Lesson 5: Business Structures
What You’ll Learn: Choosing the right business structure is one of the most important decisions you can make as you start a business, since it affects your tax liabilities, legal exposure, and potentially, your personal assets. Don’t worry, it’s not as complex as it seems and we’ll take you through the options along with the advantages and disadvantages of each.
Business Structures (continued)
Sole Proprietorships
This is the simplest structure, and in Washington State, the least frequently used since you and the company are one. The income and expenses of the business are reported on your personal income tax filings (Form 1040). The profits and losses from the company are reported on Schedule C, which you file with the 1040. You also need to file Schedule SE which reports how much you owe in self-employment taxes. These taxes need to be paid quarterly to the IRS. Basically, you pay a quarter of your estimated tax every three months. There is some art to getting the estimated payments correct. If you’re under, you may owe a penalty for underpayment.
There are some disadvantages with this structure. First, you may be personally liable for your company’s liabilities, such as a lawsuit or a workplace accident due to negligence. Your assets – cars, real estate, etc. – are at risk. Raising money as your business grows can also be problematic as your business and you are one. If you have poor credit or a less than optimal credit-to-debt ratio, you may find it hard to get a loan.
Partnerships
If your business will have several owners, you’ll want to consider creating a partnership. These come in two varieties: general partnerships and limited partnerships.
In a general partnership, the partners manage the company and assume the responsibility for the debts and obligations according to the percentage of ownership outlined in the partnership agreement. If you have a business where there are both active owners and individuals who are investors only and have no control over the company, you may want to form a limited partnership instead, which provides specific protections to the investors in terms of liability.
One of the major tax advantages with a partnership is that taxes aren’t paid by the business. Profits and losses are passed through to the partners on their individual tax returns. Taxes are reported on the Schedule K-1 form, which indicates his or her share of partnership income, applicable deductions and tax credits. A separate form, Form 1065, is used to compute income.
There are a couple of drawbacks to a partnership. First, the partners are liable for all obligations and debts as a percent of ownership as articulated in the partnership agreement. In addition, each individual partner can act on behalf of others in the partnership, including making business decisions and taking out loans.
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It’s highly recommended that you consult with an attorney about a partnership agreement. Before you do, consider these questions.
- What is each partner’s investment level? This could be in the form of cash investment or energy and expertise. It can also include the equipment that each partner is bringing with them into the new endeavor.
- What are the responsibilities and duties of each partner? Be as specific as you can. Detail is important here since any ambiguity can become points of contention down the road.
- How will disagreements be handled? How will you resolve situations where there is a deadlock and a decision must me made? And yes, a coin flip has ended up in more than one partnership agreement.
- If a partner becomes disabled, how will the share of profits or losses be shared? To address this, you may want to discuss and agree upon life insurance for each partner.
- How will outside partnerships be handled? Can a partner have an interest in a business that is or may become a competitor?
- How is the partnership ended or altered? Detail the process for dissolving the partnership or what a buyout agreement would look like, which may include a non-compete clause. You will also want to address the transfer of ownership to another party and the framework for transferring ownership.
- How will any cash infusions be handled? If the company needs capital, will the partners be expected to put the money in, and if so, how will it be apportioned?
A well-crafted partnership agreement will ensure that you adhere to the same vision for the company.