Beginnings of Your Small Business

will find the financial statements and tax returns more meaningful. If the year

closed in the middle of winter (December 31), purveyors of financial statements

would not know how the season really turned out.

Double Taxation

A drawback to the corporate form of ownership is the widely debated anomaly

known as double taxation. Here, the federal government (and most states) charge

corporations a portion of their earnings for income taxes. After the income taxes

are paid, the business may declare that some of the remaining after-tax earnings

are payable to owners as dividends. Unfortunately, dividends may not be de-

ducted by the corporation as a business expense, so corporate taxable income is

higher by this amount and corporate taxes do not benefit from the dividend

declaration. However, after the dividends are paid, the government steps in again

and asks you (as an individual) to report those dividends as income on your

personal tax return and pay a portion as part of your income taxes.

For this reason, small businesses do not normally declare dividends. How-

ever, this declaration may be forced if the IRS accuses a firm of holding excess

retained earnings. In that case, the firm is forced to declare dividends, which

leads to paying double taxes.

In reality, however, double taxation can be avoided though careful tax plan-

ning. Normally, this is accomplished when the small business corporation pays

compensation (salaries, bonuses, commissions, fees) to owners before the tax

year ends. Thus, the expense is out the door before taxes are calculated. As

business expenses go up, taxable income goes down, so fewer taxes are due. On

the other hand, payroll taxes are due on the compensation received by the small

business owner. In summary, corporate income taxes decrease—and personal

income taxes and payroll taxes increase—due to the extra compensation. No

general rule governs this particular issue. Small business owners and their CPAs

must compute this annually as year-end approaches.

There are, however, limits to this device. The IRS requires that small busi-

ness owners may not be paid compensation and avoid taxes beyond those amounts

normally paid in specific industries and locations.

Perpetual Existence

Unlike sole proprietorships, partnerships or even professional service cor-

porations, C-Corps. live on until the owners decide to terminate or sell off the

business, or upon bankruptcy. Despite changes in management or even the death

of an owner, corporations enjoy an independent and continuing legal existence.

As a result, employees, creditors, vendors, clients and other parties may be im-

pressed by this fact and feel more confident about working with your small busi-

ness. Outside parties working with fast-growing businesses especially appreciate

this corporate characteristic.

Formality

There’s no doubt about it: The corporate form of small business ownership

commands at least a little more respect from everyone. Incorporating is one of

the best ways to tell the world that your business is here, and here to stay. Your

company is now ready to enter into agreements and relationships that are nor-

mally afforded only to corporations (for example, a service contract with a big

company, or a bank loan). This benefit is intangible and impossible to quantify,

but it will help distinguish your company from competitors. In the end, many

small businesses incorporate for this reason, regardless of the tax consequences.

Access to Capital and Big Deals

The corporate form of business ownership is custom-designed to receive

capital through investment and the sale of a wide variety of equity devices; through

debt instruments such as unsecured lines of credit, collateralized loans, secured

promissory notes, debentures, and the many other options described in Chapter

11; or by landing a big corporate client. When the situation requires special fea-

tures (such as allowing debt to be converted into shares of stock; conferring

voting rights on lenders; providing for preferred stock conversion to common

stock, stock options for management, indemnification of large clients, etc.), it is

easier to write these into corp.-to-corp. agreements than into any other form of

business ownership. In the real world, small businesses requiring access to big-

time capital need to be incorporated.

Paperwork and Fees

Some small business owners feel that the corporate form of business owner-

ship requires more administration as well as attention to deadlines and details.

For example, California corporations are required each year to announce and

hold at least one shareholders’ meeting, (re)elect the officers and directors, and

convene meetings to discuss special situations, report decisions, or grant special

authority (for example, “Owen Owener is hereby granted the authority to open a

new business checking account at Corner Bank”). California corporations must

also file an annual Statement of Information with the secretary of state ($25 fee);

file corporate income tax returns; pay and file documentation for state and fed-

eral payroll taxes at least quarterly; pay a minimum annual state income tax of

$800, even if the year was a loss; and be aware of many other potential events

requiring time, work, and fees. A good accounting system is required to handle

these obligations.

The counterargument here is that this is not a great price to pay, considering

the benefits of corporate ownership. This is what is required if a small business

wants to play in the big leagues—and what kind of business these days cannot

afford Quickbooks or similar accounting software?

