com/state.html.  This same registration will permit you to register as an employer and to collect sales tax.

5. If you are an employer, you may need to register with the department of labor for remitting unemployment tax
  List of payroll websites by state

You will also need a workers compensation policy (even if it is  just one employee and that employee is the owner of the corporation)

6. If you are an employer you may want to sign up for EFTPS direct deposit of payroll taxes:  https://www.eftps.com/

7. Set up a set up books using
QuickBooks.  Call us for help selecting which product is best for your business 
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8.  Get the training you need to
use QuickBooks
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9.  Have any questions with these procedures? Help setting up and learning payroll? Economical training on QuickBooks?
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800-216-0763. We work via the telephone, fax, e-mail, high speed internet remote access, computer desktop training and more! 
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  Limited Liability Company advantages
Nolo's Quick LLC:
All You Need to Know About Limited Liability Companies
by Anthony Mancuso
$20.99
  

  Partnership negotiation
The Partnership Book: How to Write a Partnership Agreement
by Attorneys Ralph Warner & Denis Clifford
$27.99

 
The Successful Business Plan: Secrets and Strategies
by Rhonda Abrams, Eugene Kleiner
                             $20.97

 
How to incorporate plus other start-up issuesSmall Business Kit For Dummies®
by Richard D. Harroch

$20.99

 

Characteristics

Sole Proprietorship

General Partnership

Limited Liability Company

S-Corporation

Corporation

Formation

No permission required

Agreement of parties involved. No permission required

File with state for permission

File with state for permission

File with state for permission

Number of owners

1

2 or more

1
(Mass.
requires 2)

1-100
(Family members treated as 1)

Unlimited
Who can be an owner Individual

No restrictions

No restrictions
(some states, incl CA, prohibit professionals such as architects, accountants, doctors and other licensed healthcare workers
Individuals
estates, 401(a) and 501c(3)
certain trusts
No nonresident alien shareholders!
 An S corp can own shares of a Qualified
S Corp Trust (which must distribute 100% income each year)
No restrictions like in S Corp

Duration

Dependent on sole proprietor

Dissolved by death of partner or bankruptcy

Typically limited to a fixed amount of time
Ends when a partner leaves the LLC, unless operating agreement states differently

Perpetual

Perpetual

     

Regulations
by State for LLCs

   

Liability

No Protection
Sole proprietor has unlimited liability

No Protection
Partners have unlimited liability

Protected
Members not typically liable for the debts of the LLC

Protected
Shareholders are typically not personally liable for the debts of the corporation

Protected
Shareholders are typically not personably liable for the debts of the corporation

Simplicity of Operation

Relatively few legal requirements

Relatively few legal requirements

Some formal requirements but less formal than corporations
Operating agreement

Formality of board of directors, officers, annual meetings and annual reporting

Formality of board of directors, officers, annual meetings and annual reporting

Management

Full control of management and operations

Typically each partner has an equal voice unless otherwise arranged

Members have operating agreement that outlines management

The corporation is managed by the board of directors who are elected by the shareholders

The corporation is managed by the board of directors who are elected by the shareholders

Taxation

No separate business tax return.   Owner reports business and  pays all taxes
on personal tax return

Partnership tax return is needed but
each partner pays the tax on his/her share of the income through his/her personal return  Losses can be deducted against other sources of income

If 1owner  Report business income and pay tax on personal return.
If 2 or more, choice of preparing and paying tax as   partnership  (no payroll taxes issues)

No tax at entity level. Income/loss is passed through to the shareholders.

Pensions provide additional savings from Fica/Medicare Taxes. 

See chart below for a more detail on S Corporation tax benefits

Corporation is a taxable entity. See our chart on Corporate Tax rates


Pensions provide additional savings from Fica/Medicare Taxes.  

Pass Through Income/Loss

Yes

Yes

Yes

Yes

No, corporate losses can't be deducted by shareholder

Double Taxation
 

No

No

No

No

Yes

Payroll Prep and Taxes No No No
Except if  electing to be taxed as a corporation
Yes Yes

Cost of Creation

None

None

Filing fee with the state

Create an operating agreement

Filing fee with the secretary of state

Promptly file form 2553 with the IRS and with the  state

Filing fee with the state

Raising Capital

Difficult, unless individual puts in money

Contributions from partners or an addition of more partners

Possible to sell interests. Subject to operating agreement restrictions

Sell shares of stock to raise capital

Sell shares of stock to raise capital.
 

