Chapter 2

Recognizing Business Types and Their Tax Rules

In This Chapter

Exploring sole proprietorships

Taking a look at partnerships

Checking out limited liability companies

Comparing different types of corporations

All businesses need to prepare key financial statements, but some businesses can prepare less formal statements than others. The way a business is legally organized greatly impacts the way it reports its financials to the public and the depth of that reporting.

For a small business, financial reporting is needed only to monitor the success or failure of operations. But as the business grows, and as more outsiders — such as investors and creditors — become involved, financial reporting becomes more formalized until the company reaches the point at which audited financial statements are required.

Each business structure also follows a different set of rules about what financial information the business must file with state, local, and federal agencies. In this chapter, I review the basics on how each type of business structure is organized, how taxation differs, which forms the business must file, and what types of financial reports are required.

Flying Solo: Sole Proprietorships

The simplest business structure is the sole proprietorship — the IRS's automatic classification for any business that an individual starts. Most new businesses with only one owner start out as sole proprietorships. Some never grow into anything larger. Others start adding partners and staff and may realize that incorporating is a wise decision for legal purposes. (Check out “Seeking Protection with Limited Liability Companies” and “Shielding Your Assets: S and C Corporations,” later in the chapter, to find out more about incorporating.)

To start a business as a sole proprietor, you don't have to do anything official, like file government papers or register with the IRS. In fact, unless you formally incorporate — follow a process that makes the business a separate legal entity — the IRS considers the business a sole proprietorship. (I talk more about incorporation and the process of forming corporations in the upcoming section titled “Shielding Your Assets: S and C Corporations.”)

The fact that the business isn't a separate legal entity is the biggest risk of a sole proprietorship. All debts or claims against the business are filed against the sole proprietor's personal property. If a sole proprietor is sued, insurance is the only form of protection against losing everything.

Keeping taxes personal

Sole proprietorships aren't taxable entities, and sole proprietors don't have to fill out separate tax forms for their businesses. The only financial reporting sole proprietors must do is add a few forms about their business entity to their personal tax returns.

Most sole proprietors add Schedule C — a “Profit or Loss from Business” form — to their personal tax returns, but some choose an even simpler form, called Schedule C-EZ, “Net Profit from Business.” In addition, a sole proprietor must pay both the employer and employee sides of Social Security and Medicare taxes using Schedule SE, “Self-Employment Tax.” These taxes total 15.3 percent of net business income, or the business income after all business expenses have been subtracted.

Sole proprietors in specialized businesses may have different IRS forms to fill out. Farmers use Schedule F, “Profit or Loss from Farming.” People who own rental real estate but don't operate a real estate business use Schedule E, “Supplemental Income and Loss.”

Reviewing requirements for reporting

Financial reporting requirements don't exist for sole proprietors unless they seek funding from outside sources, such as a bank loan or a loan from the U.S. Small Business Administration. When a business seeks outside funding, the funding source likely provides guidelines for how the business should present financial information.

When sole proprietors apply for a business loan, they fill out a form that shows their assets and liabilities. In addition, they're usually required to provide a basic profit and loss statement. Depending on the size of the loan, they may even have to submit a formal business plan stating their goals, objectives, and implementation plans.

Even though financial reports aren't required for a sole proprietorship that isn't seeking outside funding, it makes good business sense to complete periodic profit and loss statements to keep tabs on how well the business is doing and to find any problems before they become too huge to fix. These reports don't have to adhere to formal generally accepted accounting principles (GAAP; see Chapter 18), but honesty is the best policy. You're fooling only yourself if you decide to make your financial condition look better on paper than it really is.

Joining Forces: Partnerships

The IRS automatically considers any business started by more than one person a partnership. Each person in the partnership is equally liable for the activities of the business, but because more than one person is involved, a partnership is a slightly more complicated company type than a sole proprietorship. Partners have to sort out the following legal issues:

• How they divide profits
• How they can sell the business
• What happens if one partner becomes sick or dies
• How they dissolve the partnership if one of the partners wants out

Because of the number of options, a partnership is the most flexible business structure for a business that involves more than one person. But to avoid future problems that can destroy an otherwise successful business, partners should decide on all these issues before opening their business's doors.

Partnering up on taxes

Partnerships aren't taxable entities, but partners do have to file a “U.S. Return of Partnership Income” using IRS Form 1065. This form, which shows income, deductions, and other tax-related business data, is for information purposes only. It lists each partner's share of taxable income, called a Schedule K-1, “Partner's Share of Income, Credits, Deductions, Etc.” Each individual partner must report that income on his or her personal tax return.

Meeting reporting requirements

Unless a partnership seeks outside funding, its financial reports don't have to be presented in any special way because the reports don't have to satisfy anyone but the partners. Partnerships do need reports to monitor the success or failure of business operations, but they don't have to be completed to meet GAAP standards (see Chapter 18). Usually, when more than one person is involved, the partners decide among themselves what type of financial reporting is required and who's responsible for preparing those reports.

If the partnership seeks funding from a bank or investors, more formal reporting may be needed, such as audited financial statements and business plans.

Seeking Protection with Limited Liability Companies

A partnership or sole proprietorship can limit its liability by using an entity called a limited liability company, or LLC. First established in the U.S. about 30 years ago, LLCs didn't become popular until the mid-1990s, when most states approved them.

This business form actually falls somewhere between a corporation and a partnership or sole proprietorship in terms of protection by the law. Because LLCs are state entities, any legal protections offered to the owners of an LLC are dependent on the laws of the state where it's established. In most states, LLC owners get the same legal protection from lawsuits as the federal law provides to corporations, but unlike the federal laws, these protections haven't been tested fully in the state courts.

