Over the past 3 weeks, I’ve had a bunch of clients call me up to discuss setting up new businesses.  Obviously, hope is returning after six months of quarantined life.

But, the question is what sort of entity will be used?  Since two of these folks were seniors- with well off children- choosing a C corporation wouldn’t make a lot of sense.  Because there would be a 21% tax on the profits- and then a 35% tax on the dividends they took from the business.

An S corporation could make sense, where the profits flow to the principals untaxed- except these folks don’t want to list their names as the principals on the Virginia database.  Which means an LLC (and for a few others, an unincorporated business may make sense- to them, not to me).

If just one person is starting a business, why would s/he choose to be a sole proprietorship (unincorporated business) or an LLC?  (Two or more folks starting a business need a partnership, LLC, or corporate vehicle.)

Sole Proprietorship

A sole proprietorship means that you are the business and the business is you- there is no separation of assets or liabilities between the business and the proprietor.  So, if something goes wrong- all debts and obligations flow directly to the proprietor.   But, it’s easy to start a proprietorship- no real paperwork, no upfront costs (other than perhaps securing the name), and, as long as no one is owed any money, one can close the business if it doesn’t work out the way one hoped.

The only special tax forms one needs to report business income and losses are Schedule C (part of the 1040), and Schedule SE (employer taxes on the net profits also part of the 1040).   Of course, if one is selling goods, then sales taxes must be collected, reported, and transmitted to the state authorities.

But, if you are going to need capital- then you are going to have to get a personal loan from the bank.  Proprietorships aren’t offered loans- just the principals.  And, that obligation- plus any debts or damages- are always owed by the proprietor, not the business.

And, if you want to bring in a partner- then the structure must change.  Because two people can’t share a proprietorship.  (Spouses can establish a ‘qualified joint venture’, which simply means each has to file Schedules C and SE, splitting revenue and expenses equally.)  The business would then become a partnership- the entity requires a partnership agreement- and both partners would be personally liable for the business.

We also advise Sole Proprietorships to register their name with the local county/city; that business name is referred to as a ‘DBA’ [doing business as].   (Virginia also expects that registration to be with the Commonwealth; other states may have similar regulations.)

Why an LLC?

That liability is why many folks opt to form an LLC.  This business entity is a state-registered business- and that vehicle shelters the owner(s) from liabilities. But, the LLC MUST have its own banking relationships- it is illegal to commingle the moneys of the LLC and the individual member.  (If that is not true, then there is no sheltering of liabilities.)  If there is only one member, the IRS terms this business a disregarded entity- no business tax forms are required to report the operations; the owner simply reports the revenue and expenses on Schedule C, just as if it were a proprietorship.  But, for legal purposes, the business is not you and you are not the business (as would be true for a sole proprietorship).

A sole member should realize that an LLC is more expensive to set up and operate than the proprietorship.  There are state annual fees, the costs for preparing Forms 1065 and K-1, among other costs.  And, if one uses a professional registered agent, the only public information about the member-owners of the entity will be the name of the registered agent.  (Corporations must divulge the names of their officers and directors.)

(Please note that the solo member- or a group of members- of the LLC can petition the IRS to be considered as a C corporation or an S pass-through corporation.)

While banks are comfortable loaning moneys to LLC’s, the members should realize that comfort comes with long-term history for the entity, not with an entity that was formed yesterday.

The LLC’s file separate business tax forms from the members.  Form 1065 covering the revenue and expenses is filed- with each member receiving a K-1 detailing his or her portion of the net profits or losses from the business.

Single-Member LLC (disregarded entity) and Sole Proprietorships

While not a requirement, we advise all proprietorships to obtain a Federal Employer Identification Number.  That number will be used by the banks for your business accounts- and will afford the business to hire employees (without making them your PERSONAL employees).

Both vehicles (sole proprietorships and disregarded LLC’s)  file the same tax forms- Schedule C and SE.  The net income is taxable, whether the income remains in the business bank account or not.  Both have the same deductions- and both must report the costs of their health insurance on their personal taxes, since health insurance is not deductible to the business entities.

And, again, once the LLC is formed (which costs money), personal liability for the business entity ceases.  (Again, as long as separate bank accounts are maintained for the business and the solo member.)  That small fee is cheap insurance to protect one’s assets, should the business develop a liability.  (Of course, if one is young, has no home or vehicle, then there are not many assets- other than one’s bank and equity accounts- that can be attached to cover business liabilities.)

Tomorrow, we’ll discuss why your LLC needs an operating agreement.  (Sole proprietorships have no such need for formal documentation.)