Editor's note: This article is excerpted fromTop Tax Savings Ideas from Entrepreneur Press.
You, like every new business owner, must have asked yourself at one time or another, "What kind of business entity is best suited for my particular operation?" For most entrepreneurs, the answer lies within two specific questions.
1. Legal liability. How can I get the best protection from general business liabilities that can threaten not only my business assets but my family's assets as well?
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2. Tax considerations. How can I get the best tax breaks out of the business entity that I select?
Liability is an argument best left to yourself, your business partners, and your business attorney. It is the second question involving the search for shelter from high taxes that sets the overall theme for Top Tax Savings Ideas.
How to Save Taxes with Your Business Entity
New business owners are quick to learn that confiscatory tax laws have a profound influence on the success or failure of all small business operations. As a small business owner, you want to get every break available under the law, and you don't want to see the results of all your hard work get eaten up by the IRS and the tough tax laws. The problem, however, is that those tax laws have become so painfully complex that new business owners automatically assume they could never make the best of their available options without conceding the strategy planning to the tax professionals. Interestingly, the tax professionals themselves are often at odds with each other as to the best tax saving options in this ever-changing environment.
Understand the Differences Between the Entities
Before we discuss the specific tax advantages and disadvantages of the various business entities, it is important that you know some fundamental tax considerations between a:
- Sole proprietorship
- General partnership
- Limited partnership
- Corporation
- Limited liability company
The Sole Proprietorship
The sole proprietorship is thought of as the quickest and easiest way to set up a business operation. There are no blanket prerequisites, nor are there any specific costs in starting a sole proprietorship. There may be some minor formalities, however, that will need attention depending on your state or your jurisdiction. These formalities, which of course apply to all business entities, mean that you will probably have to:
- Obtain an occupancy permit for your place of business,
- Secure a business license, and
- Apply for a franchise or registration number for your operation. This registration number will be used by the state agency to monitor the collection of sales tax and other regulatory matters.
All of these procedures are simple and can be done without the assistance of an attorney or accountant regardless of the state in which you are doing business. Once you start a sole proprietorship, you are the sole owner. Unless you are in a community property state in which your spouse is vested with a one-half interest, you alone have full control and responsibility for the operation.
The General Partnership
Like the sole proprietorship, starting up the general partnership could be a relatively easy process. No costs or formalities are required. Wise counsel, however, will give you about a dozen reasons why you should have a detailed partnership agreement drafted whenever you put yourself on the line with any other individual. A few items that you would be best advised to spell out in writing are:
- The amount of capital each partner is expected to contribute up front;
- The rights and duties of the partners;
- The method for sharing profits and losses;
- The authorization for cash withdrawals and salaries,
- The methods for resolving disputes or taking in new partners; and
- The method for dissolving the partnership should dissolution become necessary. Remember, this is often the case.
The Limited Partnership
A limited partnership is much like a general partnership except for one important fundamental difference. The limited partner is protected by law because the limited partner's legal liability in the business is generally limited to the amount of his or her investment. It enables this special type of investor to share in the partnership profits without being exposed to its debts in the event the company goes out of business. This protection exists as long as the limited partner does not play an active role in the partnership operation.
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