Cinventure - For the Cincinnati Entrepreneur

If you are like many entrepreneurs you have a great idea but are struggling to get your new venture started. Of the many decisions that you need to make - from marketing your product or service, handling logistics, to managing your cash flow, etc. one of the most important decisions will be deciding what form of business entity you will operate.

There are several to choose from:

• Sole Proprietor
• Partnership
• Joint Venture (for combining two or more existing businesses in a given project)
• C-Corporation
• Limited Liability Corporation
• S-Corporation

Since most people are familiar with the more basic sole proprietorship and partnership models, we will skip those and examine the pros and cons of the various types of corporations. We are also snubbing joint ventures since those are mostly done in a specific project setting between multiple companies.

C-Corporations

The C-Corporation will be your basic company that maintains its own financial statements and can choose to reinvest earnings or distribute them as it sees fit. The income or losses will be reported on the company’s own income tax filing and any dividends will be taxed to the individual shareholder.

Since many start-ups are smaller in nature it makes sense that an entrepreneur would not want to pay income tax as a C-corp and then again as an individual. This brings us to our next two forms of incorporation:

Limited Liability Corporations

The Limited Liability Corporation, or LLC, passes earnings on to the shareholders’ income tax return (so it is not taxed at both the individual level and the corporation level). However, if you are the SOLE owner of an LLC you will be taxed as if it’s a sole proprietorship. You may still have some of the limited liability protection that an LLC provides; for instance your personal assets may be shielded in the event the business venture goes bust.

However, most lenders and creditors are wise to the fact that a one-person LLC is really just a sole proprietorship that’s incorporated for liability purposes. Therefore, the creditors will want you to personally guarantee the repayment of any loan, usually by making you personally responsible for the debt if the business goes bust. This makes sense when you’re the only person owning/running the organization as you ultimately affect the degree of success that your business achieves.

S-Corporations

Another form of business that you may consider, especially if you’re flying solo and were thinking about filing the LLC method, is to form an S-corporation. The “S-Corp” is purely a tax maneuver with the IRS. You file the C-corp articles of incorporation the state of your choosing. You then submit the Form 2553 with the IRS and select S-Corporation. This form of business venture allows the income to pass through to your personal income tax so once again, like the LLC, it is not taxed twice (once as a corporation and once as an individual taxpayer). It’s important to note that you need to file this form within 75 days of filing your articles of incorporation, otherwise you have to wait until the next year (by March 15th if your new company operates on a calendar year) to change your tax status. You would operate as a C-corp in the meantime.

The S-corp is more limited in use than the LLC or C-Corp. An S-corp may not have more than a handful of owners… I read in one place 75 owners and in another place 35 owners. I need to seek clarification on this part. Regardless which number it is, or even if it’s neither of those numbers, that is still a limited number of shareholders allowed. Also, you cannot have more than 25% of your company’s gross receipts as passive earnings, i.e. rental property/real estate that you are not actively managing the business. If you’re a landlord but spend more of your time doing other things, it’s probably better to file as an LLC. An LLCs stock can also be held by other entities such as other companies (or even parent companies) whereas an S-corp can only be held by individuals who are U.S. citizens or permanent residents.

Wow, it really sounds like I am touting the LLC over the S-corp. Well, that’s not necessarily true. It depends on your individual situation: how many owners you have, how many of the owners are actively involved in the business, how the ownership and profits are to be split up, and so forth. A drawback to the LLC in this respect is that members (owners of LLCs are referred to as members) would have to show a gain made by the LLC regardless whether or not that gain was distributed to them by the LLC or the LLC reinvested those earnings into the company (gains not distributed are referred to as “phantom income” because it was never received). If the company reinvested earnings over multiple periods, this could have a compounding tax effect (added taxes without realized gains) by the various members. One way around the phantom income problem in an LLC is what’s known as “gross-up” clauses to be added to the LLC’s operating agreement. These clauses simply state that the LLC will reimburse the shareholders for tax incurred on income that they did not receive.

As you can tell, the water is getting kind of muddy, but I hope when you analyze your own situation you can pick out the pros and cons of the various forms of incorporation and choose one that fits you best!

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