How are you treating your home-based business?

After last week's discussion, you should now be able to watch for signs as to how the IRS could very well reassign your business as a hobby rather than a home-based business. And, as a hobby you cannot take advantage of some excellent home business tax deductions. Ouch! So, make sure you know how you're operating.

Now that you've decided where you're going with your home-based business, let's talk about your decision of what legal form to select to operate your business.

Hey, no tomato throwing here. I know, I know, this sounds awfully boring. Confession... I think it is too. But, it's just one of those things that you have to decide, like it or not. If you don't decide, the IRS will decide for you.

Besides which, with a little knowledge under your belt, you may decide to consider changing legal business forms to accommodate your growing structure or to take advantage of certain advantages one offers over another. After all, there's no law that says you can't change your mind midway.

I've hinted at significant tax consequences from your choice of business form, but just as important is to weigh the non-tax issues. What type of business form will best help you operate and grow your business? What form, at your death, will make it easier to pass your business along to your heirs?

I'll answer these and more.

There are basically four different legal business forms under which you can run your home-based business:

1) a sole proprietorship
2) a partnership
3) a limited liability company
4) a corporation

Each carries its own pros and cons. There is no rule that says you have to operate under one rule or the other. It is simply your choice.

Let's talk briefly about each. I don't profess to be an expert. However.... hint: we will have an exciting announcement coming soon of someone who will be joining our staff and who will be available to answer all your legal/tax questions. His is a name many will recognize.

SOLE PROPRIETORSHIP

The easiest and least expensive way to begin a home-based business, as a sole proprietorship, you simply decide to begin operating. That's it. When you have to declare yourself as a sole proprietorship is when you pay taxes.

A sole proprietorship can be defined as any unincorporated business with a single owner. A sole proprietorship is the most commonly used form for new home-based businesses. And, unless you incorporate under state law, the IRS will assume you are a sole proprietorship if your business essentially has only one owner.

Under this business form, the IRS treats all of the business' assets and liabilities as belonging to the you, not the business. Anything generated from your business must be included as part of your annual individual tax return. Income and expenses from your business will also need to be reported on Schedule C (Profit or Loss from Business) or Schedule C-EZ (Net Profit from Business). Figures from these forms are carried directly over to your 1040, then you pay taxes on your individual income tax schedule. Sole proprietors are also generally required to pay self-employment taxes on all of their business' net profits. Schedules C and C-EZ will help you compute this. Other than this, there is no separate tax rate schedule for a sole proprietorship.

The main advantages are simplicity and control. Accounting and tax rules are easy to understand and use. Also, since your business is essentially seen as you, you may transfer money in or out of your business with no tax effects or special accounting. You don't have to issue yourself a paycheck or withdraw payroll tax deductions. To pay yourself, you simply withdraw the money. Similarly, if you want to add some personal money to your business, you simply add it to your checking account.

As a sole proprietor, you are not shielded from personally being responsible, and you could essentially lose everything. Personal liability allows creditors of your business to go after your personal assets if the business assets are not sufficient. Likewise, your personal creditors can go after your business assets to satisfy your personal debts. If you ever need capital to grow your business, it will be difficult to find as a sole proprietorship.

PARTNERSHIP

Like a sole proprietorship, a partnership is also unincorporated. The difference is that it has two or more owners. As with a sole proprietorship, unless you incorporate under your state laws, the IRS will consider you a partnership if there is more than one owner of your business. An additional owner can be anything from your spouse, to your neighbor down the street, to someone you work with virtually over the Internet — anyone who also owns your business with you.

Income from the partnership is taxed to the individual partners, and there is no separate tax rate schedule.

However, as a partnership, you are required to file a tax Form 1065 (U.S. Partnership Return of Income) to report income and loss to the IRS. It allows you to report each partner's share of income and loss. Income is reported as distributed to each partner, and they in turn are taxed on their individual tax returns. Whether or not you actually received your shares of income or whether you agreed to retain the money in the business for capital, each must still report their income.