Transferability of Interest

No

No

Possibly

Yes, subject to consent

Shares of stock in a corporation are easily transferable

Ownership

No more than 1 owner

No restrictions like in S Corp

No restrictions like in S Corp

Some States may require at least 2 members

Only 1 class of stock. No more than 100 owners . All must be citizens or residents of the USA

No restrictions like in S Corp



Set up an LLC, Corporation, S Corporation
online for a small fraction of the cost of
having your attorney create the documents.

Don't exclude your attorney/CPA  when making these important decisions, but
certainly, do the paperwork yourself with the help of this online incorporating/LLC formation service.  They provide you with the templates you need and they will guide you through the process.


Set up an LLC, Corporation, S Corporation
online for a small fraction of the cost of
having your attorney create the documents.

Don't exclude your attorney/CPA  when making these important decisions, but
certainly, do the paperwork yourself with the help of this online incorporating/LLC formation service.  They provide you with the templates you need and they will guide you through the process.

 
 
 
 
 
 
 
 
 
 


Set up an LLC, Corporation, S Corporation
online for a small fraction of the cost of
having your attorney create the documents.

Don't exclude your attorney/CPA  when making these important decisions, but
certainly, do the paperwork yourself with the help of this online incorporating/LLC formation service.  They provide you with the templates you need and they will guide you through the process.

 
 

What should you consider before making your decision? 

In prior years, S Corporations, LLC's and Sole Proprietors and Partners were not entitled to the full 100% deduction for health insurance premiums on the owners.   But this has changed and since 2003 , 100% becomes deductible on the personal returns of the business owner.

A few differences between an S corporation and a C corporation

  S corporation C Corporation
Double taxation

None, income is taxed only
at personal rates

Corporate tax rates  for small corporations can be as low as 15% and as high as 39% for federal and add on another 3-10% for state taxes. Don't forget to add in city taxes, if any.

Any income paid out of the corporation to the owners as wages are taxed at personal rates, not Corporate.

Any income paid out of the corporation as dividends are first taxed at the corporate rates, then taxed as dividends, with a top rate of 15%.

Medical Fringe Benefits paid on behalf of the owner Generally, not deductible by the corporation unless included in wages. But, the 100% of the health and dental premiums are deductible  on the front page of the business owner's 1040 ( personal return) . Fully deductible to the corporation. Medical expenses fully deductible if same plan offered to all employees.

C Corporations - Now that S Corp owners can deduct their health premiums on their personal returns, the C corporation is generally avoided. Consider incorporating and remaining a C Corporation if :

  • the company expects to go public. 
  • a possible good choice for a company that plans to reinvest earnings for years to come. Whenever a C Corporation is a consideration, engage a Certified Public Accountant  to calculate the tax on projected income based on the different ownership types
  • a possible good choice for a company that projects a business loss for several years and the owners do not have other earnings to offset on their tax return
  • Dividends are now taxed at a top rate of 15% for those earning under $400,000.  there is also a 3.8% investment income tax on those earning more than $200,000.

    How can that save tax dollars today?

    An Example would be a new business earning $200,000 before wages. If the owner takes the net of  $200,000 as wages the owner, the business and business owner will pay a combined tax:
    • 15.3%  for Fica and Medicare up to $117,000  (2014 limit) 
    • 2.9% Medicare tax on the remainder $83,000
    • ordinary income rates on the entire $200,000 less deductions (approximately 25% effective rate). 

What if the allocation of wage and dividends changed?  Before arbitrarily determining what the gross wages are for the owner read our article on Reasonable Compensation
To see how the taxes will change if a salary of $90,000 was drawn and the remainder of $110,000 was paid as dividends
  • dividends are not subject to the Medicare tax of  2.9% 
  • owner will save 10% in income taxes on the on the dividends of $110,000 (Based on an average income tax rate of 25% on wages versus a 15% dividend rate)

What does that savings total ?   make the calculations - they can be significant

The down side?  Will need to think about what must be done in year 2014 when the tax law may change again.  Also, if you plan on selling the business the corporation will pay tax on the profit first then the distributions from the sale are taxed to the owner creating double taxation.  The double tax rate adds up to as  60% of the selling price of the business leaving the owner with only 40%   How can you avoid this?  Convert to an S corporation in year 2015 and hold onto the company an additional 10 years. At that point, the sale is only taxed on the individuals tax return.  It really depends on how long you believe you will be in the business as the business owner.

