Accounting for your money: incorporating a business
When choosing a business entity, know your options.
When deciding to start a new pizzeria, you have a million decisions to make, from finding a location to finding food suppliers and employees. The last thing you want to think about is how to select which type of organizational setup best suits your needs. Choosing whether to remain a sole proprietor or to incorporate can be a very confusing process, and it takes a lot of thought. This is why we’re going to use James Adams, our friendly (and fictitious) pizzeria owner, as the example in this story of how to decide whether or not to incorporate.
As Adams starts his planning process, he’ll need to consider some basic facts that relate to his business before choosing an appropriate entity:
• The restaurant will start small and will not initially be looking for investors.
• Adams has substantial income from other investments.
• Adams desires an entity that is as simple as possible, from a tax point of view.
• The entity will show losses for the first two years; those losses may be funded by money borrowed by the entity.
• Adams has concerns that a lawsuit against the new restaurant could wipe out his personal assets.
Since Adams is the sole owner of his business, his entity choices are limited to sole proprietor, C corporation, S corporation and limited liability company. Let’s break down the pros and cons of each entity in an effort to help him make a final decision:
Sole Proprietor. This is by far the simplest form of ownership. If he expects the restaurant to show losses in the early years, as an active owner, Adams would be able to offset the losses with other income. However, this option provides no liability protection for him, so, if he was sued, his personal assets would be at risk.
C Corporation. A C corporation is a separate legal entity that is more complex to establish and maintain but also provides a high level of liability protection for Adams’ personal assets. C corporations file tax returns separately from the stockholder’s personal returns. One drawback of a C corporation is that earnings can be taxed twice—once at the entity level, and again when earnings are distributed to the shareholders (as dividends). Sometimes, however, the corporation can avoid double taxation if it pays out all of its earnings as deductible salary (the amount must be “reasonable”) or rent.
S Corporation. An S corporation is a tax election that allows a regular C corporation to be treated like a partnership for tax purposes. It is complex to set up but provides a higher level of liability protection. If S status is elected for tax purposes, the profits or losses of the corporation are passed through and reported on each shareholder’s individual income tax returns vs. being taxed at the corporation level. This eliminates the dual taxation associated with the regular C Corporation.
Limited Liability Company. A limited liability company (LLC) is a relatively new form of business entity that provides liability protection similar to that of a corporation but is taxed as a partnership (when there are multiple “members”) or as a sole proprietorship (when there is a single “member”). Use of a single-member LLC is perhaps the simplest business form that provides limited liability. The LLC is ignored for tax purposes, and all income, expenses and credits are reported in the owner’s tax return. In some states, LLCs are subject to a gross receipts tax. If Adams chooses to form a single-member LLC, primarily for the limited liability it provides, then this tax must be considered the price of limited liability.
If Adams expects the restaurant to generate losses in the early years, then an S corporation, an LLC or a sole proprietorship might be appropriate. In most cases, this would allow Adams, as an active owner, to offset the losses against other income.
An S corporation may save Adams self-employment tax once the entity is successful, as compared to an LLC or sole proprietorship, where distributed income is generally taxed as self-employment income. To receive this benefit, Adams must pay himself a reasonable salary before taking any remaining profits as distributions.
If losses are financed by borrowings, then Adams will be limited in his ability to deduct them. An S corporation owner or an LLC member cannot deduct losses that exceed his basis (capital contributed plus profits minus losses).
The use of a corporation or an LLC does not wipe out all types of liability. Contractual liability, such as a line of credit or a building lease, is ordinarily a liability that is guaranteed by the restaurant owner. Therefore, Adams cannot be shielded from this kind of liability through use of an LLC or a corporation.
Limited liability may protect Adams from liabilities other than those that are contractual. For example, consumer products carry the potential for product liability lawsuits: Adams may inadvertently serve spoiled product or ignore expiration dates. Limited liability can shield him from this occurrence and open accounts payable where owner guarantees were not given. Limited liability can also protect him when an employee or a customer initiates a lawsuit after being injured on restaurant premises. If the issue of limited liability is a deciding factor, a business owner must always seek a competent legal opinion.
The simplest entity for Adams to choose in this scenario would be a single-member LLC, which would be reported for tax purposes as a sole proprietorship, as long as it results in the desired limited liability. Invest the time in considering which entity works best for your situation; it’s expensive to change your mind later!