Where Do You Go When You Have
Outgrown the Sole Proprietorship?
© by Fred W. Daily
Last year Martina started Spice World, a sole proprietorship
gourmet shop. Well, Martina has been overwhelmed by its success and is also exhausted from
seven-day work weeks. Dexter, a former co-worker at Martina's last job with Grind
Industries, makes her a business proposition. He wants 50% of the business in return for
investing $100,000 in Spice World. Martina sees a chance to work less and expand the
business using the $100,000 in capital. A deal is made but what happens to Martina's
simple sole proprietorship?
Martina and Dexter must form a new tax code entity for Spice
World. It could be a partnership, limited liability company or a corporation. Which one is
best? There is no "right" form of business entity for everyone. Tax-wise, there
is little advantage, if any, of one entity over the other, at least in a business' early
years. So, let's look at Martina and Dexter's most likely choices.
A partnership is one way to go. If all Martina and Dexter do is
shake hands and start splitting profits and losses, they are considered by the IRS as a
partnership by default. However, partnerships are governed by tax rules more complicated
than for their other choices, the limited liability company and a corporation. What's
more, in a partnership such as Spice World, both Dexter and Martina are personally liable
for all business debts. They can make a better pick.
You may have heard of a relatively new way to do business, the
Limited Liability Company (LLC). Tax-wise, an LLC is like a partnership, but there are
significant legal differences. LLCs give all of its' owners (called "members")
personal protection from creditors. This means if Spice World is successfully sued for
selling Upchuck, a food product that makes people sick, Martina can't lost her home, or
Dexter his life savings. The assets of the business are the extent of Spice World's
liability. LLCs are formed by filing documents (and paying a fee) to your state.
The last way to organize a small business is the corporation.
Let's get one thing out of the way-it seldom makes sense for small time operators like
Martina and Dexter to incorporate for tax reasons alone. As with the LLC, the appeal of
incorporation is to separate the personal assets of the owner from the business assets,
providing a corporate shield from creditors. Once Spice World has a solid, reliable cash
flow then incorporation might provide a wider range of tax-advantaged fringe benefits than
any other type of entity. There is a tax choice among types of corporations, either the
"S" or "C" corporation. Spice World, Incorporated can elect to be
tax-treated like an LLC or partnership by filing a form with the IRS. If no election is
made, the corporation is automatically a "C" corporation. C corporations, unlike
any other of the entities discussed, pay a separate corporate income tax. For this reason,
few small businesses like Spice World choose to be a C corporation. As with LLCs,
corporations are state formed entities. Costs of formation vary.
To find out more about choosing an entity for your business, see
my book Tax Savvy for Small Business
published by Nolo Press.
By: Frederick W. Daily, Tax Attorney,
John Raymond, Bankruptcy Attorney, and
Allan H. Rosenthal, paralegal.
All of the three have offices in San Francisco.
(This article was originally written for tax
practitioners who represent clients before the IRS. But the information
presented here is valuable for all taxpayers.)
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