I've been lurking for a few weeks, quietly gathering as much information about fermentation, making sauces, and cultivating hot peppers. I'd like to thank you all for your contributions. Since all I know about hot sauce is learned from this forum, I can't really contribute much to that discussion. However, I do know a little bit about business so I can contribute to the business subforum. I'm a CPA who's been servicing the small to mid market in Illinois for 8 years now. I've advised business owners who generate as little as $100,000 up to as much as $1 billion in sales in various industries on matters of tax and finance. I noticed that the question of entity selection seems to come up quite a bit in this subforum and I just wanted to provide some expert insight in a concise format for any would-be entrepreneurs. I will focus on the three major deciding factors when it comes to entity selection - Ease of setup/maintenance, personal liability, and income tax. For income taxes, I will limit the discussion to Federal taxes because all states have different tax laws and it'd be impossible to summarize them in a concise fashion. I won't discuss state registration, again because of all the different state rules. I also won't be going to go through all of the different forms of partnerships since some of them won't even be applicable. Instead, I will just describe the most common General Partnership for those who are interested in starting this venture with a friend, family member, or significant other.
Unregistered Sole-Proprietorship
Ownership: One owner (the "proprietor")
Ease of setup: Easiest, Aside from any food regulations, there are no legal formalities standing in your way to forming a sole-proprietorship. Simply start producing and selling your product to open the business. Dissolution is as simple as ceasing operations. Just know that even if you stop selling product, that doesn't mean your liability has ended. There are still bottles of product out there that you have sold and each one of them is a little risk to your personal assets.
Legal liability: Highest, In general all liability is directly on the owner which is okay for a small time startup. As operations start to grow, so will the risk of doing business and it will make sense to move to an entity that gives more personal liability protection to the owner like a corporation or an LLC.
Income Taxes: Moderate, income from sole proprietorships is subject to personal income tax rates, as well as what is known as Self-Employment (SE) Tax. SE Tax is an additional that is paid in lieu of social security and medicare taxes that W-2 employees pay through paycheck deductions. (Otherwise, if you didn't pay SE Tax, you wouldn't be contributing to SS/Medicare like W-2 employees) Some of you may not realize that W-2 employers match an employees withholding on that tax too. SE Tax is payment on both of these taxes and it is 15.3% of your profits. Sole-proprietorship may be the way to go when you are just starting out but if you ever plan on making real money, you will want to plan to reduce your SE Tax burden. At that point, a sole-proprietorship starts to become unfeasible from a tax standpoint. Sole-proprietors will report their income on a Schedule C with their annual Form 1040 filing.
Single Member LLC taxed as Sole-Proprietor
Ownership: One owner (member)
Ease of setup: Hard, The Company will have to be setup with IRS and registered as an LLC with the state. Depending on the state, there may varying fees and annual reports that will need to be filed to maintain the Company's legal status as an LLC. You will have to notify the state when you dissolve your business. Not the easiest thing to do for a burgeoning entreprenuer but not impossible either.
Legal liability: Moderate, Even though you've set up an entity to protect yourself from personal liability, you will find that you will have to give personal guarantees on the business too. For instance, no bank in their right mind would loan your single member LLC money without a personal guarantee. However, the LLC entity does provide better liability protection then that of a sole-proprietorship or partnership.
Income Taxes: Moderate, Substantially similar situation as an unregistered sole-proprietorship. You will also likely have annual franchise fees or registration fees to pay with your LLC.
General Partnership
Ownership: Two or more (partners)
Ease of setup: Moderate, You can start a partnership without registering with the state but you will need to file with the IRS to get an EIN to set up your partnership. This can be done pretty quickly on the IRS website without any help from a professional. Best practice would be to form a partnership agreement with your partners that outlines the terms of the partnership. You can negotiate the terms of your agreement without an attorney, but you should probably hire an attorney to help with formation of the agreement.
Legal liability: High, Just like the sole proprietorship, all partners are personally liable for their equitable share of the partnership.
Income Taxes: Moderate, This is similar to a sole proprietorship in that income is taxed at personal rates and partners will be liable for SE tax on the profits. However, the partnership will have to file it's own tax return every year - a Form 1065. The 1065 calculates each partner's share of the partnership's income. Filing a 1065 will probably require you to hire a CPA. Because of the high liability to owners and nearly no tax benefit versus the S-Corp, entities with multiple owners are organizing as a partnership less and less.
