What's your type—of business entity? - Tax Implications

California CPA, Sept, 2003 by Ernest F. Howard

Along with employment tax and fringe benefit considerations, choosing the right type of business entity is a critical consideration when starting a business. In fact, choosing the right type of entity is similar to building a home. You want to accommodate current needs, but you must keep an eye on the future. The right business entity should protect you personal assets against legal liability, but provide the flexibility to grow as your business grows.

Each type of entity--whether it's a sole proprietorship, partnership, corporation or limited liability company--carries its own legal and tax significance, the pros and cons of which must be carefully examined from the outset.

SOLE PROPRIETORSHIP

If you're an individual who'd like to go into business, setting up a sole proprietorship is probably the easiest choice. Just open a bank account in your business name and file a fictitious name statement, also called a DBA (doing business as), with your local newspaper.

Remember, opening a business bank account is important, as the segregation of assets and transactions certainly looks better to the IRS. From a tax standpoint, the nice thing about a sole proprietorship is that it only requires a Schedule C in your tax return. It's an easy process.

A sole proprietorship also is the way to go if you're a consultant for a large company and you never deal with the end user. Here, the company bears the brunt of liability, not you.

But the issue of liability complicates the relative ease of setting up a sole proprietorship. The first issue guiding your choice of entity is almost always the legal one: Do your personal assets need protection from legal liability?

Let's say you hire a bookkeeper or an independent contractor, who, from a legal standpoint, could arguably be an employee. And let's say that person is out doing your bidding and is involved in some type of car accident. In the end, if that business/employee relationship can be identified, you could have a huge liability on your hands.

There are all sorts of other liability concerns, such as environmental, slip-and-fall, sexual harassment and wrongful discharge that could leave your personal assets vulnerable.

Given that, the next question becomes: If there is a potential liability, is it easily insurable? If not, would a corporate entity give any added protection? If you could be easily covered with insurance, just having a special entity for that purpose isn't necessarily the way to go.

GENERAL PARTNERSHIP

If you have a couple of people who'd like to go into business, a general partnership is the path of least resistance. In essence, there are no legal filings. Just obtain an employer identification number from the IRS, file a DBA and open a partnership bank account.

But before launching that business, consult with an attorney and assemble a competent partnership agreement.

Unless the agreement says otherwise, all partners have equal rights in managing the partnership--and any partner can bind the entity, with every partner liable for the result. But partnerships are flexible entities and a variety of management structures and controls are available.

In a partnership, there's joint and several liability. This means you are all individually and collectively responsible--100 percent--for any liabilities, including wrongful acts or omissions of any partner.

An insurance agent familiar with your business can identify possible liability sources, and if the liabilities aren't significant, a sole proprietorship or general partnership would be ideal. Again, if insurance can be obtained at a reasonable rate, no change in entity is required.

Also be aware that licensed professionals generally may not be able to form partnerships with nonlicensed professionals.

The tax implications of partnerships include pass-through tax treatment, which avoids the dreaded "double taxation" that befalls certain types of corporations. Double taxation refers to the fact that a corporation pays federal and California income taxes on its earnings and then when it distributes a dividend or liquidates, the shareholders are taxed on the assets distributed to them.

"Pass-through" basically means that income passes through to the shareholder, partner, member or beneficiary and is taxed at the personal level for a general partnership. There is no minimum tax imposed by the Franchise Tax Board as there is for a limited partnership or limited liability company.

A general partnership can use a cash method of accounting, unless it has a C corp as a partner, has gross receipts of more than $5 million or is a tax shelter.

The taxable year of a partnership should correspond to the taxable year of its majority or principal partners. If the majority or principal partners don't have the same taxable year, the partnership must use the calendar year.

In addition, there is no double tax on liquidation, and the entity may make special allocations and pass-through tax losses.

LPs AND LLPs

Once the darling of the real estate arena, limited partnerships are used less and less now since the LLC has come to California.