Start-Up Costs Section 195 of the Internal Revenue Code is the main provision related to the deductibility of start-up costs. According to this section, deductible start-up costs are those that would be deductible if they were incurred by an existing business. Deductible start-up costs include:

• Analysis of potential markets, facilities, products, labor supply, etc;
• Advertisements announcing the business opening;
• Costs of training employees;
• Travel and other necessary costs for securing prospective distributors, suppliers or customers;
• Consulting and professional fees.

Organizational Costs Another category of pre-operational expenses that are considered a different category and that may be deductible are organizational expenses. These expenses include:

• Cost for organizational meetings;
• Costs related to temporary directors;
• State incorporation fees;
• Legal and accounting fees related to setting up a corporation or partnership.

Amount of Deduction The maximum amount that can be deducted in each category in the first year is $5,000. However, the deduction is reduced by the amount by which total start-up costs exceed $50,000. Any amount not written off in the first year must be deducted over 180 months, starting in the month after the business begins. So, if your start-up costs are $4,500, you would be able to take a deduction for the entire amount in the first year. On the other hand, if your start-up costs were $55,000, you would not be entitled to a deduction in the first year and would be required to amortize the costs over 15 years ($3,667/year).

Traps The rules related to the deductibility of start-up and organizational expenses are somewhat intricate, so watch out for a few of the common traps:

• Costs related to issuing or selling stocks or securities are non-deductible. These costs include professional fees and commissions.
• Costs of transferring assets to the business are not deductible.
• If an individual incurs costs to go into business and the attempt fails, those costs incurred before making a decision to acquire a specific business are non-deductible.

A Strategy Many of the limitations associated with start-up costs are alleviated if business operations have commenced, so it may make sense to try to generate revenue-producing activity as early as possible. An early start date may allow a current deduction for expenses that otherwise would be deferred start-up costs.

More information about tax treatment of business start-up expenses is available in IRS Publication 535, Business Expenses.

The textbook definition of a corporation is “a body of persons granted a charter legally recognizing them as a separate entity having its own rights, privileges, and liabilities separate from those of its members.”  Essentially, the corporation is a legally recognized entity separate from its members formed with the permission of the state.  As a legally recognized entity, it enjoys most of the rights and responsibilities of individuals – ownership of property, to sue or be sued, etc.

Formation: A corporation is formed when a person, the incorporator, files a document with the state known as the Articles of Incorporation.  This document contains the basic information about the corporation including the name and principle place of business, the corporation’s period of duration, the corporation’s stock, the registered agent, the directors and the incorporators of the company.  Most states maintain lengthy and detailed laws relating to the formation of corporations and may require the submission of materials in addition to the Articles of Incorporation.

Management: Although a corporation is a separate entity with rights of its own, it can’t think or act for itself but does so through its Board of Directors.  Directors are appointed by the shareholders and act like trustees, overseeing the business affairs of the corporation.  The directors generally oversee the strategic management of the corporation.  To manage the day to day operations, the directors appoint and hire officers.

Taxation: Since a corporation is an entity separate from its owners, the income of the corporation is taxed to the corporation itself at the applicable corporate tax rate.  In addition to the corporate tax, employees pay income tax on salaries and shareholders pay tax on dividends.  Thus, the revenue of the corporation is subject to taxation at two different levels before landing in the employee or shareholder’s bank account.

Liability: Generally no shareholder can be held personally liable for the debts, obligations or acts of the corporation beyond the amount of share capital he or she has contributed.

Transferability: Because the corporation is a separate legal entity, its existence does not depend on the continued membership of any of its members.  This trait makes transferring corporate ownerships fairly easy, subject to the rules the corporation subscribes for its shareholders in its organizing documents.

Dissolution: Dissolving a corporation can be a lengthy and complicated process.  At a minimum, the following steps are required:
•    Formal corporate action
•    Filing with the appropriate state offices
•    Statutory notice to creditors
•    Processing of all creditor claims
•    Sale and distribution of all remaining assets

Pros: Limited liability; possible tax advantages; clear management authority; ownership is transferable; continuous existence; easier to raise capital.

