One of the first decisions you will encounter in starting a new business is choosing a business structure. Here is an explanation of various structures and how they affect a company's tax treatment or liability.

Before you enter into any one of these business structures, the Massachusetts Office of Business Development (MOBD) strongly recommends that you seek legal and accounting advice.

SOLE PROPRIETORSHIP, PARTNERSHIP, CORPORATION

The Sole Proprietorshipis the simplest form of business. To form a sole proprietorship, you just have to let people know that you are in business and file a form in the city or town hall where you are going to do business. You personally are responsible for all debts and other legal liabilities of your business. The income from your business is reported to the IRS as part of your personal income and taxed accordingly.

A Partnership is formed when two or more people decide to go into business together. It is called a conduit because, though persons have banded together for a profit-producing motive, it is generally not considered a legal entity separate from the partners. Thus, a partnership may not be sued or be sued in its firm name only, and each partner shares a potential joint and separate liability.

In a "general" partnership, each partner is totally liable for whatever happens to the business, and for whatever the other person does. Normally, a general partner has unlimited liability, which includes personally owned assets outside the business assets.

A "limited" partner is liable only for the amount of money he or she invests into the business, but there must be at least one general partner who is liable for the total. Income from a partnership is reported to the IRS as part of each partner's personal income and taxed accordingly.

In creating a Corporationyou are creating a legal entity. From then on, your business has an identity of its own. It has certain rights. It can sue and be sued. It has to file its own tax returns, etc. The ownership of a corporation is divided into "stocks," which are sometimes called "shares." The owners are called "stockholders." One person can own all of the stocks, in which case there is only one stockholder. A stockholder meeting has to be held at least once a year to decide how to manage the company and what to do about profits or losses. The profits can be reinvested in the business or distributed among the stockholders as "dividends." Control and profit division is proportional to the stocks held. The person who has 51% of the stocks will have 51% of the dividends.

An S Corporation is a hybrid corporation that is treated like a partnership for many (but not all) tax purposes. It has virtually all of the features of a corporation, e.g., limited liability. The S corporation is treated like a partnership in that profits and losses typically are taxed directly to the individual shareholders, and it is their responsibility to report these gains or losses on their individual income tax returns.

S CORPORATION ELECTION

A corporation may elect not to be subject to the taxes imposed on regular corporations but rather pass its income, losses and deductions through to its shareholders. Qualifications of an S corporation must be met as of the first day of the first tax year of the corporation for which the election is to be effective. The election is valid only if all the shareholders in the corporation consent to the election. To qualify, a corporation must satisfy each of the following conditions:

  • Must be a domestic corporation
  • Must have no more than 75 shareholders
  • Each shareholder must be either an individual, an estate, or a specified type of trust.
  • No shareholder may be a corporation or a non-resident alien.
  • Can have only one class of stock. (However, different voting rights are allowable.)

If you qualify, you must file Election Form 2553 with the Internal Revenue Service. For further information, contact the nearest IRS office or call (800) 829-1040. if the company qualifies under the IRS requirements, then the Commonwealth of Massachusetts will recognize the company as an S corporation.

A CORPORATION? ISSUES TO CONSIDER

Limited Liability.If your business is a corporation, your liability is only limited to the amount of assets in your business (except in the case of a loan for which you offer your personal guaranty). Therefore, creditors and plaintiffs in lawsuits cannot make claims upon your personal assets.

Ease of Raising Capital and Transferability.Since owners of a corporation are liable only for the amount they invest, it is much easier to convince other people to invest in the business in exchange for a certain percentage of the profit. If one of the owners wants to pull out, all they have to do is find someone to buy their share of the business. If any one of the owners dies, his/her heirs inherit that share of the business. There is no interruption in the day-to-day operation of the business.

Ease of Separating Ownership from Management.The owners (or stockholders) of a corporation may decide they don't want to run the business themselves. They can hire a professional manager to run it. If they do not like the manager, they can call a board meeting and replace that person. The line between ownership and management can be clear-cut.

Taxes.The tax rates differ for corporations and other forms of business. An accountant can recommend how you can set up your business to get the most tax advantages.

Costs.It costs $200.00 to become incorporated. This does not include lawyers' or filing fees. There are additional costs in doing business because you will be subjected to some regulations that cover corporations and not other forms of business.

NOTE: Federal Corporate Income Taxes to Shareholders - If an S Corporation designation is elected and qualifies under the required time to make such an election, the corporation will not pay corporate income taxes on income. The shareholders will pay taxes on corporate profit even though it may not be distributed.

TO INCORPORATE OR NOT?

One of the myths about business is that corporations are big companies. Not necessarily true. The same person can be the president, treasurer, and clerk of the corporation. The only requirement in Massachusetts is that the person designated to be the clerk has to be a resident of the Commonwealth. The selection of the type of business is not irrevocable. Partnerships and proprietorships can usually be incorporated without tax incidence. (Regular corporations electing S corporation status or terminating corporate status and returning to partnership or proprietorship status involve substantially more complex planning. Neither of these steps should be undertaken without competent professional advice.) A corporation can elect S corporation status if it meets the eligibility requirements even after it has operated as a regular corporation for many years. Alternatively, an S corporation can terminate its special status at any time and, on a prospective basis, return to a regular corporation for tax purposes. The company will generally be required to wait five years before it can re-elect S corporation status.

LIMITED LIABILITY COMPANY AND PARTNERSHIP

Since January 1, 1996, two new types of business entities have been available in the Commonwealth: Limited Liability Companies and Limited Liability Partnerships.

A Limited Liability Company (LLC) is an unincorporated association which combines the advantage of limited liability for participants with the favorable tax treatment of a partnership. The participants, referred to as members, can participate in management control of the business without increasing their personal exposure beyond their contribution to the business.

Like corporations, LLCs are created by compliance with statute MGL c.156C, including filing a certificate of organization with the Secretary of State. The filing fee is $500. Once created, LLCs function in accordance with the terms of the operating agreement, a document comparable to a partnership agreement. LLCs must also file an annual report with the Secretary of State. This filing fee is also $500.

A limited liability partnership (LLP) is a partnership which, by registering with the Secretary of State, limits the personal liability of a partner for debts, obligations, and liabilities of the partnership, whether in tort, contract or otherwise from negligence, wrongful acts, errors or omissions, except that a partner cannot eliminate liability for his own negligence. The filing fee for registration is $500. LLPs must also file an annual report with the Secretary of State (also $500).