Benefits Of Starting Up Your Own Business

Of all the choices you make when starting a business, one of the most important is the type of legal structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, it will affect the amount of paperwork your business is required to do, the personal liability you face and your ability to raise money.

Starting up a business It's not a decision to be entered into lightly, either, or one that should be made without sound counsel from business experts. it's important for business owners to seek expert advice from business professionals when considering the pros and cons of various business entities.

Types of Business Entities

The type of business entity you choose will depend on three primary factors: liability, taxation and record-keeping. Here's a quick look at the differences between the most common forms of business entities:

Sole Proprietorship: Is the most common form of business organization. It's easy to form and offers complete managerial control to the owner. However, the owner is also personally liable for all financial obligations of the business.

Partnership: Involves two or more people who agree to share in the profits or losses of a business. A primary advantage is that the partnership does not bear the tax burden of profits or the benefit of losses-profits or losses are "passed through" to partners to report on their individual income tax returns. A primary disadvantage is liability-each partner is personally liable for the financial obligations of the business.

Corporation: Is a legal entity that is created to conduct business. The corporation becomes an entity-separate from those who founded it-that handles the responsibilities of the organization. Like a person, the corporation can be taxed and can be held legally liable for its actions. The corporation can also make a profit. The key benefit of corporate status is the avoidance of personal liability. The primary disadvantage is the cost to form a corporation and the extensive record-keeping that's required. While double taxation is sometimes mentioned as a drawback to incorporation, the S corporation (or Subchapter corporation, a popular variation of the regular C corporation) avoids this situation by allowing income or losses to be passed through on individual tax returns, similar to a partnership.

Limited Liability Company: A hybrid form of partnership, the limited liability company (LLC) , is gaining in popularity because it allows owners to take advantage of the benefits of both the corporation and partnership forms of business. The advantages of this

business format are that profits and losses can be passed through to owners without taxation of the business itself while owners are shielded from personal liability.

Selecting a Business Entity

When making a decision about the type of business to form, there are several criteria you need to evaluate. You have to focus on the following areas when you chose the business format for your company:

Legal Liability: To what extent does the owner need to be insulated from legal liability? You need to consider whether your business lends itself to potential liability and, if so, if you can personally afford the risk of that liability. If you can't, a sole proprietorship or partnership may not be the best way to go.

Tax Implications: Based on the individual situation and goals of the business owner, what are the opportunities to minimize taxation?

There are many more tax options available to corporations than to proprietorships or partnerships. A common disadvantage often associated with incorporation, can be avoided with S corporation status. An S corporation, is available to companies with less than 70 shareholder returns; business losses can help reduce personal tax liability, particularly in the early years of a company's existence.

Flexibility: Your goal is to maximize the flexibility of the ownership structure by considering the unique needs of the business as well as the personal needs of the owner or owners. Individual needs are a critical consideration. No two business situations will be the same, particularly when multiple owners are involved. No two people will have the same goals, concerns or personal financial situations.

Future Needs: When you're first starting out in business, it's not uncommon to be "caught up in the moment." You're consumed with getting the business off the ground and usually aren't thinking of what the business might look like five or ten-let alone three-years down the road. What will happen to the business after you die? What if, after a few years, you decide to sell your part of a business partnership?

Another important question to ask yourself is, "What do I want to happen to the business when I'm no longer around to run it?"

While a sole proprietorship or partnership may dissolve upon the death of its owner or owners, a corporation can be readily distributed to family members.

Keep in mind that the business structure you start out with may not meet your needs in years to come. Many sole proprietorships evolve into some other form of business-like a partnership or corporation-as the company grows and the needs of the owners change.

Don't take this very important decision lightly, and don't make a choice based on what somebody else has done. Carefully consider the unique needs of your business and its owners, and seek expert advice, before settling on a particular business format

Sole Proprietorship

The simplest structure is the sole proprietorship, which usually involves just one individual who owns and operates the enterprise. If you intend to work alone, this may be the way to go.

The tax aspects of a sole proprietorship are especially appealing because income and expenses from the business are included on your personal

income tax return (Form 1040). Your profits and losses are first recorded on a tax form called Schedule C, which is filed along with your 1040. Then the "bottom-line amount" from Schedule C is transferred to your personal tax return. This aspect is especially attractive because business losses you suffer may offset income earned from other sources. As a sole proprietor, you must also file a Schedule SE with Form 1040. You use Schedule SE to calculate how much self-employment tax you owe.

In addition to paying annual self-employment taxes, you must also make quarterly estimated tax payments on your income. Currently, self-employed individuals with net earnings of $400 or more must make estimated tax payments to cover their tax liability. If your prior year's adjusted gross income is less than $150,000, your estimated tax payments must be at least 90 percent of your current year's tax liability or 100 percent of the prior year's liability, whichever is less. The federal government permits you to pay estimated taxes in four equal amounts throughout the year on the 15th of April, June, September and January. With a sole proprietorship, your business earnings are taxed only once, unlike other business structures. Another big plus is that you have complete control of your business-you make all the decisions.