One disadvantage is the $1,000 to $3,000 fee normally charged by attorneys to

set up a new corporation properly. This fee can be avoided, however, if the situ-

ation is straightforward (incorporating a new small business with one owner)

and the owner has the time and patience to read and follow instructions care-

fully. Moreover, many of the forms dealing with corporate formalities can be

found easily on the Internet and at office supply stores, or may be borrowed

from colleagues.

Tax Treatment

In addition to the tax issues described previously, note that the IRS recog-

nizes corporations as entities separate and independent from their owners. Ac-

cordingly, corporations must file separate federal and state income tax returns.

Federal returns are submitted on IRS Form 1120S (Corporation Income Tax

Return). Apart from normal income taxes attributable to dividends received,

there are no income tax consequences for corporate shareholders until shares

are sold and a gain or loss is recognized. In that case, the gain or loss is treated

the same as any other security transaction.

Subchapter S Corporation

Description

A Sub S election is available only to companies that have already incorpo-

rated. As described in this chapter, corporations offer small business owners

limited liability, which is attained when the small business incorporates. When

the owners also make the “Subchapter S election,” the company is taxed like a

partnership but retains the benefits of limited liability.

The Sub S structure allows investment by a maximum of 75 shareholders, but

investors may be offered only regular common stock, thus limiting options such

as preferred stock. Further, there are limits on the types of investors allowed to

participate. For example, non-resident aliens may not invest. Insurance compa-

nies, banks, Domestic International Sales Corporations (DISCs), and certain

other businesses are not allowed to seek Subchapter S status. The rules are com-

plex, and a specialist may be needed to determine if they apply to your small

business.

All income and losses are reported, but not paid, by the Sub S Corporation.

The Sub S lists all owners and their share of the company. Each owner receives a

copy of this list from the company via a K-1 statement. Owners then report all of

the gains or losses on their Form 1040 (Individual Income Tax Return). Income

deferral is not relevant here.

Sub S businesses must comply with most of the same regulatory require-

ments as corporations, such as filing articles of incorporation, calling and hold-

ing meetings of both directors and shareholders, and keeping accurate minutes

of meetings. This results in higher set-up and operating costs than some other

forms of business ownership.

Tax Treatment

Some small businesses choose the Sub S structure because it allows start-up

losses to be passed to investors and deducted against personal income. After

this, however, election of S Corporation status makes sense only if taxes at cor-

porate rates are less than those at individual rates. Of course, this varies over

time and depends upon income and state taxes. Once a small business elects to

be treated as an S-Corp., switching back to a C-Corp. or other form of business

ownership may be complex or impossible. Do not assume that it will be simple,

easy, or cheap.

As with partnerships, Sub S Corporation income and losses are passed to

shareholders and included on their individual tax returns. Corporations elect to

be treated as Sub S companies by filing IRS Form 2553 (Election by a Small

Business). As always with the IRS, however, there are exceptions (for example,

if the LIFO inventory valuation method was used in the year prior to election as

an S-Corp.), so it is important to check the regulations.

Normally, then, income is reported (but taxes are not paid) by the S-Corp.

on IRS Form 1120S (Income Tax Return of an S Corporation). A Schedule K-1

is generated for each investor in proportion to gains (or losses). K-1’s are then

provided to each shareholder, and the information ends up on Form 1040, Sched-

ule E, of the Individual Income Tax Return for each shareholder.

Limited Liability Company (L.L.C.)

Description

L.L.C.’s have become an especially popular form of business ownership in

recent years, although they first became available in 1977.

An L.L.C. blends some of the features of partnerships and corporations.

Perhaps most important, members of an L.L.C. enjoy limited liability, much like

shareholders of a C-Corp., but they are not subject to the double-taxation prob-

lem faced by corporations. Specifically, the L.L.C. does not pay federal or state

income taxes directly but passes gains and losses on to the L.L.C. owners in

proportion to their ownership. The gains or losses are then reported on the own-

ers’ individual personal income tax returns, as in partnerships.

Beyond this, there is no limit to the number of shareholders L.L.C.’s may

engage. Having said this, L.L.C.’s do not actually issue shares, but instead deal

with owners in terms of their investment in the small business.

For example, Romeo and Juliet formed an L.L.C. in which Romeo contrib-

uted $200,000 and Juliet, $300,000. The R&J L.L.C. earns $100,000 before taxes.

Thus, Romeo earns 40 percent of this (40% × $100,000 = $40,000), and Juliet

earns $60,000.

Regarding management, L.L.C. owners may participate fully in managing the

small business’s operations. Unlike limited partners, they face no restrictions.

