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Thinking Like An Entrepreneur

Thinking Like An Entrepreneur
Table of Contents

Chapter 3
Men Are Cheaper Than Guns

Chapter 4
Intellectual Capital And Bootstrapping

Thinking Like An Entrepreneur


Choosing A Business Structure

In what legal form will your company do business? Corporations are the most common example of a business structure. Large, publicly traded companies are corporations.

Many people just start doing business and file a Schedule C with their personal 1040 income tax return for tax reporting purposes. By doing this you are considered a "sole proprietor." An individual starting a business is by default a sole proprietor unless some other business structure is chosen. You and your business are considered one and the same.

If you operate a business under a name different from your own legal name, you will be required to file a Doing Business As (DBA) document, which tells the local government who exactly is doing business under your business name. DBA is not a formal business structure. In fact, whenever corporations do business under any name other than the full legal name of the corporation, they are usually required to file a DBA form also.

I'm not a big fan of doing business as a sole proprietor, especially if you have employees. I discuss this at length in Thinking Like An Entrepreneur, where I argue that a corporation is by far a better business structure for most enterprises. Corporations shield your personal worth from most legal liabilities which could be brought against your business. Even if you are the sole owner of a business, you usually can form a corporation.

Corporations come in two flavors. C-corporations and S-corporations. S-corporations are like C-corporations, except they have some extra requirements placed upon them, such as limiting the number of shareholders and limiting who may be a shareholder. If you are a person and a U.S. Citizen, you generally can be a shareholder in a S-corporation. (note: I'm not just saying you must be a person to be funny. For example, corporations are considered separate legal entities, just like you! S-corporations are designed to be owed by (people) small business owners.)

There's a big difference in how S-corporations and C-corporations are taxed. S-corporations allow small business owners the liability protection of incorporation, while at the same time preventing earnings paid as dividends from being taxed twice.

A quick aside to corporate taxation:

Assume the corporation earns $1,000. The C-corporation is a separate taxable entity. It must pay taxes on these earnings.

Suppose you pay a 30% corporate income tax rate (I just made up 30% in our example. Corporate tax rates vary, depending upon the level of earnings, just as income taxes do. Typically, 34% is the maximum incremental income tax bracket most corporations fall into.) After taxes, the corporation is left with $700. It may retain these earnings or pay them out to the shareholder. (We neglect the fact that corporations can also pay wages to owners who are actively involved in the business. Wages are a deductible business expense to the corporation, and the corporation doesn't pay taxes on them. Thinking Like An Entrepreneur discusses this C-corporation "income splitting" in more detail.)

Suppose the corporation pays out the $700 in dividends to you, the shareholder. You must now pay personal income tax on these dividends. Again, assume you are in the 30% income tax bracket (For out example, again! There is no actual incremental 30% tax bracket, but the 28% and 31% brackets have it very pinned down and close to 30% for most individuals!) You pay $210 in personal income taxes and are left with only $490 after Federal corporate and income taxes.

The double taxation has made the effective tax rate 51%! In addition, most states charge both corporate and personal state income taxes on the money. This might collectively take another 18% (9.5% State tax rate for both personal income and corporate income assumed) of your C-corporate earnings before they flow to you!

Clearly, this is a heavy tax burden on a small business. So most small businesses set up as C-corporations make it a policy not to pay dividends. A small business which wants to pay out most of its earnings as dividends would prefer the S-corporation.

Let's consider the S-corporation case. The S-corporation earns $1,000 but is not taxed as a separate entity. From a tax standpoint, the earnings are assumed to flow to you. You owe personal income tax on them. So, since you are in the 30% tax bracket, you pay $300 in tax. This is unaffected by whether or not the remaining $700 stays within the corporation or is paid out to you (For issues of "phantom income," money on which you are taxed but never receive from an S-corporation, I refer you to Thinking Like An Entrepreneur)

The S-corporation is not always to be preferred, however. There are also some tax advantages to having a C-corporation.

My new book covers corporate business structure, with a focus upon S Corporations: How To Start And Run Your Own Corporation: S-Corporations For Small Business Owners. This book will help you understand stock basis, tax strategies, retirement plan options, issuing stock, and more.

Tax status is a big factor in choosing a business structure. You should consult with a knowledgeable tax attorney to discuss the implications of your business structure.

Another common business structure is the partnership. This form is automatically chosen when two or more people start a business and they do not form some other legal structure, such as a corporation or a Limited Liability Company to be discussed below. Repeating what I said in Thinking Like An Entrepreneur about partnerships, don't form them. You become personally responsible for all business debts, even if the debt is incurred by your partner against your will. He takes a "business trip" to Jamaica and you are liable for the cost, if he doesn't return to pay the cost!

If you are serious about going into business with someone else, form a business structure which better protects both you and your partner.

Finally, a newer structure of business is the Limited Liability Company, or LLC. The LLC does for Limited Partnerships what the S-corporation did for incorporated small business owners. It gives the general partner of a limited partnership the legal liability protection of incorporation and, at the same time, is usually taxed as a flow-through entity, which prevents double taxation.

Take your business structure seriously. It has both legal and tax consequences.

To start your corporation (or LLC), get more information from your State Government. They can provide you with applications and more details.

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