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Organizing Your Business Part III: Picking Your Business Structure Clicks-and-Bricks Used Bookstore Series by Jill Hendrix #101, 13 August 2007 Now that you've written your bookstore business plan, chosen your name, and assembled your power team, it's time to pick the legal structure of your business. Will you be a sole proprietorship, a partnership, a limited liability company (LLC), a corporation or an S corporation? Factors to consider when choosing your business structure include: number of owners, organizational costs, taxation, and liability. Choosing your business structure has tax and legal implications (which are subject to change), so consult your attorney and accountant before finalizing your decision. A sole proprietorship is a business structure that allows only a single owner. The business and the owner are legally considered the same entity, so unless your business name is exactly the same as your legal name, you will need to file a DBA (doing business as) registration with your state and/or county. When reporting yearly profit and loss from your business, you simply report it on Schedule C of your IRS Form 1040. Throughout the year you will estimate your tax liability and file a 1040-ES form with accompanying payment each quarter. The disadvantages of a sole proprietorship include the following: The sole proprietor is legally responsible for all debts against the business and his or her personal assets are at risk. Adding investors and/or creating employee stock option plans will likely require a change in business structure. The owner's medical insurance premiums are not directly tax deductible from business income (they can be deducted as an adjustment to income but do not reduce self-employment tax). The sole proprietor must pay tax on all profits, even those retained by the business to cover future expenses or expansion. If you are actively involved in running the business, you will owe self-employment tax to cover the Medicare and Social Security contribution that an employer would usually pay. A partnership is a business structure that requires two or more owners. Partnerships have the organizational cost of having a legal partnership agreement drawn up that governs how decisions will be made, disputes resolved, new partners admitted, existing partners bought out, etc. At tax time, the partnership will have to file a Form 1065: Partnership Return of Income and Schedule K-1 which shows each partner's share of the profit and losses. Each partner in turn will report his or her share of profits on Schedule E of his or her personal IRS Form 1040. Like sole proprietors, partners are each responsible for making a quarterly estimated tax payment. The partnership can usually raise additional financing by adding one or more partners. Disadvantages of a partnership include the following: Partners are liable for the actions of other partners and personal assets are at risk. Profits must be shared per the partnership agreement. Partnership disagreements may cause havoc with the business. The death or withdrawal of a partner may negatively affect the business. The partners must pay tax on all profits, even those retained by the business. Partners actively involved in running the business will owe self-employment tax to cover the Medicare and Social Security contribution that an employer would usually pay. The partner's medical insurance premiums are not directly tax deductible from business income (they can be deducted as an adjustment to income but do not reduce self-employment tax). A corporation is considered under law to be its own separate entity apart from that of its owners. It can be sued, taxed, and can enter into contractual agreements. The owners of a corporation are known as shareholders. The shareholders elect a board of directors to oversee the business. Shareholders typically have limited liability for the corporation's debts. Corporations can raise additional funds through the sale of stock; they can also deduct the full cost of benefits provided to officers and employees. If the business will be retaining profits from year to year, then the lower initial corporate tax rate may be beneficial. Shareholders who work for the corporation are paid salaries and have taxes withheld just like regular employees of any company; they are not subject to self-employment tax. Disadvantages of a corporation include the following: Corporations, which are chartered by the state in which they are headquartered, usually have the highest organizational costs of all the business structures. A corporation is the only business structure that must pay its own income taxes on profits. It files IRS Form 1120 and also must make estimated quarterly tax payments. Dividends paid to shareholders are not deductible from business income, thus taxes may have to be paid twice - once by the corporation and then again by the recipients. (Note: This is usually an issue only for larger corporations.) Officers of the corporation can be held personally liable for their actions. Corporations are monitored by federal, state, and sometimes local agencies and may have more paperwork and associated operational costs than other business structures. A Subchapter S corporation is the same as a corporation, except that it has met the appropriate IRS requirements that allow it to elect not to be taxed at the corporate level. Instead, all profits are deemed to have been distributed to the shareholders and must be reported on their personal income taxes (even if the profits are retained by the company and not actually distributed). Additionally, shareholders who work for the corporation must be paid "reasonable" wages (i.e., don't try to hide company profit by inflating your salary). In the past, the highest corporate tax rate was higher than the highest individual rate, so it made sense for highly profitable corporations to try to elect Subchapter S status. Today the situation is reversed, and thus new businesses are often electing to establish themselves as limited liability companies instead. A limited liability company (LLC) is designed to provide the limited liability features of a corporation and the flexibility of a partnership. Owners of the LLC are called members. LLCs, like corporations, are charted under state law. Many states now support the formation of single-member LLCs. Though not necessarily required, many LLCs will have the organizational cost of establishing a legal operating agreement outlining ownership interest, member responsibilities, etc., in addition to the cost of registering the LLC with the state. Without an operating agreement, the default laws in the state's statute will govern the LLC. For tax purposes, the profits of an LLC pass through to its members. In the case of a single-member LLC, profits are accounted for on Schedule C just as with a sole proprietorship. For multi-member LLCs, taxation is the same as that of a partnership. The disadvantages of an LLC are as follows: Forming an LLC is more complex than forming a partnership but less complex than forming and operating a corporation. The members must pay tax on all profits, even those retained by the business. Members actively involved in running the business will owe self-employment tax to cover the Medicare and Social Security contribution that an employer would usually pay. Members may become personally liable as a result of their own acts or conduct (but they may avoid liability for the acts of other members). Members' medical insurance premiums are not directly tax deductible from business income (they can be deducted as an adjustment to income but do not reduce self-employment tax). Although corporations and LLCs are touted as protecting their owner's personal assets, in practice this may not always be the case. As the owner of a new business, you may be asked to personally guarantee business credit card applications, lease agreements, etc. If this is the case, then you may find yourself forfeiting your legal liability in those instances. Also, in corporations and LLCs with fewer than 10 members the courts may "pierce the corporate veil" and hold shareholders responsible for corporate debts if the corporation has failed to observe required formalities (such as annual meetings), has intermingled personal and corporate assets, significantly undercapitalized the business, etc. If limited liability is an important reason you are choosing to organize as a corporation or LLC, make sure to get a list of guidelines from your attorney and accountant as to how to best maintain your corporate veil. Good luck weighing the pros and cons of the various business structures available. If you have any questions, please email me at fictionaddiction@juno.com or post your query to the BookThink Open Shop Bookstores Forum but keep in mind that I'm not a lawyer or an accountant, so please double-check all advice with the appropriate members of your power team. Stay tuned for the remaining parts of this article: Part IV - Registering Your Business Part V - Creating Your Business Logo Want to read more articles by BookThink's Contributing Editor Jill Hexdrix? Click here. Questions or comments? Contact the editor, Craig Stark editor@bookthink.com Copyright 2003-2011 by BookThink LLC