Question

Select a publicly traded company and a publicly traded, large partnership. Analyze how they are treated for tax purposes. Describe the differences in taxation of their income, formation, dissolution, and liquidation, as well as the responsibilities borne towards creditors and taxing authorities by partners, shareholders, partnerships, and corporations.

As a CPA in public practice, which type of business organization would you advise a client to adopt among sole proprietorships, various forms of partnerships, and various forms of corporations?

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Answer 1

The type of business entity

you choose will depend on three primary factors: liability, taxation and record-keeping. Here's a quick look at the differences between the most common forms of business entities:

A sole proprietorship is the most common form of business organization. It's easy to form and offers complete managerial control to the owner. However, the owner is also personally liable for all financial obligations of the business.

A partnership involves two or more people who agree to share in the profits or losses of a business. A primary advantage is that the partnership does not bear the tax burden of profits or the benefit of losses-profits or losses are "passed through" to partners to report on their individual income tax returns. A primary disadvantage is liability-each partner is personally liable for the financial obligations of the business.

A corporation is a legal entity that is created to conduct business. The corporation becomes an entity-separate from those who founded it-that handles the responsibilities of the organization. Like a person, the corporation can be taxed and can be held legally liable for its actions. The corporation can also make a profit. The key benefit of corporate status is the avoidance of personal liability. The primary disadvantage is the cost to form a corporation and the extensive record-keeping that's required. While double taxation is sometimes mentioned as a drawback to incorporation, the S corporation (or Subchapter corporation, a popular variation of the regular C corporation) avoids this situation by allowing income or losses to be passed through on individual tax returns, similar to a partnership.

A hybrid form of partnership, the limited liability company (LLC) , is gaining in popularity because it allows owners to take advantage of the benefits of both the corporation and partnership forms of business. The advantages of this business format are that profits and losses can be passed through to owners without taxation of the business itself while owners are shielded from personal liability.

Selecting a Business Entity

When making a decision about the type of business to form, there are several criteria you need to evaluate. Kalish and EnviroTech co-owner John Berthold focused on the following areas when they chose the business format for their company:

1. Legal liability.

To what extent does the owner need to be insulated from legal liability? This was a consideration for EnviroTech, says Kalish. He and Berthold had a hefty investment in equipment, and the contracts they work on are substantial. They didn't want to take on personal liability for potential losses associated with the business. "You need to consider whether your business lends itself to potential liability and, if so, if you can personally afford the risk of that liability," Kalish says. "If you can't, a sole proprietorship or partnership may not be the best way to go."

Carol Baker is the owner of The Company Corporation, a firm based in Wilmington, Delaware, that offers incorporation services. She points to the protection of personal assets as "the number-one reason our clients incorporate. In case of a lawsuit or judgment against your business, no one can seize your personal assets. It's the only rock-solid protection for personal assets that you can get in business."

2. Tax implications.

Based on the individual situation and goals of the business owner, what are the opportunities to minimize taxation?

Baker points out that there are many more tax options available to corporations than to proprietorships or partnerships. As mentioned before, double taxation, a common disadvantage often associated with incorporation, can be avoided with S corporation status. An S corporation, according to Baker, is available to companies with less than 70 shareholder returns; business losses can help reduce personal tax liability, particularly in the early years of a company's existence.

3. Cost of formation and ongoing administration.

Tax advantages, however, may not offer enough benefits to offset other costs of conducting business as a corporation.

Kalish refers to the high cost of record-keeping and paperwork, as well as the costs associated with incorporation, as one reason that business owners may decide to choose another option--such as a sole proprietorship or partnership. Taking care of administrative requirements often eats up the owner's time and therefore creates costs for the business.

It's the record-keeping requirements and the costs associated with them that led Kalish to identify the sole proprietorship as a very popular form of business entity. It's the type of entity in place at his other business, Nationwide Telemarketing.

"I would always take sole proprietorship as a first option," he says. "If you're the sole proprietor and you own 100 percent of the business, and you're not in a business where a good umbrella insurance policy couldn't take care of potential liability problems, I would recommend a sole proprietorship. There's no real reason to encumber yourself with all the reporting requirements of a corporation unless you're benefiting from tax implications or protection from liability."

4. Flexibility.

Your goal is to maximize the flexibility of the ownership structure by considering the unique needs of the business as well as the personal needs of the owner or owners. Individual needs are a critical consideration. No two business situations will be the same, particularly when multiple owners are involved. No two people will have the same goals, concerns or personal financial situations.

5. Future needs

. When you're first starting out in business, it's not uncommon to be "caught up in the moment." You're consumed with getting the business off the ground and usually aren't thinking of what the business might look like five or ten-let alone three-years down the road. What will happen to the business after you die? What if, after a few years, you decide to sell your part of a business partnership?

The issue of ownership was a key one for EnviroTech. "When we started EnviroTech," Kalish remembers, "our reasoning for forming it as a corporation was because of ownership; we wanted to be able to bring in stockholders as we grew."

"A corporation's capital," Baker says, "can be expanded at any time in a private offering by issuing and selling additional shares of stock. This is especially helpful when banks are being tight with money."
Another important question to ask yourself is, "What do I want to happen to the business when I'm no longer around to run it?" While a sole proprietorship or partnership may dissolve upon the death of its owner or owners, a corporation can be readily distributed to family members.

Keep in mind that the business structure you start out with may not meet your needs in years to come. Many sole proprietorships evolve into some other form of business-like a partnership or corporation-as the company grows and the needs of the owners change.