Income and losses can be distributed to each of the partners as any percentage, i.e one partner receives 40% of profits but 60% of losses. This can be done as long as you can prove a business purpose and that you are not doing this for tax avoidance. During the normal first years of losses of a new business, a partnership allows partners to use these losses to offset other income from another job or other investments. Note: you may not deduct losses that exceed the amount of your investment in the business.

Like a sole proprietorship, you are not protected personally against lawsuits against your business. Additionally, in a partnership, choices affecting how income is computed must be made by both partners, i.e. accounting methods, methods of depreciation, etc. Make sure you really like and get along well with your partner.

LIMITED LIABILITY COMPANY

A relatively new legal business form, a limited liability company (LLC) can be described as somewhat of a mix between a corporation and a partnership that is created under state law. Incorporated, but conveniently treated as a partnership for tax purposes.

Many home-based business owners are intimidated by incorporating. It's really not that bad. You just need to know what to file and then keep a schedule of required meetings. I'll discuss this more in a later article. Basically, to form an LLC, articles of organization must be filed with the secretary of state's office. Some areas also require that an operating agreement be filed.

For federal tax purposes, an LLC is treated identically to a partnership and it must also file a Form 1065. There are single-owner LLC's. As far as tax forms, they are treated like a sole proprietorship.

What's the difference, then, between a partnership or sole proprietorship and an LLC? Under individual state laws, LLC owners are given protection from liability that was previously reserved only for corporations.

You may choose to be treated as a partnership or as a corporation for tax federal purposes (not always so for state taxes). As such, you are allowed to make disproportionate distributions to owners (remember the 40%/60% example above?). You also have limited liability if your business is involved in a lawsuit. LLC's enjoy flexible membership. Members can b individuals, partnerships, trusts, or corporations, and there is no limit on the number of members.

Some states do not allow LLC's to only be one member (yourself), although far more will. An LLC usually costs more to form and maintain than a sole proprietorship or a general partnership. States may also charge an initial formation fee and an annual fee.

A Note About S Corporations:

An S corporation is really just an extension of an LLC. The difference? S corporations must generally make all income and loss distributions pro-rata in accordance with the number of shares held by each owner (no 40%/60%). Furthermore, an LLC can have an unlimited number of investors, whereas an S corporation is limited to 75 shareholders. For our small, home-based businesses, this would most likely not be an issue. Remember, you can always change your business form as your business grows.

CORPORATIONS

If your business is taking off and you foresee a bright future, you may want to consider this option. This may be an option you consider down the road as your business grows.

The main difference taxwise between a corporation and a partnership is that a corporation (business) is generally subject to income tax law. The business is organized in such a way so that business is treated as a separate entity from any owners.

From a tax perspective, there are two options for corporations under federal income tax law:

1) C Corporations - "regular" corporations subject to corporate income tax
2) S Corporations - not subject to corporate income tax under special filing with the IRS - treated somewhat similarly to partnerships for tax purposes (see above)

This is a must if you are in a position as your business grows to have a business lawsuit. Also, as a corporation, you are better able to receive venture capital. As a separate legal entity, the corporation is liable for its own debts and can only be held liable to the extent of the corporation's assets. The corporation can also retain its earnings for future investment. Furthermore, because the corporation has a perpetual life, this puts you in a better position to pass the business down to your children or other successors upon death or retirement.

A corporation must follow certain formalities (meetings, structure, accounting) as dictated by the state. If you do not follow these formalities, you will lose your incorporated status. Tax procedures are more complicated i.e. filing requirements. Corporations can be more expensive, i.e. annual filing fees, accounting, tax preparation, etc.

Well, have you had enough with this? This is only meant to provide a basis to begin. You really should check out as many sources as possible in deciding which direction to go, and you may need to talk with an accountant and/or attorney.

Depending on what you're trying to accomplish, don't overwhelm yourself with this. You may wish to start as a simple sole proprietorship, learn all you can, and then go from there.

There is so much to learn when you are self-employed. I suggest you take baby steps... one step at a time.

You'll have to hurry on this one if you want to save on books at Borders. I found this offer the other night while browsing at a Borders store:

Simply register for Border's email newsletter (only two issues per month) by February 15th, and receive a $5 gift certificate good towards any book, music and video items in stock at Borders.com.

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