Types of Businesses Entities

(First published in the CAD++ Newsletter in early 1996)

Last month I went over some of the safer ways to start a business, either by moonlighting or contracting or both. However, unless you’re doing your own very private thing and don’t want to communicate with the outside world, you’ll need to establish a valid, legal business presence.

This presence is necessary for two reasons. The first is that you want to establish an identity and image for your new business so that your potential clients have something they can get comfortable with. Image and identity are vital for building a business, but I won’t really cover that in this column, since I wrote a multi-part column on the same topic last year. You can find the column in CAD++ (contact XYZ Publishing for details on obtaining back issues).

The second reason is a combination of legal and accounting issues – both of these are unfortunately intertwined. In any event, they form the basis for this month’s column.

The Business Structure
There are a number of different business entities (each with its own structure) you could establish: a sole proprietorship, a DBA, a subchapter S corporation, a subchapter CĀ  corporation, an LLC, a partnership, etc. Note that the distinctions made here apply primarily to U.S. business entities, and entities in other countries may vary.

Sole Proprietorship
A sole proprietorship is a business that you own and run, and frequently it shares your name, i.e. John Smith Consulting. It has very little legal structure, and also don’t have very much liability protection. The business’s income/loss is applied via your personal 1040 Schedule C, meaning profits are taxed at your normal tax rate. As a sole proprietor, you may employ others, as well as yourself, or you could pay yourself via a “draw” – giving yourself whatever funds you need and the business can spare whenever convenient for both. Note that all profit for a sole proprietorship is potentially subject to FICA tax (also known as social security or self-employment tax), which amounts to just over 15%. This frequently comes as a shock to people, but is something every employee and employer have been paying all along – the amount is split between the two, each paying half, up to a certain amount per year. If you run your own business, you’re responsible for both halves. Another issue with a sole proprietorship is that you can’t have multiple owners. If that’s a need, you need to look at partnerships or corporations.

A DBA, which stands for Doing Business As, is just another form of a sole proprietorship, wherein you legally register a legal business name for your venture. The governmental body you need to register the name with (and this may be necessary even for sole proprietorships that use the owner’s name) varies from state to state. In New York State, for example, you register with the town or city you’re in. In Massachusetts and New Hampshire, you register with the respective Secretary of State. Check with your town or city clerk for details.

A corporation is a much more formal and complex business structure, but also has a number of benefits. While a sole proprietorship and DBA are just facets of you as an individualĀ  (from a legal sense), corporations are legal entities in their own right. This separate identity can help insulate your personal assets from legal action in the event a product or service your corporation provided is found to be the basis for such action. A corporation may also have stockholders, which means ownership by multiple parties. Finally, corporations have certain tax advantages and disadvantages over sole proprietorships. One of the advantages is to not have to pay FICA on all profits – only on those amounts paid out as salaries. There are several types of corporations, including Subchapter S, Subchapter C, and Limited Liability.

An “S” corporation is designed for the small proprietor who wants incorporation for the sake of increased liability protection, and the option to have multiple owners. For taxation, all profit is split on a prorated basis among all shareholders based on their percentage of ownership. There is a limit on the number of shareholders in “S” corporations, and certain expenses that “C” corporations are entitled to are not available to “S” corporations.

A “C” corporation is the true standalone entity, and all publicly traded companies are “C” corporations. There can be an unlimited number of shareholders, and there is greater leeway in terms of deductible expenses, including R&D credits. R&D credits allow you to deduct some percentage of your product development expenses from your tax bill, and while they have expired, Congress is in the process of reinstating them for use in the 1995 tax year. Also, certain insurance and child care expenses for corporate employees are deductible. A “C” corporation also has its own tax rate, which is lower than an individual’s tax rate for low profits, but higher past a certain threshold. Note that if your company can be classified as a professional services corporation (such as a legal firm, accountant, etc.) which solely provides services and does not create things (products, marketing materials, etc.), you do not have the benefit of the lower 15% tax rate on the initial part of your profit.

Limited liability corporations (LLCs) are something of a new concept, combining, as I understand it, the best aspects of an “S” corporation with a sole proprietorship. However, not all states have LLCs, and therefore some of these states do not honor the liability that LLCs can afford you, so it’s only a recommended path to take if you will be doing business in states that honor LLCs. For the record, Massachusetts does not have LLCs.

A couple of financial drawbacks of corporations are annual minimum fees payable to your state government (for Massachusetts and New Hampshire, they run around $500), as well as potentially higher corporate state tax rates (compared to personal state tax). One thing that was recently pointed out to me by the IRS is that officers of a company cannot be consultants – they must be employees, which may nix the idea of doing a draw instead of a salary. You also have to register a corporation, which can cost as much as $1500, depending on what route you take. If you’re planning on moving to another state, you may also be better off creating a Delaware corporation, and then registering to do business in your state as a “foreign corporation”. The paperwork a corporation has to file in terms of taxes, employment taxes, etc., can be onerous.

One tip if you want to create a corporation though, is to pick up a couple copies of the Wall Street Journal and look through the ads for companies which provide incorporation services. These companies can incorporate a Delaware corporation for as little as $99 – Delaware corporations have certain annual fee and liability benefits. By the way, some of these incorporation companies also have Web sites. I’ll be going this route in the next few weeks for my company, and will provide some insight on some of the problems and challenges faced in deciding which company to use, and how much to pay.

Partnerships are not really an area I’m altogether familiar with, but basically they provide a means to run a small business with multiple owners, with all sharing potential liabilities.

IRS Section 1706
In the event you’re planning on being a consultant or independent contractor, and starting your business based on this, I want to make sure that you’re aware that the IRS has guidelines on determining whether an individual is really a contractor or just an employee in disguise – they don’t want to miss out on various payroll taxes. One way that helps insulate you from this is to incorporate, and have your corporation provide the services, but then you risk having the corporation being labelled a professional services corporation. If you are consulting, or planning to do so, check out the famous “20 Questions” the IRS uses to determine if a contractor is really an employee. I’ve posted the list on my Web site.

Several of the basic questions you need to ask yourself in order to determine what type of business entity you want to create are:

  • Will you pay yourself on a regular basis, or on a draw (i.e. as you need it, and as the business has money to pay you)? In other words, will you become a regular employee of the business?
  • Will you have other employees?
  • Do you currently have health insurance through your normal employer, or a spouse?
  • Do you plan on having other people own stock in your venture?
  • What tax bracket are you in personally?
  • Does the state you reside in not have a personal income tax?
  • Are you planning on being a consultant or contractor?
  • Will you have just one client or many?
  • Do you plan on moving to a different state any time soon?
  • Will you be spending significant resources developing products?

Once you’ve answered these questions, consult experts – in particular a lawyer specializing in setting up companies, and your accountant. My descriptions above are meant to make you aware of some of your options, but professionals are the only ones that can help you make the right decisions in how and what type of business entity to establish for your venture.

In case anyone’s interested, my company (actually, my wife’s), Stroke of Color, was registered as a DBA last year. Due to tax reasons, and some other things we’re planning, including joint ownership, we’ll be incorporating as a Delaware corporation shortly.