Cons: Highly regulated; Expensive formation and compliance; extensive record keeping necessary; double taxation of dividends; personal guarantees undermine limited liability advantage.

Bottom Line: A corporation is usually the most expensive and administratively complex entity to form, run and dissolve.  But, the corporate form offers the most definite division between ownership and the entity and therefore may provide the most liability protection for business owners.  Additionally, most investors prefer the corporate form as a barrier to personal liability and for its specificity of ownership and control via stock.

According to the IRS, a sole proprietor is someone who owns an unincorporated business by himself or herself. Individuals need do nothing formal to establish a sole proprietorship. The sole proprietorship is the most common form of business structure for small companies. It is viewed as being one and the same as its owner from both a legal and tax perspective. This characteristic has the advantage of simplicity but also has the disadvantage of exposing the owner to personal liability.

Formation: Simply start doing business. Most states and localities impose registration requirements, so make sure to review local requirements or consult a small business expert in the region.

Management: The sole proprietor controls all business decisions alone.

Taxation: The sole proprietorship is a disregarded entity for tax purposes. All business income and expenses are reported on the owner’s federal tax
return. In addition to federal income taxes, self-employment tax of 15.3% generally applies.

Liability: The business owner is liable in contract and tort for the activities of the business. Creditors of the business may claim against both the sole proprietor’s personal and business assets. Conversely, personal creditors of the business owner may claim against both personal assets and those of the sole business.

Transferability: The existence of the sole proprietorship business is linked to the business owner. So, continuity of business operation is uncertain if the owner wants to transfer the business assets or operation to another person.

Dissolution: To dissolve the business, the sole proprietor simply stops doing business. The business owner still has an obligation to notify creditors of the cessation of business. Additionally, state and local regulations may impose notification requirements upon the sole proprietor. The sole proprietorship will also cease to exist upon the death of the owner.

Pros: Fewest legal formalities (easy to start, transfer assets and dissolve), unlimited control, minimal income tax filing requirements.

Cons: Unlimited liability, uncertain continuity in the event of owner’s death or incapacitation, limited access to investor capital.

Bottom Line: The sole proprietorship is the easiest entity to start, operate and manage from a legal and tax perspective. It may be a suitable choice where the nature of the business is simple and potential liability for the owner is minimal.

One of the first decisions a business owner must make when embarking on a new venture is how the company should be structured. The decision has far-reaching and long-term implications, so a proper consideration of the available options and their implications is vital.

Traditionally, the most popular business entities were the sole proprietorship, the corporation and the partnership. But, these traditional entities now require consideration of variations like the S corporation, limited liability partnership or newer business forms such as the limited liability company.

The choice of entity analysis requires a careful assessment of relevant income tax considerations. Each entity option offers certain tax benefits or traps that may pose problems in the future. Good business planning involves a review of the tax benefits and traps of each entity type and their potential relevance to the specific business model contemplated.

Some perceive the choice of entity decision solely as a tax-driven exercise. Although tax implications are vitally important, there are many important non-tax factors that can impact the ultimate decision. In most situations, the analytical process requires the business owner and the planner to make some predictions on what is likely to happen in the business’ future. Some of those predictions include:

• Potential for liability;
• Projected earnings and losses;
• Capital expansion needs;
• Possibility of adding new owners;
• Potential exit strategies;
• Likelihood of a sale;
• Estate planning needs of the owners;
• and a variety of other factors.

Consequently, the decision making process is not an exact science that produces a single perfect answer for every situation. There is a need to weigh and consider a number of factors, while being sensitive to the consequences of the alternative options.

This article is the just the introduction in a series in which we will break down the choice of entity in more detail and discuss many of the subtle issues involved. However, any entrepreneur considering forming or changing a business entity would be best served by gathering the relevant business facts and consulting with a qualified Tax-Business Attorney.