Reporting requirements for LLCs aren't as strict as they are for a corporation, but many partnerships do decide to have their books audited to satisfy all the partners that the financial information is being kept accurately and within internal control procedures determined by the partners.

Taking stock of taxes

LLCs let sole proprietorships and partnerships have their cake and eat it, too: They get the same legal protection from liability as a corporation but don't have to pay corporate taxes or file all the forms required of a corporation. In fact, the IRS treats LLCs as partnerships or sole proprietorships unless they ask to be taxed as corporations by using Form 8832, “Entity Classification Election.”

Reviewing reporting requirements

The issues of business formation and business reporting are essentially the same for a partnership and a sole proprietorship, whether or not the entity files as an LLC. To shield themselves from liability, many large legal and accounting firms file as LLCs rather than take the more formal route of incorporating. When LLCs seek outside funding, either by selling shares of ownership or by seeking loans, the IRS requires their financial reporting to be more formal. Some partnerships form as LLPs, or Limited Liability Partnerships. In an LLP, one partner is not responsible for the other partner's actions. In some countries, an LLP must have at least one general partner with unlimited liability.

Shielding Your Assets: S and C Corporations

Company owners seeking the greatest level of protection may choose to incorporate their businesses. The courts have clearly determined that corporations are separate legal entities, and their owners are protected from claims filed against the corporation's activities. An owner (shareholder) in a corporation can't get sued or face collections because of actions the corporation takes.

The veil of protection makes a powerful case in favor of incorporating. However, the obligations that come with incorporating are tremendous, and a corporation needs significant resources to pay for the required legal and accounting services. Many businesses don't incorporate and choose instead to stay unincorporated or to organize as an LLC to avoid these additional costs.

Before incorporating, a business must first form a board of directors, even if that means including spouses and children on the board. (Imagine what those family board meetings are like!)

Boards can be made up of both corporation owners and nonowners. Any board member who isn't an owner can be paid for his service on the board.

Before incorporating, a company must also divvy up ownership in the form of stock. Most small businesses don't trade their stock on an open exchange. Instead, they sell it privately among friends and investors.

Corporations are separate tax entities, so they must file tax returns and pay taxes or find ways to avoid them by using deductions. Two types of corporate structures exist:

• S corporations: These corporations have fewer than 100 shareholders and function like partnerships but give owners additional legal protection.
• C corporations: These corporations are separate legal entities formed for the purpose of operating a business. They're actually treated in the courts as individual entities, just like people. Incorporation allows owners to limit their liability from the corporation's actions. Owners must split their ownership by using shares of stock, which is a requirement specified as part of corporate law. As an investor, you're most likely to be a shareholder in a C corporation.

Paying taxes the corporate way

If a company organizes as an S corporation, it can avoid corporate taxation but still keep its legal protection. S corporations are essentially treated as partnerships for tax purposes, with profits and losses passed through to the shareholders, who then report the income or loss on their personal tax returns.

The biggest disadvantage of the S corporation is the way profits and losses are distributed. Although a partnership has a lot of flexibility in divvying up profits and losses among the partners, S corporations must divide them based on the amount of stock each shareholder owns. This structure can be a big problem if one of the owners has primarily given cash and bought stock while another owner is primarily responsible for day-to-day business operations. Because the owner responsible for operations didn't purchase stock, he isn't eligible for the profits unless he receives stock ownership as part of his contract with the company.

Only relatively small businesses can avoid taxation as a corporation. After a corporation has more than 100 shareholders, it loses its status as an S corporation. In addition, only U.S. residents can hold S corporation stock. Nonresident aliens (that is, citizens of another country) and nonhuman entities (such as other corporations or partnerships) don't qualify as owners. However, some tax-exempt organizations — including pension plans, profit-sharing plans, and stock bonus plans — can be shareholders in an S corporation.

One big disadvantage of the C corporation is that its profits are taxed twice — once through the corporate entity and once as dividends paid to its owners. C corporation owners can get profits only through dividends, but they can pay themselves a salary.

Unlike S corporations, partnerships, and sole proprietorships, which pass any profits and losses to their owners, who then report them on their personal income tax forms, C corporations must file their own tax forms and pay taxes on any profits.

Getting familiar with reporting requirements

A company must meet several requirements to keep its corporate veil of protection in place. For example, corporations must hold board meetings, and the minutes from those meetings detail the actions the company must take to prove it's operating as a corporation. The actions that must be shown in the minutes include:

• Establishment of banking associations and any changes to those arrangements
• Loans from either shareholders or third parties
• The sale or redemption of stock shares
• The payment of dividends
• Authorization of salaries or bonuses for officers and key executives (Yep, those multimillion-dollar bonuses you've been hearing about as major corporate scandals must be voted on in board meetings. The actual list of salaries doesn't have to be in the minutes but can be included as an attachment.)
• Any purchases, sales, or leases of corporate assets
• The purchase of another company
• Any merger with another company
• Changes to the Articles of Incorporation or bylaws
• Election of corporate officers and directors

These corporate minutes are official records of the company, and the IRS, state taxing authorities, and courts can review them. If a company and its owners are sued and the company wants to invoke the veil of corporate protection, it must have these board minutes in place to prove that it operated as a corporation.

If a C corporation's ownership is kept among family and friends, it can be flexible about its reporting requirements. However, many C corporations have outside investors and creditors who require formal financial reporting that meets GAAP standards (for more on this topic, see Chapter 18). Also, most C corporations must have their financial reports audited. I talk more about the auditing process in Chapter 18.