There are a few disadvantages to consider, however. Selecting the sole proprietorship business structure means you're personally liable for your company's liabilities. As a result, you're placing your own assets at risk, and they could be seized to satisfy a business debt or legal claim filed against you.

Raising money for a sole proprietorship can also be difficult. Banks and other financing sources are reluctant to make business loans to sole proprietorships. In most cases, you'll have to depend on your own financing sources, such as savings, home equity or family loans.

Partnership

If your business will be owned and operated by several individuals, you'll want to take a look at structuring your business as a partnership. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership's debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners.

Unless you expect to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form.

One of the major advantages of a partnership is the tax treatment it enjoys. A partnership doesn't pay tax on its income but "passes through" any profits or losses to the individual partners. At tax time, each partner files a Schedule K-1 form, which indicates his or her share of partnership income, deductions and tax credits. In addition, each partner is required to report profits from the partnership on his or her individual tax return. Even though the partnership pays no income tax, it must compute its income and report it on a separate informational return, Form 1065. Personal liability is a major concern if you use a general partnership to structure your business. Similar to a sole proprietorship, general partners are personally liable for the partnership's obligations and debt.

Corporation

Using the corporate structure is more complex and expensive than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires complying with more regulations and tax requirements.

The biggest benefit for a small-business owner who decides to incorporate is the liability protection he or she receives. A corporation's debt is not considered that of its owners, so if you organize your business as a corporation, you're not putting your personal assets at risk. A corporation also can retain some of its profits, without the owner paying tax on them. Another plus is the ability of a corporation to raise money. A corporation can sell stock, either common or preferred, to raise funds. Corporations also continue indefinitely, even if one of the shareholders dies, sells the shares or becomes disabled.

The corporate structure, however, comes with a number of downsides. A major one is higher costs. Corporations are formed under the laws of each state with their own set of regulations. You'll probably need the assistance of an attorney to guide you through the maze. In addition, because a corporation must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax preparation services.

Another drawback: Owners of the corporation pay a double tax on the business's earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.

To avoid double taxation, you could pay the money out as salaries to you and any other corporate shareholders. A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. Keep in mind, however, that the IRS has limits on what it believes to be reasonable compensation.

How To Incorporate

To start the process of incorporating, contact the secretary of state or the state office that is responsible for registering corporations in your state. Ask for instructions, forms and fee schedules on business incorporation.

It's possible to file for incorporation without the help of an attorney by using books and software to guide you along. Your expense will be the cost of these resources, the filing fees, and any other costs associated with incorporating in your state.

If you do file for incorporation yourself, you'll save the expense of using a lawyer, which can cost from $500 to $1,000. The disadvantage of going this route is that the process may take you some time to accomplish. There's also a chance you could miss some small but important detail in your state's law.

One of the first steps you must take in the incorporation process is to prepare a certificate or articles of incorporation. Some states will provide you with a printed form for this, which either you or your attorney can complete. The information requested includes the proposed name of the corporation, the purpose of the corporation, the names and addresses of the parties incorporating, and the location of the principal office of the corporation.

The corporation will also need a set of bylaws that describe in greater detail than the articles how the corporation will run, including the responsibilities of the shareholders, directors and officers; when stockholder meetings will be held; and other details important to running the company. Once your articles of incorporation are accepted, the secretary of state's office will send you a certificate of incorporation.

Once you're incorporated, be sure to follow the rules of incorporation. If you don't, a court can pierce the corporate veil and hold you and the other owners personally liable for the business's debts.

It's important to follow all the corporation rules required by state law. You should keep accurate financial records for the corporation, showing a separation between the corporation's income and expenses and that of the owners'.

The corporation should also issue stock, file annual reports and hold yearly meetings to elect officers and directors, even if they're the same people as the shareholders. Be sure to keep minutes of these meetings. On all references to your business, make certain to identify it as a corporation, using Inc. or Corp., whichever your state requires. You also want to make sure that whomever you deal with, such as your banker or clients, knows that you're an officer of a corporation.

The S Corporation

The S corporation is more attractive to small-business owners than a standard (or C) corporation. That's because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there's just one level of federal tax to pay.

In addition, owners of S corporations who don't have inventory can use the cash method of accounting, which is simpler than the accrual method. Under this method, income is taxable when received and expenses are deductible when paid. Some relatively recent tax law changes brought about by the Small Business Job Protection Act of 1996 have made S corporations even more attractive for small-business owners. In the past, S corporations were limited to 35 shareholders. The 1996 law increased the number of shareholders to 75. Expanding the shareholder number makes it possible to have more investors and thus attract more capital, tax experts maintain.

