You’ve been thinking for some time about starting your own business and you have now finally decided to do so. NOW WHAT?
You asked about operating as a sole proprietorship, a corporation or a limited liability company (LLC). Specifically, you wanted to know what is necessary to begin operating in any of these forms. You were also concerned about liability exposure and wanted information about the tax implications.
To operate as a corporation or LLC, you must form the entity by filing the necessary documents with the Texas Secretary of State. You will also need to obtain an employer’s identification number from the IRS. If you had previously operated the business, it may be necessary to sign documents transferring business assets to the corporation or LLC. If you have any business loans, it will be important to make sure that the transfers do not trigger due on sale clauses in your loan documents.
To operate as a sole proprietor, you will need to file documents in the county in which you will operate your business to advise the public of the name under which you are conducting business. This is frequently referred to as a dba. Assuming you are using a name other than your personal name, you will also need to obtain an employer’s identification number from the IRS.
You then asked about exposure to liability. Operating as a sole proprietor provides no protection from liability. By forming a corporation or LLC, you will be protected from liabilities as long as you observe the necessary formalities.
Due to the lack of liability protection, you decide that you are not interested in operating as a sole proprietor and begin inquiring about the tax implications of forming a corporation or LLC.
You have heard about subchapter C corporations and subchapter S corporations, but do not understand the difference.
There is no difference between a subchapter C corporation and a subchapter S corporation under state law. It is strictly a matter of treatment under the federal income tax laws.
A subchapter C corporation is subject to double taxation. The corporation is taxed on its own income, and if it pays a dividend, the shareholders of the C corporation will be taxed on any dividends received. You have heard that this double taxation may be avoided by paying yourself a salary (or some other form of payments deductible by corporation). This is generally true, provided that the amount of the payments to you are not unreasonably high.
This sounds quite complicated to you so you ask about the taxation of S corporations. An S corporation files a corporate tax return, but generally does not pay any tax on its income. Instead, the income and losses flow through to the shareholders who report such income and losses (subject to certain limitations) on their personal returns. Upon subsequent payment of dividends, there is generally no additional tax. You have heard that this can be used to avoid employment taxes. This is generally true, provided that the salary paid to you is not unreasonably low. You find this difficult to understand because this rule is the opposite of the rule for C corporations.
You were not aware of the various restrictions that apply to S corporations. For example, S corporations can have only one class of stock, cannot have more than 100 shareholders, and (with certain limited exceptions) can only have individuals as shareholders. To become an S corporation, the corporation must file Form 2553 with the IRS, and all shareholders of the corporation must sign Form 2553, thereby agreeing to the S election.
You then asked about the taxation of LLC’s. A LLC is treated as a partnership for federal income tax purposes as long as it has two or more members. However, as in your case, if the LLC has only member, it will be treated as a sole proprietorship for federal income tax purposes. In other words, it would be treated as if the entity did not exist for federal income tax purposes and you would report the income (and loss) on a Schedule C on your personal income tax return. This treatment for federal income tax purposes is the same as if you were operating as a sole proprietor. I remind you that, even though the single member LLC and a sole proprietor, are treated the same for income tax purposes, the two are not the same. The single member LLC provides liability protection, but the sole proprietorship does not. Furthermore, the LLC, unlike the sole proprietorship, will be treated as a separate entity for federal employment tax purposes and Texas franchise tax purposes. You find it difficult to understand how the LLC can be treated as existing as a separate entity for one purpose and as not existing for another purpose.
Due to these inconsistencies in the treatment of single member LLC’s, you once again ask if the result would be different if the LLC had more than one member. Whenever a LLC has more than one member, it is treated as a partnership for federal income tax purposes. The partnership files its own return, and its income and losses flow through to the partners who report such income (and losses subject to certain limitations) on their personal income tax returns.
It had always been your understanding that all partnerships were audited at the partnership level and that the results of any audit flowed through to the partners. However, you heard recently that new legislation had been enacted by Congress providing that the partnership itself, rather than the partners, could be held liable for any underpayment in any underpayment in tax from prior years. What you heard is correct. Beginning January 1, 2018, unless the partnership is able to elect out of the provisions, the partnership, rather than the partners, will be liable for any underpayment of tax. For further information, see the blog on the Partnership Audit Rules Effective 1/1/18.
Lastly, you asked whether it is necessary for the entity to maintain its own bank account. To preserve limited liability, all formalities must be observed. This includes maintaining a separate bank account for the entity, signing documents as a representative of the entity, having regular meetings and having special meetings to authorize extraordinary transactions.