You have worked for someone else all your life up to this point. You are very good at what you do. Going at it alone is what you always wanted to do. You have decided to work for yourself and start your own business. Starting your own business can be exciting, fun and often times scary. If you decide to do it all by yourself, you could be making one of your first mistakes.
You may be a good mechanic, baker, toolmaker or stylist, but you have never run your own business. The setting up of your new business can be very complicated. There are things that you will not know what or how to do. For those things that you do not know how to accomplish, surround yourself with people who can assist you. Your professional team should be chosen at the outset. This team should include a tax advisor/accountant, attorney, insurance agent and banker.
One of the first choices that you have to make is what form of entity to use for your business. When setting up your business, you have several options. Your business can generally be a sole proprietorship, a general partnership, a limited partnership, a C corporation, an S corporation or a limited liability company. Working with your attorney and tax advisor/accountant will aid you in determining which form to choose.
A sole proprietorship is a type of business where you act on your own behalf as the business. All income and expenses are reported on your individual income tax return. The biggest downside of a sole proprietorship is that your personal assets are at risk for all business liabilities. If the business gets sued and receives a large judgment against it, all of your personal assets are at risk to pay for the judgment, including your home and personal investments.
However if you have little exposure to business liabilities, a sole proprietorship may be an appropriate choice of entity. For example, if you have an internet mail order business that requires little investment, a sole proprietorship may be adequate. On the other hand, if you have a high traffic retail store, you may want a different business entity that limits your liability.
Many people choose a sole proprietorship initially because it is very economical to set up. You file an assumed name certificate with the county, apply for a tax identification number from the IRS, get a business license if required by your local municipality, and you are off and running.
If you have a partner in the business, you may want to use a partnership. A general partnership is an agreement between you and one or more partners to run a business. Items of income and expense flow through to you and the other partners to be taxed on your individual income tax returns. Every partner has full authority to act on behalf of the partnership. However, like a sole proprietorship, you and each of your partners have all of your personal assets at risk for company liabilities and debts, even if your partner caused it.
Like a sole proprietorship, you file a certificate with the county, apply for a tax identification number from the IRS and get a business license if required by your local municipality. You should also have partner meeting(s), issue partnership interests and adopt a partnership agreement. The partnership agreement governs the operation of the business and sets forth the rights and responsibilities of all the partners.
If some of the partners will not be active in the business and want to limit their liability, a limited partnership might be a good choice. A limited partnership is an agreement between two or more partners to run a business in which at least one of you is a general partner and at least one of you is a limited partner. Items of income and expense flow through to you and the other partners to be taxed on your individual income tax returns.
If you are a general partner, you have the full authority to act on behalf of the partnership, but you have unlimited personal liability for partnership debts. As a limited partner on the other hand, your liability is typically limited to the extent of your capital commitments, but you have no authority over the management of the partnership. You set up a limited partnership like a general partnership, except that the partnership certificate is filed at the state level rather than with the county.
You may want to use a corporate form if you and the other shareholders want to have limited liability for most corporate debts. If you are working in the business, you have to be paid a reasonable wage if the company can afford it. Any other distributions to the shareholders that are not wages generally have to be paid as dividends in proportion to the shareholdings. A corporation can be a C corporation or an S corporation.
A C corporation is generally going to be taxed on its income as a separate entity. Except for certain qualified dividends, distributions to you and other shareholders in the form of dividends will usually be taxed again on your individual income tax returns. You report your wages on your individual income tax return.
To set up a corporation, you file articles of incorporation with the state, get your tax ID and get your business license, if required. In addition, you must issue stock, have meetings of the shareholders and directors, elect officers and directors and adopt bylaws. The bylaws govern the operation of the business and set forth the rights and responsibilities of the shareholders, directors and officers.
An S corporation differs from a C corporation in that items of income and expense flow through to you and other shareholders to be taxed on your individual income tax returns. Income distributions to you and the other shareholders in the form of dividends usually have no tax effect since you have already been taxed on the income. You set up an S corporation just like a C corporation, except in addition, you file an S election with the IRS.
A limited liability company, also called an LLC, is a type of entity which is owned by one or more persons who own membership interests in the LLC. An LLC can be member managed where each member has full authority over the management of the LLC, or manager managed where certain members or others are appointed to manage the LLC.
You and the other members of the LLC can generally choose how the LLC is going to be taxed either as a partnership (or proprietorship if there is only one member), a C corporation or an S corporation. I most often see LLCs taxed as partnerships or proprietorships. If you are going to be taxed as a corporation, it is best to have your business set up as a corporation so that your organizational documents are consistent with the tax treatment.
To set up an LLC, you file articles of organization with the state, get your tax ID and get your business license, if required. In addition, you must issue membership interests, have meeting(s) of the members, appoint a manager if needed and adopt an operating agreement. The operating agreement governs the operation of the business and sets forth the rights and responsibilities of the members and managers.
The choice of business entity is often determined by your tax and business liability situation. If you have other income, it may be advantageous at least initially to have the business taxed at the individual level so you can offset start-up losses against other income. If the company income is not going to be distributed to you and will just be utilized to build the business or you want certain employee benefits, you may want to use a C or S corporation.
The Michigan Small Business & Technology Development Center (MI-SBTDC) offers classes locally to assist business owners in in the setting up and running of their businesses. The local representative for the MI-SBTDC is Mike Mancini. He can be reached at 810.987.3682.
You should review your business and tax situation with your attorney and tax advisor to determine the best form of entity that should be utilized for your business. An experienced business attorney should be used to prepare your organizational documents. And surround yourself with qualified people to assist you in doing the things you do not know how to do or have the time to do.
By Matthew M. Wallace, CPA, JD
Published edited October 16, 2016 in The Times Herald newspaper, Port Huron, Michigan as: Choose the right entity for your business