The bottom line? Don't take this very important decision lightly, and don't make a choice based on what somebody else has done. Carefully consider the unique needs of your business and its owners, and seek expert advice, before settling on a particular business format.

Sole Proprietorship

The simplest structure is the sole proprietorship, which usually involves just one individual who owns and operates the enterprise. If you intend to work alone, this may be the way to go.

The tax aspects of a sole proprietorship are especially appealing because income and expenses from the business are included on your personal income tax return (Form 1040). Your profits and losses are first recorded on a tax form called Schedule C, which is filed along with your 1040. Then the "bottom-line amount" from Schedule C is transferred to your personal tax return. This aspect is especially attractive because business losses you suffer may offset income earned from other sources. As a sole proprietor, you must also file a Schedule SE with Form 1040. You use Schedule SE to calculate how much self-employment tax you owe.

In addition to paying annual self-employment taxes, you must also make quarterly estimated tax payments on your income. Currently, self-employed individuals with net earnings of $400 or more must make estimated tax payments to cover their tax liability. If your prior year's adjusted gross income is less than $150,000, your estimated tax payments must be at least 90 percent of your current year's tax liability or 100 percent of the prior year's liability, whichever is less. The federal government permits you to pay estimated taxes in four equal amounts throughout the year on the 15th of April, June, September and January. With a sole proprietorship, your business earnings are taxed only once, unlike other business structures. Another big plus is that you have complete control of your business-you make all the decisions.

There are a few disadvantages to consider, however. Selecting the sole proprietorship business structure means you're personally liable for your company's liabilities. As a result, you're placing your own assets at risk, and they could be seized to satisfy a business debt or legal claim filed against you.
Raising money for a sole proprietorship can also be difficult. Banks and other financing sources are reluctant to make business loans to sole proprietorships. In most cases, you'll have to depend on your own financing sources, such as savings, home equity or family loans.

Partnership

If your business will be owned and operated by several individuals, you'll want to take a look at structuring your business as a partnership. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership's debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners.

Unless you expect to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form.

One of the major advantages of a partnership is the tax treatment it enjoys. A partnership doesn't pay tax on its income but "passes through" any profits or losses to the individual partners. At tax time, each partner files a Schedule K-1 form, which indicates his or her share of partnership income, deductions and tax credits. In addition, each partner is required to report profits from the partnership on his or her individual tax return. Even though the partnership pays no income tax, it must compute its income and report it on a separate informational return, Form 1065. Personal liability is a major concern if you use a general partnership to structure your business. Similar to a sole proprietorship, general partners are personally liable for the partnership's obligations and debt.

In addition, each general partner can act on behalf of the partnership, take out loans and make business decisions that will affect and be binding on all the partners (if the general partnership agreement permits). Keep in mind that partnerships are more expensive to establish than sole proprietorships because they require more extensive legal and accounting services.

Corporation

Using the corporate structure is more complex and expensive than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires complying with more regulations and tax requirements.

The biggest benefit for a small-business owner who decides to incorporate is the liability protection he or she receives. A corporation's debt is not considered that of its owners, so if you organize your business as a corporation, you're not putting your personal assets at risk. A corporation also can retain some of its profits, without the owner paying tax on them. Another plus is the ability of a corporation to raise money. A corporation can sell stock, either common or preferred, to raise funds. Corporations also continue indefinitely, even if one of the shareholders dies, sells the shares or becomes disabled.
The corporate structure, however, comes with a number of downsides. A major one is higher costs. Corporations are formed under the laws of each state with their own set of regulations. You'll probably need the assistance of an attorney to guide you through the maze. In addition, because a corporation must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax preparation services.

Another drawback: Owners of the corporation pay a double tax on the business's earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.

To avoid double taxation, you could pay the money out as salaries to you and any other corporate shareholders. A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. Keep in mind, however, that the IRS has limits on what it believes to be reasonable compensation.

How to Incorporate
To start the process of incorporating, contact the secretary of state or the state office that is responsible for registering corporations in your state. Ask for instructions, forms and fee schedules on business incorporation.

It's possible to file for incorporation without the help of an attorney by using books and software to guide you along. Your expense will be the cost of these resources, the filing fees, and any other costs associated with incorporating in your state.

If you do file for incorporation yourself, you'll save the expense of using a lawyer, which can cost from $500 to $1,000. The disadvantage of going this route is that the process may take you some time to accomplish. There's also a chance you could miss some small but important detail in your state's law.
One of the first steps you must take in the incorporation process is to prepare a certificate or articles of incorporation. Some states will provide you with a printed form for this, which either you or your attorney can complete. The information requested includes the proposed name of the corporation, the purpose of the corporation, the names and addresses of the parties incorporating, and the location of the principal office of the corporation.

The corporation will also need a set of bylaws that describe in greater detail than the articles how the corporation will run, including the responsibilities of the shareholders, directors and officers; when stockholder meetings will be held; and other details important to running the company. Once your articles of incorporation are accepted, the secretary of state's office will send you a certificate of incorporation.

Once you're incorporated, be sure to follow the rules of incorporation. If you don't, a court can pierce the corporate veil and hold you and the other owners personally liable for the business's debts.
It's important to follow all the corporation rules required by state law. You should keep accurate financial records for the corporation, showing a separation between the corporation's income and expenses and that of the owners'.

The corporation should also issue stock, file annual reports and hold yearly meetings to elect officers and directors, even if they're the same people as the shareholders. Be sure to keep minutes of these meetings. On all references to your business, make certain to identify it as a corporation, using Inc. or Corp., whichever your state requires. You also want to make sure that whomever you deal with, such as your banker or clients, knows that you're an officer of a corporation