Business entities for small businesses
Updated: Aug 1
A small business is generally defined as a business with less than 50 employees or $5,000,000 annually in sales. Chrysler Corporation once qualified as a small business by Congress to get a Small Business Loan especially designated for small manufacturing businesses with the Chrysler label. However, here we will cover normal businesses that might use a credit card with unbearable interest rates to cover some bills.
The form that a startup should take is an important consideration. Partnership? LLC? S-Corp? C-Corp? Choosing can be a daunting task. The implications of not making the correct choice can be enormous.
Mr. Chute recommends a comprehensive approach to business structuring that addresses investors and tax implications for both the short and long term goals.
Our business formation practice includes:
The formation of partnerships, LLC’s, Subchapter S corporations, and so-called “C-Corporations” Formations of nonprofits and tax-exempt corporations.
Ownership shares and stock plans
Obtaining necessary business licenses
Phillip also provides continuing counsel on best tax practices, as businesses that he has helped nurture grow and mature.
The easiest business form is the sole proprietorship. As the term implies, this means one person in business as owner. As the IRS would say, "a person with a vested economic interest in the profits or losses of a going concern." The profits are normally subjected to Social Security [Self Employment] taxes [the cap limit of which is raised every year, for the more fortunate], Medicare taxes [which have an unlimited ceiling], and personal income taxes.
The owner is also subjected to unlimited liability, even if "the help made the mistake which resulted in the demise of the client's favorite champion coon dog."
GENERAL LIMITED PARTNERSHIPS
This entity can diversify into various parts. Firsthand, a partnership can be a statement between two parties to do something together. "Let's go to the store together." is a partnership, but not for business since it doesn't involve an economic purpose. Businesses require a written document declaring partner's interests, involvement, profit/loss distributions, purpose, and is recommended because you have created an entity which is required to file form 1065 tax returns each year.
An alternate can be a casual Joint Venture, which is a minor event where both partners share in it equally [a lemonade stand for a weekend]. A real Joint Venture would be two construction companies building a building together. Partnerships require more than one partner and at least one must be the general partner. If any partners are limited [investment only and no active participation in the operations], then you have a limited partnership and there are limits on losses flowing though to the limited individual's tax returns.
If all partners are active, it is a general partnership and all gains or losses flow directly to the individual partners on a K-1 form, although there are other capital restrictions on losses.
LIMITED LIABILITY PARTNERSHIPS
Limited liability partnerships are not what they seem. California requires a legal filing to commence business and will tax the business sales each year for the privilege. A limited partnership must have more than one partner [note word usage here] and files a partnership return every year like a general partnership. If there is only one partner, it becomes a schedule C business on the individual's tax return.
Limited liability is a misnomer since you can't blame the mistake on the help and the lawyers can attack your bank account without protection. Many professionals have LLC businesses but only to distribute the profits or losses since they can't professionally say, "the help made the mistake which killed the patient," to escape litigation.
There are many kinds of corporations but the most common type is the C corp [as in Common]. It is a "close" corporation until it goes public by way of the SEC, which means you can't sell shares of stock on the street corner. It must be registered with the state where it does business, file corporate 1120 tax returns, and pay it's own taxes each year because it is a legal entity.
In California, a corporation is subject to a minimum $800 "Franchise Tax" which is a clever way of getting around that the tax table effect that sometimes 9 % times $0 is equal to $0. Owners must put themselves on payroll because officer's loans are considered taxable distributions. The minute book should be kept up at least annually, minutes should be accurate, annual Declaration of Officers and Shareholders statements should be filed so lawyers know where to send the guy with the summons.
If you fail to file tax returns for three years your little business has suffered a corporate death and all legal activities are invalid, which doesn't matter since the small business owners [think President] must sign personally for leases, cars, insurance, etc.
There is some liability protection because employees can sometimes be blamed although I had to testify in a wrongful death suit that the murder weapon was indeed bought with business funds which opened the door for Corporate Officer's and Director's malpractice insurance coverage to kick in, plus more money from the deposed president-owner. A Corporation designed to hold investment assets is a holding company and subject to special taxes.
A cooperative corporation requires participation by shareholders who are also clients [think local water company]. A Foreign Corporation is a business located, not in Cuba, but in California, after paying the internet jokers all those fees to incorporate in Las Vegas, Nevada to evade California taxes. California has a special interest in their businesses avoiding taxes and assesses them the normal high taxes and penalties earned by locals.
An S corporation is a corporation that wishes to be taxed as a partnership but still maintain Corporate liability coverage. This hybrid is rarely initiated properly by the incorporators or lawyers filing for the incorporation. To do it correctly an 8879 form must be filed with the IRS within 2 1/2 months from the inc. date with all shareholders acquiescing.
It must also be noted in the minute book at inception. Corporate officers should draw a salary and the remaining profits or losses flow through to the individual shareholder/partner's tax returns as investment income not subject to Social Security taxes. IRS is now auditing many of these businesses to see if the owners are paying their taxes correctly.
There are limits on the number of shareholders, types of shareholders, and other considerations. I had one with the reverse problem whereas the original owners had actually filed for the Sub S authorization and lost all the paperwork including the Federal ID number application.
NOT-FOR-PROFIT OR FOUNDATIONS (NONPROFIT)
Local charities might consider an IRS tax code 501c3 application to conduct a non-profit business. It may be required to cash checks or conduct business otherwise for your little volunteer fire department. The non-profit entity does not pay income taxes since the benefits must be distributed for charitable means.
There are many restrictions and qualifications. The paperwork required for the application filing with the state is huge because there are many abuses. A defaulted non-profit becomes a normal taxable C Corporation.
Many credit counseling agencies are now restricted by the Federal government to become non-profit businesses and provide very limited advice in a much-abused industry. Foundations require a Federal application and it is truly onerous. However, if your rich Uncle Tom wants to put millions into a special fund to aid Maine Coon Cats and give you an executive director job forever, then it might be worth it.
* Phillip B Chute is an Enrolled Agent, tested, licensed, and appointed by the IRS directly. He has prepared or supervised over 25,000 tax returns over 30 years.