Accounting Essentials for Start Ups – Episode I: What Type of Business Entity Should You Choose?

Guest Blog by: Kerri L. Kutlenios, CPA

So you’ve got a great idea for a new business, discussed your new venture with friends and family, and are ready to take the leap into entrepreneurship!  One of the first decisions you will make to set up your new business is unfortunately, kind of legal and boring.  But, can cause headaches down the road if not handled correctly.  So what type of entity should your new business be?  The answer will depend on a few questions:

How much do you want to pay in taxes every year?

 Trick question!  As little as possible, right?  I’ll try to keep this as brief as possible, because even though I’m an accountant, I know that for many, taxes=snooze fest, and this is really important:

A C-Corporation is taxed at the entity level, meaning you will file a tax return, and may owe taxes, for your business, and you will also file your 1040, and may owe taxes, personally.  If you are earning a paycheck from your C-Corporation, you are paying tax on the wages on your 1040, along with employer payroll taxes through the Corp.  If you pay a dividend to yourself from the Corporation, you will be taxed on the income on your 1040.  This is the concept of “double taxation” you may hear thrown around by us accountant-types.  Unless you’re a fan of donating to the dysfunctional machine we call our Federal government, this scenario is not very pleasant.

Profit or loss from an S-Corporation or an LLC “passes through” to your 1040, and all tax is paid on your individual tax return.  In many cases, if you pay yourself a distribution from your S-Corporation or LLC, that distribution is not taxable when paid to you, however it will reduce your ownership value, or basis, in the company (the basis discussion can fill up another post, so I won’t go into detail here).

How much liability are you willing to assume personally?

This is a very important issue to consider with your entity selection.  If you are leaning toward a sole proprietorship based on ease of setup and tax filing requirement, keep in mind this entity will not provide you any protection of your personal assets in the event of a lawsuit.  For instance, if a suit is brought against your business, your home and other personal assets may be attached to the business assets.  For this reason alone, a single member LLC would be the better option, as this will limit the liability against you personally.

How much time and money do you want to spend to set up your business?

Let’s be honest, the majority of new businesses will not have an unlimited budget, and the seed money you will have may need to be spent on inventory and the build-out of your operating location, not on attorney fees for your business set up.  A corporation (C or S) is typically the easiest to set up, and requires usually a minor filing fee, depending on the state where you are registering your business.  However, an LLC will require drafting an operating agreement, which outlines the overall allocation of business profit, loss, and risk to each member.  This document is drafted by an attorney, and will require a higher initial investment to set up.

How many owners do you have, or will plan to have in the future?

If you are the only owner, and plan to be the only owner for the life of the business, a sole proprietorship or single member LLC may work for you.  If you are planning to have several investors, an LLC or C-Corporation does not restrict the number of owners you may have.  However, S-Corporations limit the number of owners you may have to 100 (which is still a heck of a lot, so may not be a deal breaker).

What type of owners will you have (individual, partnership, etc.)?  This is important if you plan to work with venture capital investors.

S-Corporations restrict the type of owners you may have, for instance, the IRS does not allow for entities other than individuals and certain trusts and estates to be a shareholder of an S-Corporation.  In addition, non-U.S. entities cannot own an S-Corporation.  So, if you have a VC interested in buying in, an S-Corporation may not be an option.

How many tax returns do you want to file?

If you only have one owner, the annual profit and loss of a single member LLC or sole proprietorship can be filed on Schedule C of your individual tax return, which may reduce your tax preparation fees.  However, Corporations and LLCs with multiple members will be required to file a separate tax return.

Hopefully you’ve read through this, have it all figured out, and you’re convinced I’m an accounting genius.  However, if you’re still struggling with this decision, first of all, I’m glad you’re struggling a bit!   This is a big decision and shouldn’t be taken lightly.  I can advise you that, if you have one or a few individual owners, the LLC, single member LLC, or S-Corporation is the way to go, with the S-Corporation being slightly easier to set up.  And, if you decide to make a change down the road, you can switch entities, but you may have some tax issues to navigate in that process (again, another blog post entirely).

Congratulations on your new venture, good luck, and stay tuned for Episode II!

 

 

KLKWho is Kerri? Just one of Stacy’s bestest friends EVAR. They’ve known each other since kindergarten (and yes, she probably knows more about her than Stacy would like to admit) but here’s some more interesting stuff about her: she’s also CPA licensed in Arizona, spent 17 years as both an auditor and accounting consultant in public accounting, and as a controller for an international franchise company, before venturing out with Liaison Accounting and Consulting, LLC, to assist start-ups and sophisticated small businesses with outsourced controller and financial consulting.  Kerri believes that, although some businesses may not have the resources for a full-time financial professional, they shouldn’t be deprived of the benefit that is provided to more established businesses.  A graduate of Michigan State University, she bleeds green and white, and takes pride in being told she “doesn’t seem like a typical accountant” – just what you’d expect from a BFF of the chick with the hot pink hair, right??.  You can contact Kerri at [email protected]

 

One Response to Accounting Essentials for Start Ups – Episode I: What Type of Business Entity Should You Choose?

  1. Well explained for the reader; I have found that most clients need the overview of the different types of legal entities and then need the recommendation from the accountant. Most serious entrepreneurs with capital at risk should choose incorporation. Also, the use of a holding company could be beneficial from day 1.

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