Choosing the Best Organization for Your Business
What is the best entity for operating your tennis facility or shop? For tax purposes, the predominant forms of business enterprise are the regular, so-called “C” corporation; its pass-through small-business cousin, the “S” corporation; a partnership; a limited-liability company (LLC); or a sole proprietorship.
To choose among those entities is to choose among significant differences in federal income tax treatment. Although many of the tax law’s provisions apply to all entities, some areas of the law are specifically targeted for each type of business organization.
Unfortunately, there is more to choosing the right structure for a tennis business than just tax considerations. Not only will the decision have an impact on how much is paid in taxes, but also it will affect the personal liability faced by the principals, the operation’s ability to raise money, and the amount of paperwork required.
The tax question
Of all business entities, the C or regular corporation is subject to the toughest tax bite. The earnings of an incorporated tennis shop or facility are taxed twice. First a corporate income tax is imposed on the tennis operation’s net earnings and then, after the earnings are distributed to shareholders as dividends, each shareholder must pay taxes separately on his or her share of the dividends.
Naturally, a corporation can reduce, or even eliminate, its federal income tax liability by distributing its income as salary to shareholder-employees who actually perform valuable services for the corporation. Although this can reduce taxation at the corporate level, those who receive profits from a corporation in exchange for services must pay tax on the amount received, which is treated as salary. Fortunately, there is some relief available to individual shareholders who currently benefit from the new, lower tax rate on dividends.
This scheme of taxation differs radically from that applied to S corporations, partnerships, LLCs, and sole proprietorships. These entities, often referred to as “pass-through” entities, do not pay an entity-level tax on their earnings. Only the owners of these entities are taxed on their share of the business’s earnings.
Going it alone
The easiest structure is the sole proprietorship, which usually involves just one individual who owns and operates the retail business or facility. The tax aspects of a sole proprietorship are especially appealing because income and expenses from the business are included on the sole proprietor’s personal income tax return.
Of course, as a sole proprietor, a retail shop or facility owner must also file Schedule SE with Form 1040, which is used to calculate how much self-employment tax is owed. And don’t forget that quarterly payments of estimated taxes are due from self-employed tennis professionals and business owners.
Naturally, there are a few disadvantages. Selecting the sole proprietorship structure means that the owner or proprietor is solely responsible for the operation’s liabilities. As a result, a sole proprietor places his or her own assets at risk, subject to seizure to satisfy a business debt or legal claim.
If the tennis business will be owned and operated by several individuals, take a close look at partnerships. Partnerships come in two varieties: general and limited. In a general partnership, the partners manage the business and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners.
In a limited partnership, the general partner owns and operates the business and assumes liability for the partnership, while the limited partners serve as investors only; they have no control over the operation and are not subject to the same liabilities as the general partners. Obviously, unless many passive investors are involved, limited partnerships are not the best structure to use.
One of the major advantages of a partnership is the tax treatment it enjoys. A partnership does not pay tax on its income but “passes through” all profits or losses to the individual partners. Each partner is required to report profits from the partnership on his or her individual tax return. Even though the partnership pays no income tax, it must complete and file a parternship informational return, Form 1065.
Personal liability is a major concern for many facility owners, especially those employing a general partnership. Similar to a sole proprietorship, general partners are personally liable for the partnership’s obligations and debt. Partnerships are also more expensive to establish than sole proprietorships because they require more extensive legal and accounting services.
Incorporating the business
Using the corporate structure for a tennis operation is, as mentioned, more complex and expensive than for other types of business entities. The resulting corporation, however, is an independent legal entity, separate from its owners. As such, the corporation must comply with more regulations and tax requirements.
The biggest benefit for the owner of an incorporated business is the liability protection he or she receives. Although the courts are increasingly “reaching behind” the corporate structure, for the most part, a corporation’s debt is not considered to be that of its owners.
Another plus is the ability of a corporation to raise money. A corporation can sell stock, either common or preferred, to raise funds. Corporations also continue indefinitely, even if one of the shareholders dies, sells his or her shares, or becomes disabled.
The corporate structure also comes with a number of downsides. A major one is higher costs. Corporations are formed under the laws of each state with their own set of regulations. A corporation must also follow a more complex set of rules and regulations than either a sole proprietorship or a partnership. And, don’t forget that other downside: the double tax paid at both federal and state levels.
An S corporation is merely an incorporated business that has chosen to be treated as a partnership for tax purposes. It offers some appealing tax benefits while still providing its owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result there is just one level of federal tax to pay.
On the downside, S corporations are subject to many of the same requirements corporations must follow resulting in higher legal and accounting fees. They must also file articles of incorporation, hold directors and shareholder meetings, keep corporate minutes and allow shareholders to vote on major corporate decisions.
Another major difference between a regular corporation and an S corporation is that S corporations can only issue one class of stock despite the limit of having up to 75 shareholders. Experts say this can hamper the tennis operation’s ability to raise capital.
No limits to the LLC
While the S corporation remains the most-used entity for small businesses, the limited-liability company or LLC introduced in 1997 is a fairly recent phenomenon. An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations.
LLCs were created to provide business owners with the liability protection that corporations enjoy without the double taxation. Earnings and losses of an LLC pass through to the owners and are included on their personal income tax returns.
Although it sounds similar to an S corporation, the LLC has no limit on the number of shareholders. In fact, any member or shareholder of the LLC are allowed a full participatory role in the business’s operation.
To set up an LLC, articles of organization must be filed with the secretary of state where the facility, retail shop or other tennis business will operate. Some states also require the filing of an operating agreement, which is similar to a partnership agreement.
Like partnerships, LLCs do not have perpetual life. Some states stipulate that the business must dissolve after 30 or 40 years. Technically, an LLC dissolves when a member dies, quits or retires.
Despite its popularity and the attractions, LLCs also have disadvantages. Since an LLC is a relatively new entity, its tax treatment varies by state.
Finding the right entity
The annual tax return provides one incentive to reconsider the options for your tennis business. Entities with more than one member are allowed to elect corporate status on the annual tax returns. Thus, an entity that is a partnership under state laws may elect to be taxed as a C or S corp for federal taxes by using Form 8832 (Entity Classification Election). Unfortunately, under those so-called “check-the-box” regulations, entities formed under a corporation statute are automatically classified as corporations and may not elect to be treated as any other kind of entity.
Changing circumstances, changes in the tax laws and even the success of the tennis business might prompt a reassessment of the form your retail shop or facility operates under. It makes sense to ensure you are using the best entity to provide your business — and you — with the most benefits and consistently lowest tax bill.
See all articles by Mark E. Battersby
About the Author
Mark E. Battersby is a tax advisor and author in Ardmore, Pa.
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