Starting a business is both an exciting and nerve-racking time.
Exciting due to the prospects of success and possible financial security and freedom. Nerve-racking because there are so many questions about how to get started, what kind of business entity is best, and how to deal with the big “T” — Taxes.
In this post, we’ll look at the most common entities for a new small business; sole proprietorships, and partnerships, with the intent of helping you determine which would work best for you in your personal situation.
A sole proprietorship is a business owned and operated by a single person. While a sole proprietorship can hire employees, contractors, and even partner with other businesses to make money, the legal responsibility for business activities — and taxes — lies with a single person. The business itself is a “pass-through” entity. Operating profits and expenses are treated as though they are the direct activities of the owner for tax and liability purposes. A sole proprietor reports business activity on Schedule C of IRS Form 1040 each year and must pay self-employment tax (FICA and Medicare) in addition to regular income tax. The owner of a sole proprietorship is legally responsible for all debts and obligations the business takes on: For example, creditors can seize personal assets if the business defaults on a loan.
If you do business with another person, you are by definition a partnership. This structure is a general partnership — essentially the same as a sole proprietorship — unless the partners sign a legal limited liability partnership agreement (LLP). An LLP has at least one general partner and one limited partner. The general partner is like a sole proprietor — he or she has full control over business activities and may be held liable for business obligations. The limited partner is a silent partner, someone who provides financial backing without a say in the business. He or she is entitled to a portion of the business profits but enjoys limited responsibility for business obligations.
A Limited Partnership may be ideal for a married couple. If a spouse is a limited partner, their share of the income is excluded from FICA or Medicare taxes; however, both of you would still qualify for the 20% pass-through deduction enacted in the new 2018 tax law. In this arrangement, the limited partner DOES NOT participate in the operations or decisions of or for the business. The spouse is simply considered an investor in the company.
Your structure choice really depends on your long-term goals and the involvement of each partner. LLPs are beneficial if one partner is operating solely as financial support for the venture. If, however, you and a business partner are sharing equally in both decision-making and business obligations, a general partnership may be all you need. If the partners are working together on a temporary basis, it may be best if each person remains a sole proprietor without a formal partnership.
The options discussed here are simply that; options. If at some point in time you feel there are advantages to changing your business entity you can do so. As with anything related to your business and important business decisions, you should contact a legal or tax professional to help you make the best decision for your situation.