30

To set up an L.L.C., the prospective owners establish the entity at the state

level by filing articles of organization, entering into an operating agreement that

defines their rights and obligations as members (much like a C-Corp. sharehold-

ers’ agreement). L.L.C.’s do not have a perpetual life, so small business owners

must check state laws to learn about limits to the lives of their L.L.C. small

businesses, and then plan accordingly.

Tax Treatment

The IRS considers “L.L.C.” a state designation and therefore requires tax-

payers to file under one of the business ownership forms that it recognizes. The

small business L.L.C. will always file at the state level as an L.L.C., but in some

cases it will file at the federal level as one of the following:

Sole Proprietorship. The single L.L.C. owner files a Schedule C with a Form

1040.

Partnership. As in a general or limited partnership, the L.L.C. files Form

1065 (Return of Partnership Income); gives K-1’s to the investors in proportion

to their ownership; and requires that owners enter the K-1 information on

their individual income tax returns.

Subchapter S Corp. The Sub S files Form 1120S (basically a corporate tax

return), and investors carry this amount onto their personal tax returns via

Schedule E, which carries onto individual tax returns. To file as a Sub S with

the IRS, the firm must register as a Sub S as described previously.

Corporation. The corporation files Form 1120S and pays the taxes. Individual

investors pay taxes only upon receiving gains and dividends. Note that in this

case, the L.L.C. may not avoid the problem of double taxation.

Although the L.L.C. is increasingly popular among small businesses, the laws

are still new and untested. Accordingly, there is still great uncertainty as to how

well the “limited liability” benefit of an L.L.C. will really stand up when attacked

by creditors. We can only wait and see how this develops in different states and

over time.

Additional protection may be gained by organizing the ownership through an

offshore managing company to provide asset protection.

Due to the uncertainties involved in organizing and operating an L.L.C., an

experienced attorney or CPA should assist in the structuring if issues such as

asset protection and corporate tax treatment are complex.

Professional Corporations

Description

The Professional Corporation form of business ownership provides that cer-

tain services may be offered only through persons who are properly licensed to

engage in particular professions. The Professional Corporation is recognized

only at the state level, not at the federal level. In California, for example, attor-

neys, chiropractors, clinical social workers, dentists, doctors, and members of

several other professions who wish to incorporate must do so as Professional

Corporations. Others, such as engineers and financial advisors, may incorporate

as a regular “C-Corp.” but have many other options as well.

An additional benefit of a Professional Corporation is that persons outside

of the chosen profession cannot end up as partners with equal rights. For ex-

ample, Dr. Sarah Bellum and Dr. Ann Eurism are brain surgeons who are in

business together. Sarah dies. Dr. Ann is relieved that Sarah’s sit-at-home hus-

band, who aspires to appear on “Celebrity Bowling” will not end up as an equal

partner. Of course, this also allows the public to be confident that Professional

Corporations are owned and managed only by professionals.

Tax Treatment

“Professional Corporation” is a state designation and has no meaning to the

IRS. Small businesses offering professional services must determine whether to

file at the federal level as a C-Corp. or as an S-Corp. (both described more fully

in this chapter). In either case, the small business files IRS Form 1120 (Corpora-

tion Income Tax Return).

Fans of tax minimization may prefer to be treated as a C-Corp., due to the

relatively low initial tax rates (currently 15 percent on the first $50,000 in taxable

income); however, Form 1120 asks taxpayers to “check [box] if a qualified per-

sonal service corporation under section 448(d)(2).” (In case you are not already

confused, this will do it: The IRS does not recognize Professional Corporations,

but it does recognize “qualified personal service corporations” that perform pro-

fessional services where substantially all activities involve accounting, actuarial

science, architecture, consulting, engineering, health, law, and the performing

arts, and where at least 95 percent of the firm’s stock is owned by employees

performing services for the corporation, retired employees, the estates of de-

ceased employees, or other persons acquiring stock in the corporation by reason

of the death of employees.)

When the IRS understands that your small business fits the definition of a

qualified personal service corporation, a different—and much higher—tax sched-

ule must be used, in which shareholders pay a flat (not graduated) rate on all

income. In fact, the personal service corporation is a penalty situation as far as

the IRS is concerned: Corporate taxpayers are slapped on the wrist for even

thinking about the 15 percent initial C-Corp. tax rates. The taxable income of

qualified personal service corporations is currently subject to a flat tax rate of 35

percent instead of the graduated rates available to most corporations.

