Starting a family business is a wonderful way to build a legacy that can last for generations. You’ll want to protect and nurture the business so that it can grow into a company that the whole family can be proud of, so it’s important to make the right decisions both before and after you launch.
One of those decisions is the type of business entity to form. You have several options, which we’ll detail here so that you can make the best choice for you and your family.
One option is simply to run the business as a sole proprietorship, with one family member as the sole owner and other family members as employees of the business. The advantage of doing this is simplicity. No business registration with the state is required, although you may need various business licenses and permits depending on the type of business.
In a sole proprietorship, the owner and the business are considered the same entity, so profits are reported on the owner’s personal tax returns. The business itself is not taxed.
However, because the owner and the business are one and the same, the owner is personally liable for the debts and obligations of the business. If you are the owner, that means that your personal assets are at risk if the business is sued.
If multiple family members are going to have ownership in the business, you could operate as a general partnership. Again, no business registration with the state is required, and the business itself is not taxed. Profits pass through to the owners based on their ownership percentages to be reported on their personal tax returns. However, you will have to file Form 1065, the U.S. Return of Partnership Income, but it’s for information purposes only.
While no registration is required for a general partnership, you should draft a partnership agreement that defines the ownership of the business, the roles and responsibilities of the partners, and more. Even though it’s a family business, it’s important to have these things in writing to protect everyone.
But again, like a sole proprietorship, the owners and the business are considered one and the same, so all owners are personally liable for the obligations of the business.
A more popular choice for family businesses is a limited liability company (LLC). An LLC is a separate entity from its owners, who are called members, so it has its own obligations, meaning that the members are not personally liable for those obligations.
However, like sole proprietorships and partnerships, an LLC is considered a pass-through entity, meaning that profits pass through to the members to be reported on their personal tax returns. The LLC is not taxed. But if the LLC has more than one member, it must file Form 1065 for informational purposes, just like a general partnership.
An LLC is formed by filing articles of organization with the state, which you can usually do online. Fees to file range from $40 to $500 depending on the state.
You should do some research to find out everything about LLCs in your state.
Forming a corporation is also an option and offers personal liability protection, but a corporation is more complex than an LLC. When you form a corporation with your state, you must have corporate bylaws drafted. A corporation must also have a board of directors and appointed officers of the company. Each state has different rules regarding corporation requirements.
A corporation is also a taxable entity, subject to corporate taxes. Dividends paid to owners, who are called shareholders, are also taxed. This means that some of the company’s profits are taxed twice, which is referred to as double taxation.
However, a corporation does have one tax advantage over an LLC. LLC members must pay self-employment taxes on all profits of the business. In a corporation, shareholders who are actively involved in the business are paid a salary, which is subject to employment taxes. But any dividends paid to shareholders after their salaries are paid are not subject to self-employment taxes.
It sounds complicated – and it is! Usually, the benefits of a corporation come into play when the business reaches a certain level of profit. When that point occurs is best determined with the help of a tax advisor.
Now, here’s a caveat. If you form an LLC, but at some point, you reach the level when corporate status makes financial sense, you can elect to have your LLC taxed as a corporation, either an S Corp or a C Corp. Again, consulting your tax advisor about the best option is advised.
Sole proprietorships and partnerships have the advantage of simplicity. They are not registered with the state, have no reporting requirements, and taxes are straightforward. However, they do not offer personal liability protection.
Many business owners instead choose an LLC because you get the best of two worlds – the personal liability protection of a corporation and the pass-through taxation of a sole proprietorship or partnership.
And, if it ever becomes financially beneficial, you can elect corporate tax status.
However, if you plan to raise capital from professional investors, a corporation may be a better choice. The ownership of a corporation, which is in the form of shares, can be easily transferred to investors in exchange for capital. Transferring the ownership of an LLC is not as straightforward, which makes corporations more attractive to investors.
Related reading: 4 Mistakes Young Entrepreneurs Should Avoid
Choosing the right business entity for your family business is important, so if you’re in doubt, seek the advice of a business attorney and a tax advisor. They can help you to make the decision that’s right for your family. Then you can focus on launching your business and building your legacy!
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