Hans Kasper, MS-CPA, PS

Legal Form of Business

 

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Sole Proprietorship

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Table of Pros and Cons of Forms of Legal Entities

Act Like A Corporation    Site Link

So you’ve been thinking about starting a business in Washington State?  You’ve got the concept and the name, and you have a good idea of your marketing tools.  You’ve done all the legwork to find out if the idea will fly, and you’re confident of your ability to accomplish it. You’ve written a business plan, and interested investors.  Now you have to decide what form your business will take.

If you are going into business alone, your choices include operating as a sole proprietor, incorporating as a regular corporation, or incorporating as a limited liability company (LLC).  If you are going into business with associates, you may choose to operate as a partnership, a corporation, or an LLC. If you are concerned with limiting your personal liability, your choice is between a regular corporation and an LLC.

For an individual who wants a small and simple operation, a sole proprietorship is the easiest and least regulated type of business.  Other than registering your business name and obtaining the necessary licenses, a sole proprietorship can be set up anywhere. It is an unincorporated business owned by one individual.


Sole Proprietorship

The sole proprietor has total responsibility and control, can hire any number of employees, and set all the rules for the business.  However, the owner is personally liable for all claims, taxes and debts against the business. Our firm does not recommend operating your business as a sole proprietorship where there is any significant risk of a potential lawsuit against the business.  A food business where e-coli is a potential issue, or a contracting business where future claims against the company can result in lawsuits are two examples.

As a sole proprietor, you report business profit or loss on your personal tax return on a Schedule C. Top


Partnership

A partnership is the relationship existing between two or more persons who join to carry on a trade or business.  A general partnership can be formed by simply making an oral agreement between two or more persons, but it’s better to have an attorney draw up an agreement, clearly stating the duties and rights of each of the partners.  Each partner has equal rights as laid out by the terms of agreement.  And they have equal shares in the liabilities as well.  Personal assets can be attached and liquidated if the partnership cannot satisfy creditors’ claims. Our firm does not recommend the partnership form of business since each partner is individually liable for the other partner’s actions.  For example, if one partner commits fraud against a client, the other partner becomes personally liable for all of the damages.

A partnership is not a separate legal entity for legal liability purposes, but it reports its income on an informational tax return (Form 1065) which passes through any profits (or losses) to each partner’s individual tax return.  If you are a partner, you report your share of partnership profit & loss on a Schedule K-1.  Top


Corporations

If you decide to incorporate, you should hire an attorney to set it up, and make sure it complies with the corporate laws.  Think of a corporation as a legal entity completely separate from you. It can continue to function even without the existence of the original owners.  Many people choose this form because it limits personal liability for the debts and other liabilities of the business, unless one of the owners is required to give a personal guarantee for a loan or is found to cause harm due to gross negligence.  However, you need to know how to Act Like A Corporation.

The profit of a "C" corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. However, shareholders cannot deduct any operating losses of the corporation.

An "S" Corporation is generally exempt from federal income tax other than tax on certain capital gains and passive income.  Its shareholders include on their tax returns their share of the corporation’s separately stated items of income, deduction, loss, and credit, and avoid double taxation (once to the corporation and again to the shareholders). You may elect Subchapter "S" status for your small business corporation (the election must be filed with the IRS on Form 2553 within 75 days of the start of the corporation or each calendar year) if it meets the following requirements:

  • the corporation has no more than 35 shareholders;

  •  the corporation has only one class of stock;

  •  all of the shareholders are U.S. residents, either citizens or resident aliens;

  •  all of the shareholders are individuals (i.e., no corporations or other entities own the stock) and

  •  the corporation operates on a calendar year financial basis.

None of the members of a Limited Liability Corporation (LLC) are personally liable for its debts.  An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or a sole proprietorship.  A separate election is made in choosing the form of the LLC.

To incorporate your business or register your partnership in the State of Washington, you must file with the Secretary of State.  This license is separate from the license with the Department of Revenue.

Following is a table showing the advantages and disadvantages of each form of business to help you make an informed decision. Top

The issue of the type of entity for your business can be very complicated.  Be sure that you consult with an attorney or an accountant to choose the best form for you.  On the next page is a table showing the various tax entities, and hopefully helps make your decision a little easier.

 


PROS & CONS OF FORMS OF LEGAL ENTITIES

Type of Entity

Pros

Cons

Sole Proprietorship

Inexpensive to start

Owner has unlimited personal liability.

Simple to run

Business has unlimited liability for owner’s personal liabilities.

No double taxation on profits

Ownership is limited to one person

 

Greatest freedom of action

Growth limited to personal energies

Simple IRA, Sep IRA, Keogh plans, and defined benefit plans are allowed for retirement contributions.

Profit sharing plans are not allowed but may be substituted with a Keogh plan.

Can deduct medical insurance and medical expenses for self and spouse, if spouse works for business. A special legal document electing this plan must be authorized.

Single taxpayers and married taxpayers, whose spouse does not work for the business, may take this deduction if the business is a "C" corporation.  A more limited deduction is available with an "S" corporation.

Partnerships

Very flexible form of business

Partners have unlimited personal liability for business liabilities.

Permits ownership by more than one individual.

Partnership is legally responsible for the business acts of each partner.

 

Avoids double taxation

General partnership interest may not be sold or transferred w/o consent of all partners

 

Few legal formalities for its maintenance

Partnership dissolves upon death of general partner

 

Additional sources of venture capital

Difficult to get rid of bad partners

 

Almost all retirement plans are allowed.

 

 

Can deduct medical insurance and expenses for self and spouse, if spouse works for business. A special legal document electing this plan must be authorized.

Married taxpayers, whose spouse does not work for the business, may not take this deduction.

Corporations

Provides limited liability to owners

More costly to set up and maintain

 

Easy to transfer ownership

Requires separate tax returns

 

Insures continuity

Less freedom of activity

 

Easy to add additional owners/investors

"C" corporations are subject to double taxation.

 

Can deduct medical insurance and expenses for single & married taxpayers; the spouse does not have to work for business. A special legal document electing this plan must be authorized.

Available for "C" corporation and is more limited for "S" corporations.

 

S-corporations avoid double taxation upon the sale of business but may be double taxed on operating income during life of business.

C-corporations are double taxed upon the sale of the business but may avoid some double taxation on operating income during life of business.

 

Almost all retirement plans are allowed.

 

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This page was last updated on 05/13/2010

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