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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.

© 1997

(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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