Let me start with the caveat that I am not a lawyer and you should not construe this article as legal advice and you should seek legal counsel on all matters of corporate governance and taxes. In addition the laws may be different from state to state so do your research and consult an appropriately licensed expert.
That all being said, having spent a lot of years in business and having owned and managed several different start-ups and private equity groups, I have a strong opinion on what might be the best legal structure for most individuals wanting to start a health and fitness business. Check with your accountant or attorney on this matter but in most cases the answer to this is going to be to create a Limited Liability Company (LLC) which is essentially recognized as a partnership for tax purposes unless you are the only member (owner) which then the IRS ignores the entity and treats you like a sole proprietorship simplifying your tax return. Note that being a single owner LLC does not affect its legal status and the protections it provides.
The LLC structure gives you the most amount of flexibility on how the entity will be run and governed as well as allowing for virtually any profit or loss distribution sharing arrangement or cash distribution priority irrespective of which partner owns what percentage of the LLC. This allows for members to consider not only money invested, but also time and work invested when distributing profits.
For purposes of an LLC, the terms "Partner" or "Shareholder" may be used to describe the equity owners but the proper legal term is "Member". An owner of an LLC is a Member of the LLC. A Managing Member is a legal term that gives responsibility to a certain individual or entity to manage the affairs of the company on behalf of all the other members. Note that the Manager of the LLC does not have to be a "Member" or owner in the LLC. So you can hire and designate an outside independent firm to be your Non-Member Manager of your LLC to manage your business operations, tax and legal affairs.
Members can be working members or merely financial investors that never step foot in the business. This distinction becomes important for tax purposes. Members have limited liability for the debts of the business, unless they personally guarantee loans.
Structure and Flexibility
So for example, I could give 99% of the equity in the LLC to my children and keep 1% but yet I can create an operating agreement that states I get 100% of the profit distribution and or losses until which time the Managing Member and or the shareholders of the LLC decide to change that language. In addition I can designate myself, the 1% owner as the only Managing Member (see below) that gets to make any decision on how the business is run and profits are shared barring any overriding state laws that may take precedent.
Salaries or Draws
Technically an owner takes a draw or a guaranteed payment from the LLC and not a Salary as they are not an employee of the LLC.
Owners/Members in an LLC are prohibited from being an employee of the LLC. This doesn't mean an LLC cannot have employees, they just can't classify an owner as an employee.
A guaranteed payment compensates people for their time, while a Draw typically compensates people for their ownership percentage. Guaranteed payments and Draws do not have any taxes withheld, it is much like paying an independent contractor.
The distinction is that a Guaranteed payment is not associated with the profits of the business. In other words the Member is paid a fair wage for their job duties irrespective of if the company makes a profit or not. Meaning the money to pay that person their Guaranteed Payment must come from Members equity investment or borrowed funds (debt). This is often found when one partner is a sweat equity partner and one is a financial investment partner. This situation often does not go well when the entity is losing money for reasons I wrote about Sweat Equity Partners - 1 and Sweat Equity Partners - 2.
Guaranteed payments are typically deductible by the entity on Form 1065 as a business expense.
The downside of an LLC is the business profits are subject to Self-Employment taxes (Social Security and Medicare taxes) like all other income except you get to pay both the "employers" and the "employees" portion, so essentially double what it would be if you were an employee of a company you don't own.
The distinction as to what type of Member or Partner you are is important when it comes time to distribute profits and pay taxes. The IRS has taken the position that limited liability company (LLC) members who participate in management or provide significant services are subject to self-employment (SE) tax on their distributive shares, even if a substantial portion of that income is attributable to returns on invested capital. Simply, if you work in the business and are active you are subject to self-employment taxes.
Limited partners or members such as financial investors are treated differently. They are only subject to self-employment tax on guaranteed payments for services they provide to the partnership as noted above. So if a financial investor provided a consulting service for a business he/she has an investment in as well, that compensation would be a guaranteed payment. But they’re otherwise exempt from Self-Employment taxes on their distributive shares of partnership income. Limited partners, who have no management authority, are essentially passive investors and otherwise not active business participants.
If your LLC loses money this could change your total taxes owed depending on the partnership agreements and how losses and capital accounts are settled at year-end. Get a qualified tax accountant to work with you to optimize your tax position.
There is much more to the legal structure and how it is set up and what you can do, but suffice to say, you get the personal protection of working within a legal structure (as much as the laws of your state allow), yet the flexibility to run the business virtually any way the Operating Agreement among the partners dictates.
Pro Tip: Obtain Your EIN
An EIN is an Employer Identification Number. This is also known as the Federal Tax Identification Number, and is a very important number to have if you're setting up a business!
You can get an EIN from the IRS - and you can register for it online right now.