Businesses are formed around a certain charge, aka idea, that drives them to exist and persist in the world. This idea is akin to a child to many business owners and any inhibition to their child’s growth is the enemy. Think of MyPillow or the ShamWow. Both ideas came from entrepreneurs who were at difficult places in their life, yet were able to spin their idea into a successful enterprise. Without the risk taken by these people to actually put their idea to paper, fund it, create it, expand it, and market it, we would have aching necks and wet stains all over the place. So, in the event that you have a great idea churning in that vacuous space within your head, how do you protect it to the best of your ability? What are you protecting it from?
If you follow any news source in today’s world, I am sure you’ve heard different talking heads discuss the phrase “taxes” in one way or another. Taxes have played a small, but persistent role in our lives all the way back to Ancient Egypt where you were either forced to provide grain or labor for essential public services like cat praising, alligator wrestling, or some other small items like protection from a standing military. To some, taxes are the bane of their existence as they would rather spend their dollar as they choose. To others, they are a collaborative solution to broad issues facing their communities or the world. Regardless of your opinion on how much people should be taxed and how philanthropic you say you are, when you receive $10 for your work or idea and the government says like a schoolyard bully, “Wait...No, I think that’s only $6. Yep, four of those dollars are mine,” it doesn’t feel as altruistic as you may hope. Businesses are the first to decry this system as inefficient and favor the jungle of private enterprise to solve the issues facing their local communities, states, provinces, countries, etc. Due to this ideology, differing business structures have been created over the years to allow for differing tax structures as well as asset and legal liability deflection. For example, if you wave the white flag and determine that your business is no longer able to produce enough income to pay off your debts, you may declare bankruptcy. In certain business structures, creditors (most likely banks) are able to claim your personal assets like your home, car, laptop, etc. In other structures, your personal effects are distinctly separate and therefore when all business assets are stripped they cannot ask for your personal property. When starting out as an entrepreneur it is important to understand these common structures and how they impact your personal financial security.
Types of Businesses
Sole Proprietorship – The default business categorization. If you operate as a business that tracks personal income and business income separately, but have not registered as a corporation, LLC, or other business type, you are recorded as a sole proprietorship for tax purposes.
Taxes: Only File Personal Taxes
Liability: Unlimited Personal Liability
Independent Contractor (1099) – This is NOT a business type, but given its recent popularity we wanted to discuss it’s differences from a Sole Proprietorship. A 1099 is a self-employed person who provides work for one or various different corporations. They are separate from a traditional employee as they are required to provide their own materials and equipment to complete their job. The corporations they work with do not have to pay payroll taxes for this person as they are not an official “employee”. Instead, the 1099 must file “self-employment taxes” (Medicare and Social Security) along with income taxes.
Taxes: Personal and Self-Employed
Liability: Unlimited
Limited Partnership – A common business structure for a small business with two or more owners, such as law offices, or professional groups. The partnership consists of a General Partner (GP) and Limited Partner(s) (LP). In a limited partnership, the GP typically has greater control over the company’s operations, but in exchange is personally liable and must pay both personal income and self-employed income taxes like a 1099.
Taxes: GP (Personal and Self-Employed) LP (Personal)
Liability: GP (Unlimited) LP (Limited)
Limited Liability Partnerships – Similar to the above organization except that there is no GP, and all partners are LPs.
Taxes: LP (Personal)
Liability: LP (Limited)
Corporation - As defined by the court case Citizens United v. FEC, a corporation is a separate entity from its owners in terms of profits, taxes, and legal liability. This means that it’s owners (determined by stock ownership) can change out without an alteration to the filing of the business - this is a core difference between a corporation and a partnership or proprietorship. There are a few types of corporations, but for our purposes we will discuss: C, S, B, and Non-Profit which differ in terms of tax implications. All corporations have a corporate tax which is determined off of their independent income, and not solely the personal income of the owners.
C Corporation - A corporation whose owners suffer from double taxation, but is more flexible in terms of size and type of ownership allowed. The owners are taxed on both the income of the corporate entity, as well as their personal income.
Taxes: Corporate and Personal
Liability: No personal liability
S Corporation - A corporation type allowed in some states that passes taxation to the personal level, and does not pay corporate taxes on income. This is only allowed for companies with under 100 shareholders (owners) that are all US citizens.
Taxes: Personal
Liability: No personal liability
B Corporation - A “benefit” corporation that is a for-profit charitable entity. It is taxed the same as a C-Corp, yet must adere to a strict code of conduct and business mandate.
Taxes: Corporate
Liability: No personal liability
Nonprofit Corporation (501c3) - A charitable, religious, or educational organization that is exempt from both state and federal taxation. They are restricted and where they can spend profits and can not give DIRECTLY to its members or political organizations.
Taxes: None, but profits cannot be directly distributed to its members
Liability: No personal liability
Limited Liability Company (LLC) - A mixed business structure that has attributes of both a partnership and corporation. All of your personal assets as an owner are protected, similar to a corporation. Taxes are passed to a personal level, like a S-Corp. However, owners must also pay the 1099 “self-employed” personal income tax. Unlike a corporation, when an owner leaves or is transitioned for another, the LLC must be re-defined.
Taxes: Corporate and Self-employed
Liability: No personal liability
Worker Cooperative - A form of entity where all workers within a business are given an exactly equal voting share - 1:1. That means that the CEO and the janitor have the same voting rights, although they have different levels of ownership. They have a board of directors which try to push the business in the correct direction, but always need to have the best interest of every employee in mind, otherwise this business type will crumble-in on itself.
Taxes: Corporate
Liability: No personal liability
Employee Stock Ownership Program (ESOP) - A business entity in which a tax-exempt trust acquires a majority of a company. A trust is a separate legal entity solely made to be an impartial judge of the direction of it’s charge - aka the reason why it was founded. If it was founded on the principles of maintaining the wealth of a single family, the trust MUST do all in it’s power to ensure that principle. This trust is run by “trustees” that make all decisions regarding ownership and stock. An ESOP is a company whose trust is charged with the benefit of its employees for the purpose of maintaining their wealth and retirement interests.
Taxes: None
Liability: No personal liability
Business Structure Manipulation
How companies avoid taxes is a much larger topic which we will elaborate on at a later time, but is done through a mixture of complex corporate structures and accounting / legal tactics. For example, say you run a medical operation. Medical firms are not allowed to claim themselves as LLCs to avoid liabilities such as malpractice, and are therefore commonly organized as partnerships. This in turn makes owners of medical practices susceptible to not only liability of the owners, but also it's employees. In terms of taxes, they are forced to pay both personal and self employed taxes unless some creativity is applied. If they were to, for example sake, formulate three separate companies - one limited partnership (LP) for the medical professionals, one LLC for the other back-office employees, and another LLC for the ownership of the office locations, they can receive the benefits of all three.
Maintain benefit of a LP - no corporate income tax
Employee liability is deferred through the LLC
Rent can be charged to the LP to reduce personal income and therefore taxes
Wallah, a corporate-structure attorney's wet dream.