consultant
Does Your Company’s Organizational Structure Provide You With The Best Liability Protection and Tax Benefits?  

When starting a new business, every entrepreneur faces an important decision regarding which of the various organizational structures they should choose for their company.  Generally organizational structures are broken into the following categories:

A)   Sole Proprietorship B)    Partnership C)   Corporation (C Corp and S Corp) D)   Limited Liability Company (LLC)

Below are some general insights regarding the advantages and disadvantages of both, the applicable tax form, along with how to establish each organizational structure:

Sole Proprietorship - A sole proprietorship is an organizational structure by which the sole owner and the business are treated as one.  To establish this organizational structure, the business owner will simply register an Assumed Name at the county clerk’s office (Approx. $20), and use their Social Security Number in lieu of a Tax ID #.  For income taxes, the sole owner will simply add a Schedule C to their form 1040 to reflect their gross revenue, business expenses, and net income.  The company’s net income will be subject to the Self Employment Tax Rate.

The advantage of this organizational structure is that it can be easily established at a minimal cost.  The disadvantage of this organizational structure is that the owner will have unlimited liability, meaning that in the event of a lawsuit, the plaintiff can go after both your business assets, and your personal assets as well (residence, vehicles, etc.)

Partnership - A partnership is very similar to a sole proprietorship except instead of having one owner, the company will have two or more owners.  To establish this organizational structure, the business owner will simply register an Assumed Name at the county clerk’s office (Approx. $20), and obtain a Tax ID # from the IRS. The partners who own the company should create a partnership agreement stating the ownership percentage of all partners, who will perform which specific business functions, etc.

For income taxes, the company will file taxes on a form 1065, and each individual owner will be given a K-1 showing the distribution they received from the company’s profit.  The advantage of this organizational structure is that it can be easily established at a minimal cost.  The disadvantage of this organizational structure is that all owners will have unlimited liability, meaning that in the event of a lawsuit, the plaintiff can go after both their business assets, and your personal assets as well (residence, vehicles, etc.)

Corporation –  The advantage of establishing a Corporation over a sole proprietor or partnership is that it affords the business owner(s) limited liability protection, meaning that in the event of a lawsuit, the plaintiff can go after the business assets, but the personal assets of the business owner(s) are protected.  To establish this organizational structure, the business owner(s) must complete a form 201 to send to the Secretary of State (cost of $300), and obtain a Tax ID # from the IRS. The shareholders who own the company will create company by-laws authorizing a board of directors, stating the ownership percentage of all shareholders/partners, listing who will perform which specific business functions, etc.

As a Corporation, there are specific administrative requirements that must be maintained.  The owners/shareholders must have annual/bi-annual/or quarterly meetings, which are documented in the company’s minutes.  The Corporation must issue and cancel (as applicable) company stock certificates, which are recorded in the company’s stock ledger.

The default taxation classification is to be taxed as a Chapter “C” Corporation, through which the IRS taxes the profit of the company on the form 1120, and also tax the distribution of profit/gains to each shareholder.  This is process is called “double taxation” (not recommended).  A corporation can file a form 2553 with the form to be taxed as a Sub Chapter S small business corporation, which helps you avoid double taxation by allowing pass through taxation on the corporation’s profit/gains.

Limited Liability Company – The advantage of establishing an LLC over a sole proprietor or partnership is that it affords the business owner(s) limited liability protection, meaning that in the event of a lawsuit, the plaintiff can go after the business assets, but the personal assets of the business owner(s) are protected.  The advantage of establishing an LLC over a Corporation is that you get the same liability protection without the administrative burden of maintaining a corporate minute book containing meeting minutes, issuing/maintaining stock certificates, etc.

To establish this organizational structure, the business owner(s) must complete a form 205 to send to the Secretary of State (cost of $300), and obtain a Tax ID # from the IRS. The member(s) who own the company will create an operating agreement stating the ownership percentage of all partners, who will perform which specific business functions, etc.  How income taxes are filed for an LLC will vary:

-The default taxation classification of an LLC that is owned by either one member, or a husband and wife is to be taxed as a sole proprietor by simply adding a Schedule C to the form 1040 listing the company’s revenue, expenses, and net income.

-The default taxation classification of an LLC that is owned by two or more members (non-husband and wife) is to be taxed as a partnership by using a form 1065, and including a K-1 to show the distribution of profits to each member.

-The LLC’s Members (owners) have the option to fill out the form 8832 (to be taxed as a corporation), and a form 2553 (to be taxed as a Subchapter S small business corporation).  Once you complete these two forms and submit them to the IRS, your company will complete a form 1120S at the end of the year which will be strictly for your company’s revenue, expenses, and income.

I would personally recommend this tax classification as it allows for passed through taxation on your company’s net income. As small business pursuing contracts with local, state and federal agencies, my recommended organizational structure is to establish your company as an LLC electing to be taxed as a Subchapter S Corporation.  The risk of liability is ever present when performing on contracts and as such, the limited liability protection is essential to protect your assets.

An LLC affords you the same liability protection as that of a corporation without the additional administrative burden (documenting meetings, maintain stock certificates, etc.)  Lastly as an LLC electing to be taxed as a Subchapter S Corporation, it allows you to avoid double taxation while separating your business from your personal taxes.

If needed, Sams Contracting Consulting and Training can assist with establishing or converting your company’s organizational structure, obtaining EINs/Tax ID #s, creating/amending by-laws and operating agreements, etc.

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