S corporations do come with some downsides. For example, they're subject to many of the same requirements corporations must follow, and that means higher legal and tax service costs. They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. The legal and accounting costs of setting up an S corporation are similar to those of a standard corporation.

Another major difference between a standard corporation and an S corporation is that S corporations can only issue common stock. Experts say this can hamper the company's ability to raise capital. In addition, unlike a standard corporation, S corporation stock can only be owned by individuals, estates and certain types of trusts

Limited Liability Companies

Limited liability companies, often referred to as "LLCs," have been around since 1977, but their popularity among small-business owners is a relatively recent phenomenon.

An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations. "An LLC is a much better entity for tax purposes than any other entity," says Ralph Anderson, a CPA and small-business tax specialist with accounting firm M. R. Weiser. LLCs were created to provide business owners with the liability protection that croporations enjoy without the double taxation. Earnings and losses pass through to the owners and are included on their personal tax returns.

Sound similar to an S corporation? It is, except an LLC offers small-business owners even more attractions than an S corporation. For example, there's no limitation on the number of shareholders an LLC can have, unlike an S corporation, which has a limit of 75. In addition, any member or owner of the LLC is allowed a full participatory role in the business's operation; in a limited partnership, on the other hand, limited partners aren't permitted any say in the operation. To set up an LLC, you must file articles of organization with the secretary of state in the state where you intend to do business. Some states also require you to file an operating agreement, which is similar to a partnership agreement.

Like partnerships, LLCs do not have perpetual life. Some state statutes stipulate that the company must dissolve after 30 or 40 years. Technically, the company dissolves when a member dies, quits or retires.

Despite the attractions, LLCs also have their disadvantages. Since an LLC is relatively new, its tax treatment varies by state. If you plan to operate in several states, you must determine how a state will treat an LLC formed in another state. If you decide on an LLC structure, be sure to use the services of an experienced accountant who is familiar with the various rules and regulations of LLCs.

Even after you settle on a business structure, remember that the circumstances that make one type of business organization favorable are always subject to changes in the laws. It makes sense to reassess your form of business from time to time to make sure you're using the one that provides the most benefits.

Why LLC?

• Limited liability. Your only risk is capital paid into the business. Business debts and other liabilities can't be squeezed out of your personal assets. Caution: If you personally guarantee a debt, you've forfeited your "limited liability."

• Tax simplicity. Profits and losses are reported and taxed on owners' individual returns. There's no separate business tax return, unless you have more than one member and choose to be taxed as a partnership, in which case you file Form 1065. And there's no corporate "double taxation," in which both the business and the shareholders are taxed.

• Flexible management. A "member" (shareholder equivalent) can be a person, partnership or corporation. Members get a percentage of ownership. If your idea people can't manage their way out of a paper bag, you can hire management help. Smaller LLCs are usually member-managed, but not always.

• Flexible distribution. Profits and losses don't have to be distributed in proportion to the money each person puts in. A regular C corporation can't allocate profits and losses. And in a subchapter S corporation (taxed as a partnership), profits and losses are in proportion to shares held.

Why Not?

• No stock. LLCs are tough if you have several investors or raise public money, since you don't have shares or stock certificates to offer. If you give a percentage of ownership to o

utside investors, you must decide whether they'll be managing members. Seidel cautions entrepreneurs: "Ask yourself if you need more flexibility in terms of corporate stock ownership, financing options, etc. If so, the LLC is probably not a good idea-try a C corporation."

• Two's a crowd. LLCs in most states require only one member: you. But if you live in Massachusetts or the District of Columbia, you must have two members, and that could be a deal-buster.

• Fewer incentives. LLCs aren't ideal if you want to give fringe benefits to yourself or employees. Unlike with a C corporation, you can't deduct the cost of benefits with an LLC. And since there's no stock, you can't use stock options as incentives for your employees.

• Paperwork. LLCs file articles of organization with the State Corporation Commission or Secretary of State and must draft an operating agreement listing members' rights and responsibilities. Some paperwork that must be filed, like an application for employer ID number (IRS Form SS-4) and choice of tax status (IRS Form 8832), are one-shot; others (annual report, quarterly withholding and tax deposit coupons, and business bank account) are ongoing. While it's not an impossible burden, there's more paperwork than if you're a sole proprietor.

• Taxes. LLC members pay self-employment taxes, the Medicare/Social Security tax paid by entrepreneurs; it's calculated on 15.3 percent of profits. Contrast this with an S corporation: Self-employment tax is due on salary only, not your entire profits. You're caught in the self-employment tax net if: 1) you participate in the business for more than 500 hours during the LLC tax year; 2) you work in a professional services LLC (health, law, engineering); or 3) you can sign contracts on behalf of the LLC.

Ultimately, the LLC decision is one you won't want to make alone. "Get advice from a specialist about the ideal corporate form to take," advises Seidel. "It can make a huge difference later on." In business, as in life, one size rarely fits all.