The IRS believes that professionals who earn the majority of their income from

the performance of services should not be allowed to enjoy the low, graduated tax

rates offered to C-Corps. Since the tax-minimization factor is not relevant to pro-

fessionals, other factors will normally determine the best form of ownership (such

as limited liability).

Small business owners must check state laws to determine which professions

require registration as Professional Corporations.

Differing Laws and Many Exceptions

It should be clear from our discussion that a general explanation of the dif-

ferent forms of business ownership may be offered, but rules vary from state to

state, and there are many exceptions in each state. In simpler situations, this

overview may be sufficient for you to understand the alternatives and head in the

right direction. Under more complex conditions, however, small businesses may

find this overview useful but should seek legal help before proceeding.

Incorporating in Another State

These days it is popular to incorporate a small business in one state and

conduct operations in another. As state income tax rates have become more

burdensome, some small business owners have reacted by incorporating in states

with minimal or no corporate income taxes, such as Delaware and Nevada. This

is not a tenable solution.

The essence of the issue is that states want to tax for business activity that

occurs within their boundaries. If you drive on their roads, rely on their police,

and use their courts, then your small business must pay for this, in part through

corporate income taxes.

Small businesses that register in one state and use a sham address for their

corporate headquarters may get away with this for a while—maybe even for a

few years. But one day, the state really hosting the firm will understand the true

situation and the small business will likely need to pay all back taxes, penalties,

and interest.

Further, your small business will probably be charged with violating the law.

Businesses are normally required to register and qualify to do business in each

state in which significant business volume occurs. Registering and qualifying ex-

penses are usually not significantly different from the fees a domestic corpora-

tion would pay to register properly, so there is little to be saved in this sense.

When the state finds out that all of this has been going on, there is a chance

that your corporate status will be suspended. In this situation, you will likely

receive a letter demanding that your company not

legally transact business, defend or initiate an action in court, protest

assessments…[or] use the entity name.

The result of suspension is that the corporation cannot utilize that state’s

courts to prosecute any claims or initiate other types of actions. Any court pro-

ceedings then in process or contemplated where the small business is the plain-

tiff (for example, trying to collect from a deadbeat customer) would not be allowed.

Setting things right again is often very expensive, given the need to pay all back

fees, fines, penalties, and interest.

Incorporating out of state does not allow small businesses to avoid payment

of state income taxes. In fact, such behavior will lead to big-time trouble when

the real situation becomes known.

How to Decide on the Best Form of Ownership

This chapter has provided a good deal of information on the best form of

ownership for your small business. You have many options, and each has many

implications, including taxes, liability, perpetuity, formality, ease of doing busi-

ness, filing and regulatory demands, access to capital, year-end, image, and

more.

Making a decision is important, and it is not one that is changed frequently.

Hopefully, your situation is simple and the various alternatives discussed in this

chapter will be enough to enable the right choice. Some small business owners

will even be able to set up the business themselves. In many cases, however, it

will be necessary to discuss this with an attorney or accountant. For some small

businesses, the ability to minimize taxes will be paramount; for others, addi-

tional factors will be more important, such as limited liability.

More help and information on this subject is available at www.TheSmall

BusinessOwnersManual.com.

Entrepreneurs should revisit this decision every few years, and especially

after major events occur (departure of a partner, hiring extra employees), to

reassess whether the current form of ownership remains the best for your small

business.

Other Start-up Matters

Sales Tax Permit

In addition to other business start-up and registration activities, all small

businesses should check with their CPA or call a local sales and use tax office to

see if a seller’s permit is needed. More than one permit may be needed depend-

ing upon the products sold and the location of the business. With this permit,

your company is on the state’s radar screen and will be able to submit and pay

sales taxes. Otherwise, the business may not legally sell products.

See Chapter 7 for a complete discussion on sales and use taxes.

Employer Identification Number (EIN)

The EIN is a special number issued by the IRS upon the request of new small

businesses and is used in virtually all communications with the federal govern-

ment. A similar identification number is probably needed at the state level as

well. If the business form of ownership is a sole proprietorship, then an EIN is

not needed, because your Social Security number is used instead.

The easiest and fastest way to get an EIN is to call the IRS at 1-800-829-4933.

The number is issued immediately. Otherwise, fill out form SS-R (Application

for Employee Identification Number) at www.irs.gov. The IRS will send back

the EIN in about a month.

Every small business (except sole proprietorships) should get an EIN be-

cause it is needed to submit payroll tax returns and pay the associated taxes,

even if you are the only employee of your small business.

See Chapter 7 for more information on payroll taxes.