Corporation (AKA "C-Corp")
Ownership: One or more (shareholders or members if LLC elected to be taxed as Corporation)
Ease of setup: Hard, Depending on if you are doing a straight incorporation or setting up an LLC to be taxed as a corporation, the process will be similar. You'll have to get an EIN from the IRS and register with your state as a corporation or LLC. You may also want to consult with an attorney to set up your corporate By-Laws, which are basically the guidelines under which the corporation will operate.
Legal liability: Lowest, In general, Corporations can effectively shield their shareholders from personal liability of the corporation's actions. For example, if you were a shareholder of Google, and Google got sued by Microsoft, the plaintiffs wouldn't come after you, the shareholder, would they?. No, they wouldn't. The same basic concept applies. However, small business owners will still have to make personal guarantees on things like loans. That concept is consistent throughout.
Income Taxes: Highest, Corporate tax rates in the US are higher than personal tax rates. There are two ways that a shareholder can pull their money from a corporation: through a W-2 paycheck (which is subject to social security and medicare taxes, as well as personal income tax) or through a dividend that is taxed on earnings that have already been taxed (known as "double taxation"). Because corporate taxes are so high and dividends are subject to "double taxation", C-Corps are really only advised when they are necessary (in general, when you have over 100 shareholders or have a publicly traded company). C-Corporations will annually file a Form 1120. This entity type is usually for larger companies. Publicly traded companies will be C-Corps.
Corporation electing Sub S status (AKA an "S-Corp")
Ownership: One or more, no more than 100 owners (shareholders or members if LLC is taxed as corporation and elected S)
Ease of setup: Hardest, Setting up this entity type is the same process as setting up a corporation. In addition, this type of entity will have to file an S-Election with the IRS to declare the intention to be an S-Corp.
Legal liability: Lower, The shareholders in an S-Corporations will have insulation like a corporation. However, since these entities are inherently smaller than a corporation, primary shareholders will often have to make personal guarantees but it is possible for shareholders to shield themselves from liability similar to a C-Corp.
Income Taxes: Lowest, Income is taxed as personal tax rates of the shareholders and earnings are not subject to SE tax. However, owners who are substantially involved in operations will need to pay themselves as an employee of the Company. There have been many tax cases recently where the IRS has disputed with S-Corp owners about "reasonable compensation" for their services to the company. Owners were paying themselves low salaries so that most of the income from the Company could avoid SE Tax. Because there is opportunity to earn income that is not subject to SE tax, this entity is still the most tax favorable for small business owners from a Federal tax standpoint. S-Corps will file a Form 1120-S, which is similar to the partnership's Form 1065 in that it calculates each shareholder's share of the company's income.
With all of that said, I'm not sure if I should give any true advice here. I will say that the smallest start-ups with simple dreams of turning their hobby into a weekend business might want to stick with an easy to manage Sole-Proprietor entity. However, if you plan on operating a legitimate business with employees with sales in multiple states, it may be wise to form an LLC or Corporation and elect to be taxed as an S-Corp. Hope this helps some of you as much as you've helped me.
Unregistered Sole-Proprietorship
Ownership: One owner (the "proprietor")
Ease of setup: Easiest, Aside from any food regulations, there are no legal formalities standing in your way to forming a sole-proprietorship. Simply start producing and selling your product to open the business. Dissolution is as simple as ceasing operations. Just know that even if you stop selling product, that doesn't mean your liability has ended. There are still bottles of product out there that you have sold and each one of them is a little risk to your personal assets.
Legal liability: Highest, In general all liability is directly on the owner which is okay for a small time startup. As operations start to grow, so will the risk of doing business and it will make sense to move to an entity that gives more personal liability protection to the owner like a corporation or an LLC.
Income Taxes: Moderate, income from sole proprietorships is subject to personal income tax rates, as well as what is known as Self-Employment (SE) Tax. SE Tax is an additional that is paid in lieu of social security and medicare taxes that W-2 employees pay through paycheck deductions. (Otherwise, if you didn't pay SE Tax, you wouldn't be contributing to SS/Medicare like W-2 employees) Some of you may not realize that W-2 employers match an employees withholding on that tax too. SE Tax is payment on both of these taxes and it is 15.3% of your profits. Sole-proprietorship may be the way to go when you are just starting out but if you ever plan on making real money, you will want to plan to reduce your SE Tax burden. At that point, a sole-proprietorship starts to become unfeasible from a tax standpoint. Sole-proprietors will report their income on a Schedule C with their annual Form 1040 filing.
Single Member LLC taxed as Sole-Proprietor
Ownership: One owner (member)
Ease of setup: Hard, The Company will have to be setup with IRS and registered as an LLC with the state. Depending on the state, there may varying fees and annual reports that will need to be filed to maintain the Company's legal status as an LLC. You will have to notify the state when you dissolve your business. Not the easiest thing to do for a burgeoning entreprenuer but not impossible either.
