David W. T. Carroll, Esq.
Carroll, Ucker & Hemmer LLC
175 S. 3rd St., Suite 200
Columbus, Ohio 43215
fax: (614) 547-0354
Small business owners frequently ask whether they should incorporate. Actually, there are several possible business entities that could be formed. A corporation is only one of them. We discuss the choice of business entity below.
The answer to the question about whether a small business owner should form a business entity has two parts. One part has to do with limiting liability. The other part has to do with potential tax ramifications. A business entity such as a corporation or a limited liability company can potentially limit the small business owner’s liability to creditors. It will not limit the liability to any creditor if the business owner has personally signed a contract agreeing to be liable to the creditor. It will not limit anyone’s liability for torts personally committed by the small business owner or for certain statutory liabilities.
A liability-limiting business entity is always recommended when the small business owner (1) has employees; (2) is a group of professionals practicing a profession with one or more partners; or (3) is any business that enters into contracts in the normal course of business which could result in significant liability (which includes all contractors and subcontractors in construction).
The second category of reasons to incorporate relate to tax ramifications. With a corporation, medical insurance paid by the corporation are generally tax deductible. There are exceptions, you cannot offer low cost insurance to employees and high cost insurance to owners and expect to deduct the entire amount of the owner’s premium. The corporation may provide an opportunity to minimize Social Security taxes paid to owners. The precise tax ramifications change from time to time, so this decision must or should be made in consultation with a qualified tax advisor who knows the owner’s specific financial situation.
Each business entity except a sole proprietorship is legally a separate person. As a separate person, each business entity must have a separate bank account and must be treated as a separate entity. The entity will not succeed in limiting the owner's liability if the owner treats the corporation as merely an extension of the owner. That is, all the owner’s personal expenses must be paid from the owner’s personal account. Never pay personal expenses from the business entity’s bank account.
Each state establishes requirements for the various business entities which may include annual filings such as tax returns and other filings, annual financial statements, annual meetings of owners and so forth. The law of each state must be consulted to learn what those requirements are. Each of those requirements involves a cost, either owner time or employment of a professional to prepare the various documents. In Ohio and Arizona, where author practices, many of the annual requirements can be eliminated for small corporations. (See article on Close Corporations)
The two most common business entities formed today are corporations and limited liability companies. In a corporation, the owners own shares of stock and are called shareholders or stockholders. The shareholders elect a board of directors to manage the corporation. The board of directors appoints officers, such as president, secretary and treasurer to perform specific duties. The board of directors retains authority over the action of the officers.
The corporation is a separate legal person and a separate entity for tax purposes. Income is taxed to the corporation where it is earned. If the income is paid to the shareholders in a form of dividends (rather than salaries or bonuses), the income would be taxed again on the shareholder’s return. This is known as a “C corporation.”
If the shareholders file a form with the Internal Revenue Service called an election to be taxed as a small business corporation (“S corporation”), the corporation is taxed similarly to but not exactly like a partnership. Income to the corporation will not be taxed on the corporation’s return. Instead, the corporation files an information return. All corporate income is taxed on the shareholder’s returns. Just as profits are taxed on the shareholder’s returns, losses are deducted from the shareholder’s returns. This gets complicated. Not all losses will flow through to the shareholders. Passive losses like depreciation will not flow through to the shareholder’s returns. For the details of any specific situation, you should consult your accountant.
In contrast to a corporation, a limited liability company is organized like a partnership but has the limited liability aspects of a corporation. The governing document of a limited liability company is called an operating agreement. The operating agreement establishes the management structure, which is infinitely flexible. Like a corporation, a limited liability company could have owners, called members, electing a board of managers (like directors), who appoint officers. However, that is unnecessary. Management may be structured in any form that makes sense to the members. Like a partnership, rights to income can be allocated in different proportions than the ownership interest.
A general partnership does not have any limited liability protection. However, in Ohio and Arizona, there are two types of partnerships that can be formed that do have limited liability characteristics, called limited partnerships and limited liability partnerships. These types of partnerships are used only in rare specialized situations.
However, general partnerships are important because they can be formed without any formality and sometimes are formed by accident. A joint venture is a short term form of a general partnership. In a partnership, the partnership is a separate entity. However, the partners have unlimited liability for the debts of the partnership, including debts resulting from torts committed by another partner. For tax purposes, a partnership must file an informational return, but all income and losses flow through to the partners individual tax returns as income tax returns.
In general, when planning an new business, the preferred entities are corporations and limited liability companies. The precise choice of entity is generally tax-driven and the decision should be made in consultation with one's accountant.
The information on this web site is for general reference only. To apply the information to an individual situation, you must consult a qualified professional. Unless you contract for specific services from us, there is no attorney-client relationship established.
Ucker & Hemmer LLC