Starting a business with a partner? Awesome! You‘ve probably already discussed how to split income and what each person will bring to the table. Now, it’s time to tackle the next big step: figure out how to structure your business legally, what documents to sign, and what kind of a tax return to file.
And here’s where things can get a little tricky.
Many entrepreneurs come to us saying, “We need a multi member LLC,” or “we need a partnership. Or "we need a corporation.” They’ve got their business idea all planned out but feel totally lost when it comes to legal and tax details. If that sounds familiar, don’t worry! This blog will walk you through the basics. We will also give you suggestions on how to proceed with legal paperwork and accounting set up.
First, Let's Understand the Difference Between the Legal and Tax Aspects of Setting up a Business.
When people talk about business structures, they’re often mixing up legal and tax concepts. Legally, there are all sorts of state, contract and business laws to follow. But from the tax perspective, most small businesses with partners fall into one of two categories: Partnerships or S Corporations. Yep, it’s that simple. Only two options. Yes, my educated readers, there are also C-Corps, but those are usually popular with startups looking for investors and/or with intentions of going public, and we won’t be covering that topic here. This blog covers more simple situations along these lines: you and your friend want to start a joint business endeavor by sharing income and expenses.
Why so Much Confusion?
Lawyers and CPAs often speak different languages, and plain people researching things on the internet get confused. Lawyers can call your business a multi-member LLC, while your CPA might refer to it as a partnership—or even an S-Corp.
Suggested Approach.
Since I am a tax CPA, I would like to start with explanation of partnerships and S Corps. After that, you, the reader, can have an informed discussion with a business lawyer or proceed with legal paperwork yourself if funds are tight.
Let’s Start With the Two Available Tax Options: Partnerships and S Corporations.
The biggest difference between these two? Flexibility. In a partnership, you can be creative with how you split your income, losses, and even distributions. Want to take all the losses on your personal return this year? No problem. Want to make sure you’re first in line for distributions? That can be arranged too. As long as the rearrangement makes financial sense and there is no intent for tax evasion, the partnership has options.
S-Corps, on the other hand, are much more rigid. Income and expenses are divided strictly according to ownership percentages. Want to capture that business loss on your personal return because you worked all year while your partner went on multiple vacations? Sorry, can’t do that. Want to take money out of the S Corp and short-cut the partners? No, we can’t do that either. Everything has to be done proportionally to the shareholder ownership.
S Corps are also more complex and expensive in administration because they require payroll set up, which is an additional expense and time burden for the business owner.
Why So Many of Us Set up S-Corporations?
Well, S-Corps are beneficial as a legal tool to avoid self-employment taxes. The lower the reasonable salary of the owner, the more tax savings they get. You can read more about this topic here.
Is an S-Corp Always Necessary?
Not always. For example, if your partner has a full-time job through which they pay self-employment taxes, the S-Corp status may not be beneficial to them. Also, what if, in the first year, your business venture produces a loss? In this case, the S-Corporation status is also useless because the business loss can be taken regardless of the entity type as long as you materially participate in the business. No reason to create an S Corp just to recognize a tax loss.
Another key difference between an S-Corp and a Partnership is how the owner's basis is increased. The idea of basis is important because the basis allows you to take business losses on personal returns and also to withdraw money from the business without being taxed on these distributions. In S Corps, owners do not get basis for debt taken by their corporation, even if they personally guarantee it. For example, if an S Corporation takes an SBA loan and then the owners distribute this loan to themselves, they will have to pay taxes on this distribution because they didn’t have the basis. In partnerships, the same type of the SBA loan creates a basis and allows for a nontaxable distribution of the loan as long as partners personally guaranteed it.
Transfer of assets out of the S Corp often results in a taxable event, since asset withdrawals are considered a sale at fair market value at the time of withdrawal. However, in the case of a partnership, property distributions are generally tax-free.