Legal liability: Moderate, Even though you've set up an entity to protect yourself from personal liability, you will find that you will have to give personal guarantees on the business too. For instance, no bank in their right mind would loan your single member LLC money without a personal guarantee. However, the LLC entity does provide better liability protection then that of a sole-proprietorship or partnership.
Income Taxes: Moderate, Substantially similar situation as an unregistered sole-proprietorship. You will also likely have annual franchise fees or registration fees to pay with your LLC.
General Partnership
Ownership: Two or more (partners)
Ease of setup: Moderate, You can start a partnership without registering with the state but you will need to file with the IRS to get an EIN to set up your partnership. This can be done pretty quickly on the IRS website without any help from a professional. Best practice would be to form a partnership agreement with your partners that outlines the terms of the partnership. You can negotiate the terms of your agreement without an attorney, but you should probably hire an attorney to help with formation of the agreement.
Legal liability: High, Just like the sole proprietorship, all partners are personally liable for their equitable share of the partnership.
Income Taxes: Moderate, This is similar to a sole proprietorship in that income is taxed at personal rates and partners will be liable for SE tax on the profits. However, the partnership will have to file it's own tax return every year - a Form 1065. The 1065 calculates each partner's share of the partnership's income. Filing a 1065 will probably require you to hire a CPA. Because of the high liability to owners and nearly no tax benefit versus the S-Corp, entities with multiple owners are organizing as a partnership less and less.
Corporation (AKA "C-Corp")
Ownership: One or more (shareholders or members if LLC elected to be taxed as Corporation)
Ease of setup: Hard, Depending on if you are doing a straight incorporation or setting up an LLC to be taxed as a corporation, the process will be similar. You'll have to get an EIN from the IRS and register with your state as a corporation or LLC. You may also want to consult with an attorney to set up your corporate By-Laws, which are basically the guidelines under which the corporation will operate.
Legal liability: Lowest, In general, Corporations can effectively shield their shareholders from personal liability of the corporation's actions. For example, if you were a shareholder of Google, and Google got sued by Microsoft, the plaintiffs wouldn't come after you, the shareholder, would they?. No, they wouldn't. The same basic concept applies. However, small business owners will still have to make personal guarantees on things like loans. That concept is consistent throughout.
Income Taxes: Highest, Corporate tax rates in the US are higher than personal tax rates. There are two ways that a shareholder can pull their money from a corporation: through a W-2 paycheck (which is subject to social security and medicare taxes, as well as personal income tax) or through a dividend that is taxed on earnings that have already been taxed (known as "double taxation"). Because corporate taxes are so high and dividends are subject to "double taxation", C-Corps are really only advised when they are necessary (in general, when you have over 100 shareholders or have a publicly traded company). C-Corporations will annually file a Form 1120. This entity type is usually for larger companies. Publicly traded companies will be C-Corps.
Corporation electing Sub S status (AKA an "S-Corp")
Ownership: One or more, no more than 100 owners (shareholders or members if LLC is taxed as corporation and elected S)
Ease of setup: Hardest, Setting up this entity type is the same process as setting up a corporation. In addition, this type of entity will have to file an S-Election with the IRS to declare the intention to be an S-Corp.
Legal liability: Lower, The shareholders in an S-Corporations will have insulation like a corporation. However, since these entities are inherently smaller than a corporation, primary shareholders will often have to make personal guarantees but it is possible for shareholders to shield themselves from liability similar to a C-Corp.
Income Taxes: Lowest, Income is taxed as personal tax rates of the shareholders and earnings are not subject to SE tax. However, owners who are substantially involved in operations will need to pay themselves as an employee of the Company. There have been many tax cases recently where the IRS has disputed with S-Corp owners about "reasonable compensation" for their services to the company. Owners were paying themselves low salaries so that most of the income from the Company could avoid SE Tax. Because there is opportunity to earn income that is not subject to SE tax, this entity is still the most tax favorable for small business owners from a Federal tax standpoint. S-Corps will file a Form 1120-S, which is similar to the partnership's Form 1065 in that it calculates each shareholder's share of the company's income.
With all of that said, I'm not sure if I should give any true advice here. I will say that the smallest start-ups with simple dreams of turning their hobby into a weekend business might want to stick with an easy to manage Sole-Proprietor entity. However, if you plan on operating a legitimate business with employees with sales in multiple states, it may be wise to form an LLC or Corporation and elect to be taxed as an S-Corp. Hope this helps some of you as much as you've helped me.
