Small business financial tune-up

COMMENTARY By Jamshid Hoorfar
Special to the Journal

Like the name implies, a financial tune-up is a fresh look at how well your small business is working for you, the owner. Part of a tune-up is a re-consideration of the form of business entity you've selected for your business. There are several choices available for you to consider with your tax and legal advisors:- Sole proprietorship- Partnership- S Corporation- C CorporationLimited Liability Company Each form of business entity has advantages and disadvantages. What was right when you started your business may no longer be the best choice. Knowing your options puts you in control.Sole proprietorship The sole proprietorship is characterized by its ease of formation as compared to the other three legal "entities." A sole proprietorship and sole proprietor are unified in connection with: - Assets- Liabilities- Length of existence This means the sole proprietor is personally liable for the debts and claims of business creditors. Also, the sole proprietorship does not continue after the death, bankruptcy, or voluntary cessation of business by the sole proprietor. From a tax perspective, it means that profits and losses pass through to the sole proprietor and are reported on Schedule C of Form 1040.A major disadvantage to the sole proprietorship is its inability to attract investment capital. If you need additional capital for planned growth, it may be time to look at a different type of business entity. Another disadvantage is that the pass-thru of taxable profits directly to you, limits tax planning opportunities that are available with C and S corporations. Income cannot be shifted to other family members by making them owners of the business. Also, sole proprietors are unable to take full advantage of tax breaks associated with group health, disability, and group-term life insurance.Partnerships A partnership is defined as two or more co-owners carrying on a business for a profit. Partnerships take two forms: the general partnership and the limited partnership. Partnerships remain a prevalent form of business organization for long-established law and accounting firms, other professional practices, real estate development and the management of family enterprises. As in the case of the sole proprietorship, appropriate licensing and registration of a name, if the name used differs from that of the partners, are the only formalities that need be followed. Although advisable, a written agreement is not necessary to form a partnership and the partners may change their original understanding from time to time without notification of authorities. General partnerships share other characteristics with sole proprietorships. Unless agreed otherwise, each partner has co-equal management rights. Furthermore, unless otherwise agreed, the partners share equally in profits and losses. Also, each general partner, like a sole proprietor, is fully liable for the business operations and actions of the other partners who act within the scope of the business. In a limited partnership the general partners possess all the rights and responsibilities they have in a general partnership. Limited partners, on the other hand, enjoy the investment opportunity afforded by the limited partnership but possess no management control. Also, although a limited partner's investment is at risk to partnership creditors, personal assets are not. Profits and losses pass through to the partners, retaining their character as capital gain or ordinary income in the hands of the partners. Although partnerships do not pay taxes, they are required to file an informational return. The form, a K-1, reflects allocations of income and loss to the individual partners. Each partner receives a K-1 reflecting his or her allocable share of partnership profit or loss and identifying how to reflect these items on the usual Form 1040. As a trade-off to pass-thru taxation, partners lose the ability to receive the full tax advantages of certain employee benefits such as group health and group-term life insurance. C corporations Unlike the case with partnerships and sole proprietorships, state laws require certain formalities in the formation and operation of a corporation. At a minimum, the incorporators must file articles of incorporation with the Secretary of State and adopt bylaws. A corporation is a separate legal entity from its shareholders. Consequently, the owners of a corporation need not expose personal assets to corporate liability. Also, unlike sole proprietors and partnerships, C corporations are separate taxable entities. Most C corporations are subject to income taxes at rates ranging from fifteen to 34 percent. Because corporations are separate taxable entities there is more opportunity to shift income and appreciation away from an older, founding generation to a younger, succeeding generation. A disadvantage to the C corporation is the potential for double taxation, the taxing of earnings first at the corporate level, then at the personal level. It is this disadvantage that has led to the popularity of S corporations.S corporations Somewhat less common since the advent of limited liability corporations, are S corporations, which combine aspects of both C corporations and partnerships. From a legal standpoint, shareholders of S corporations enjoy the limited liability afforded owners of C corporations. On the other hand, S corporations are pass-thru entities (like sole proprietorships and partnerships) for tax purposes. There are, however, certain restrictions placed on S corporations: - No more than 100 shareholders.- Each shareholder must be an individual who is a citizen or resident of the United States, estate, certain trusts or certain tax exempt organizations.- The corporation must have only one class of stock. (However, voting differences are permissible.)- The corporation must use the calendar year as its fiscal year, unless there is a natural business year for the corporation or more than half the shares are owned by shareholders with the fiscal year end or there is a valid business purpose to a particular fiscal year end. - Not more than 25 percent of the corporation's income can come from passive activities, such as annuities, dividends, rents, royalties, etc. Many small businesses elect the S corporation form. Unlike unincorporated sole proprietors who pay self-employment taxes of 15.3 percent on net income up to $97,500 (2007 limit), S corporation owner/employees are subject to employment tax withholding on his or her compensation. Net earnings over and above a reasonable salary are included in income, but are not subject to employment taxes. Furthermore, while more than two percent shareholders are prevented from fully enjoying tax breaks associated with health insurance and other employee benefits, company paid health insurance premiums are not taxed to owners/employees.Limited liability company The Limited Liability Company (LLC) is a relatively new and increasingly more common type of business entity. Its most distinctive feature is that it can provide owners with the liability protection of a corporation and the tax benefits of a partnership. Furthermore, LLCs are not encumbered by many of the restrictions placed on S corporations. Most states require two owners (owners are also referred to as members) to form an LLC, but unlike the S corporation, there is no upper limit on the number of owners with the LLC. The members of an LLC enter into an operating agreement. This agreement controls how profits, losses, distributions, and management powers are shared among members. Like S corporations, management duties may be reserved solely for owners, or the owners may elect managers who operate in a role similar to a board of directors. Whatever business form you started with, it makes sense to reconsider your choice from time to time as profits and losses, tax laws, needs for additional capital, and liability risks change. Seek the guidance of financial and legal professionals to help you assess your needs and to implement any changes.Jamshid Hoorfar, Financial Planner, PhD, CHFC, LUTCF, CLTC, offers investment advisory services through Prudential Financial Planning Services, a division of Pruco Securities, LLC. He can be reached at jamshid.hoorfar@prudential.com and 816-525-0900.