S-Corporations also aren’t a good option if you're looking to raise money from investors who want more than just a standard stock or whoa are foreigners. If you create an S Corp with a non-resident, your S Corp election will become invalid. Or, if you offer an investor a different type of stock, the S Corp election will also be voided. If you want to learn more about S Corp requirements, you can read up on them here.
Now Let's Move to the Legal Side of It.
As we mentioned above, the tax structure determines your method of taxation. But you still need to think about liability protection, agreements between partners, your exit strategy, ect. All of this is a legal aspect of the business set up. And here’s the kicker: the same tax entity can be set up in different legal ways. For example, a partnership could be a general partnership, a limited partnership, or even a limited liability partnership. A partnership can also be a multi-member LLC. Things are even more confusing with S Corps: to be an S Corp at the tax level, the entity must first register on the state level as either an LLC or a corporation.
When talking to a business lawyer, it’s important to keep in mind your tax entity and make sure your governing business agreement does not contradict the IRS rules of your chosen tax entity.
For example, if you’re writing an operating agreement for a multi-member LLC taxed as a partnership, you can write down things like disproportionate allocations of profit and loss, capital accounts, and maybe even touch on the priority of distributions. However, if you mention the same terms in the operating agreement for an LLC that is meant to be taxed as an S Corp, these provisions may create a second type of stock and cause you to lose your S Corp status.
Pro Tip: If you go with an S-Corp election for an LLC, have your CPA review the operating agreement to make sure it follows S-Corp tax rules. This way you will ensure that your LLC operating agreement cannot void the S Corp status.
What’s the Right Way to Start a Business with a Partner?
Circumstances are different, but here’s a step-by-step general guide:
- Evaluate Your Tax Structure Options
Begin by understanding the taxation differences between partnerships and S corps ( I hope my post was helpful). - Seek Tax Guidance
Pay a CPA or EA for an hour of their time. Ask them about the bookkeeping process and how to deposit and withdraw funds from your bank accounts. If you like the professional, also make an appointment to bring in your paperwork for preparing your business tax return in the Spring. - Draft Governing Documents
Once you have a sense of your preferred tax structure, work with a business lawyer (or if funds are limited, find a template on the internet) to create your governing documents, which cover responsibilities, income allocations, distribution rules, and more. If you need a referral to a business lawyer, we will be happy to provide you with one. - Establish Your LLC or Corporation (if needed depending on your research).
Register your chosen structure (usually either an LLC or a Corp) with the state. A business lawyer can assist with this, or you can do it yourself if you are brave. Research what registered agents do and decide of you need to get one. - Obtain an EIN
Apply for an EIN for your business on the IRS website. It is done online and is a matter of minutes. If setting up an S Corp, also apply for a state ID. - Open a Business Bank Account
Use your EIN to establish a dedicated business bank account for your business. - Track Business Miles
If you use your vehicle for business-related errands, such as picking up supplies, start tracking your mileage right away. Many overlook this in the first year, yet it’s a valuable tax deduction. You can read on the subject of vehicle deductions for businesses here. - Record Out-of-Pocket Expenses
Keep track of any business expenses paid personally by you and not through your business joint account. You can use a simple Excel sheet for this, and your CPA will account for these deductions when filing your business taxes. - Learn Bookkeeping or Hire Someone
Familiarize yourself with a Profit & Loss (P&L) statement—there are many helpful tutorials on YouTube. Learn about accounting methods for small businesses (you can read about it here) and figure out how to set up your accounting system (your are welcome to read this blog on this topic) - Submit Your Your Accounting Files on Time to Your CPA. When tax time arrives, bring all your accounting paperwork to the tax professional you consulted in Step 1. Avoid procrastination, as tax professionals become very busy as the deadline approaches. Remember, partnership and S Corp returns are due on March 15th, so be prompt to avoid penalties.
And now a little bit of self promotion. If you need help to decide what's the best tax structure for multiple partners or need to know about best bookkeeping practices, please reach out. We've helped hundred of small business owners with their accounting and taxes questions. And you are also welcome can check out our services here.