LLC - Looking for something less complicated? A limited liability company is a good choice for the small new business.  Protection of personal assets from liabilities created by the business, lower cost to set up, if one owner, no additional tax returns needed. For a company with multiple owners, there is flexibility in splitting income differently among owners.  No double taxation.  If the company generates a business loss the owner can deduct losses against other income.  If the owner has no other income to offset the losses he may carry forward the loss to the next year (after adjustment - see a CPA for assistance on this). 

Should you choose S Corp or LLC if you are a manufacturer, contractor, engineer or architect? 

The section 199 deduction for domestic manufacturers provides a case to choose the corporation (with S Election) rather than an LLC if the owner wants to include his/her wages as qualifying wages.  This law provides a 9% additional deduction (beginning in the year 2010).  S Corporations are more rigid in the way earnings are distributed among the shareholders. Also when its time to offer ownership to colleagues/affiliates or capital contributors,  flexibility as to ownership & share in profits & losses are strictly in accordance of % of shares held.  LLC's allow for flexibility in ownership/management/profit & loss sharing- areas that will allow the current owner to transfer earnings/ownership at a pace he/she is comfortable with.  An LLC has less regulatory issues and is easier to set-up.  New start-up LLCs can avoid payroll tax filings if all the employees are owners.  BUT,  with the new Section 199 deduction, an S Corporation may provide significant tax savings over the life of the entity.

S Corporations-   Are you a professional, now offering consulting services?  Read our article on reasonable compensation and the S Corporation.  Make a calculation of tax savings from social security taxes vs additional costs needed for payroll and payroll tax preparation. Consider your pension funding requirements (lower wages mean lower pension contributions).  It is always good to get a knowledgeable tax and business advisor. The Medicare savings may pay for the services of a top notch CPA that will advise you wisely on finance and business decisions.  See discussion about C Corporations above. 

Manufacturers/Producers/Construction/Engineer/Architect  - Section 199 is a Manufacturer's deduction limited to 50% of gross wages (W2 wages in the USA only).     LLC owners do not get payroll checks reported on form W2, instead they receive distributions so for start-up manufacturers, talk to your accountant to determine if an S Corporation might be a better choice so you can take advantage of this new deduction.  Section 199 deduction is phased in through the year 2010 when it will reach 9% of qualified "production" activities income

Who might get this deduction?   Very simplified explanation:  If you

  • produce tangible personal property, computer software, sound recordings,  that is manufactured, produced, grown, or extracted by you in whole or significant part within the USA . (Computer software receipts exclude sales from internet access services, online services, customer support, telephone services, games played on the internet, provider-controlled software on-line access services.)  Does not include food processing at a retail establishment.
  • produce a qualified film 9motion picture, video tape, or live or delayed tv programming if NOT less than 50% of total compensation  is fro services performed in the USA by actors, production personnel, directors and producers.
  • produce electricity, natural gas, potable water in the USA
  • perform construction or erection of real property (and its components) including buildings,  inherently permanent land improvements and infrastructure in the USA.  Activities include the erection of new or substantially renovate real property (but do not include tangential services such as hauling trash and debris, and delivering materials. 
  • engineer or provide architectural services for construction or erection of real property (and its components)  in the USA.

Only one taxpayer may claim the deduction under 199 with respect to the same function performed to the same property, In other words, if you subcontract out the manufacturing, producing, growing, or extracting, then the 199 deduction is available to your subcontractor.

 


 

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Pros and cons of each entity type Small Business administration document discusses each entity type from a tax, liability and cost point of view.  You need Adobe Acrobat Reader software view and download this document.  If you do not have Acrobat Reader installed, click here to access the software from Adobe.
An attorney's point of view Discussion of each entity type
A comprehensive discussion of entity types Find Law resources
Disregarding entity choice for tax purposes
 
Form 8832
Want the legal characteristics of one entity and the tax characteristics of another?  There are some options open to noncorporate entities to be taxed differently.  Frankly, the only time we have seen this implemented is with the LLC.  If you are a sole owner of an LLC, the regulations default to being taxed as a sole proprietor (schedule C on form 1040), you may instead choose to be taxed as a corporation and with file form 2553 to be taxed as an S Corporation. Any savings with this election may be entirely offset with  the additional payroll taxes and tax preparation fees. Before going this route, speak to a tax professional and get it in writing what the advantages are. For the most part, selecting a form of taxation that is different from what is standard will probably convert into high professional tax preparation fees.

State and federal contact numbers, websites, for forms and applications.

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