Chapter 2
Choosing the Right Foundation: From Partnerships to Corporations
IN THIS CHAPTER
Deciding which business form is best suited to you
Establishing yourself as a sole proprietorship
Evaluating alternative legal structures
Operating by the rules of incorporation
Modifying your ownership structure
At the top of every start-up checklist is a line item that reads “Establish the formal structure of your business.” This line means that you start by deciding how you want your company legally organized. You can be the sole owner or have 2 partners or 50 shareholders. Each form of business has definite advantages and disadvantages, depending on your goals for the business.
Read the information we provide in this chapter about all these options before making your final decision.
Strategizing for the Best Organization
Choosing how to set up your business is easier than you might think. Considering that you have only four primary choices, the odds of narrowing the selection quickly are in your favor. Yet one of the most frequently asked questions when someone is starting a business is “Which structure is best for me?” To get started, you need to resolve four key issues:
- Ownership: Deciding who ultimately owns or controls your company is a primary influence on your choice of legal structure. A second factor is the number of people who control the business. Some forms of business are limited by both the number of owners and the type of owner (individual or corporation) it can have.
- Liability: You must choose where you want the legal responsibility for the business to reside. Deciding whether you’re comfortable accepting full liability for the actions of the company or whether you need the protection (or veil) of a corporation is an important choice.
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Taxes: Each of the business structures is subject to various forms of taxation. For instance, you might pay a self-employment tax based on your earnings. Or you could be taxed on the dividends paid out to all owners from the business. In the case of one type of incorporation, you might even experience double taxation — paying tax as the business and again as an individual stockholder.
Because the tax issues are so complex, talk with a tax attorney or certified public accountant to determine which option best fits your specific circumstances. - Funding: The way in which you finance the growth of your company can play a significant role in determining its structure. If you’re bootstrapping (self-financing) the company, any of the structures might work for you. However, if you seek outside financing from angel investors or venture capitalists, you need the option of having stock available for distribution. If another business entity plans to own stock in your company, your choice of business structure is severely limited. See Book 1, Chapter 4 for more info on how to fund your business.
Now that you understand these four primary areas of concern, you should have a better idea of where your specific requirements fit in. To make your final decision, read the detailed descriptions in the following sections for each business entity.
Operating Alone as a Sole Proprietor
If you’re interested in simplicity, look no further. A sole proprietorship is recognized as the quickest, easiest, and least expensive method of forming a business. The main caveat is that only one person can operate as a sole proprietor. You and the business are literally the same entity. The upside of that arrangement is the ease of getting up and running. With the mere act of conducting business (and obtaining a license), you’re considered a sole proprietor.
The downside of being a sole proprietor is the potential legal ramifications. Because you and the company are one, you’re fully accountable for the losses of the business along with any legal matters. Whether the business is involved with lawsuits or problems with creditors, you’re personally liable. No corporate protection is available — your personal assets (such as your home) can be sold and your personal bank accounts used to pay off creditors.
As a sole proprietor, you’re also responsible for all taxes. The profits and losses of the business are listed on Schedule C on your personal tax return. And you pay self-employment tax (Schedule SE), which is a combined Social Security and Medicare tax. The self-employment tax is calculated as a percentage of your earnings; as of the 2016 tax year, the percentage is 15.3 percent (12.4 percent for Social Security and 2.9 percent for Medicare). Up to $118,500 of your self-employment income is subject to the Social Security tax, and all your income is subject to the Medicare tax.
In addition to obtaining a business license and paying taxes, you must address two other topics if you’re considering operating as a sole proprietor:
- Registering your company name
- Forming a sole proprietorship with your spouse
We discuss these topics in the next two sections.
Fictitious name registration
Unless you choose to operate your company under your exact legal name (or use your last name), you need to register a fictitious name with the state. The name of your company is different from that of its legal owner (you). Suppose that your name is John Smith and you decide to name your company Online Information Services. By registering that fictitious name, you become John Smith dba (doing business as) Online Information Services. Your business name should then appear on your checking account, business license, and any other legal documents.
Check with your city and state governments to determine how you should register your fictitious name. Some states require only that you submit an application and pay a small filing fee. Others mandate that you publish in a newspaper your intent to use the fictitious name before you begin to use it.
Husband and wife sole proprietorship
Togetherness is a wonderful thing, as you and your spouse might have found out when you got married. You and your spouse might even want to operate a business together. Does this mean that you no longer qualify for the simplified structure of a sole proprietorship? That depends.
The IRS legally recognizes a sole proprietor as having only one owner. If a spouse is working for the company, the IRS expects you to treat that person as an employee (which means that you have to pay payroll taxes). Alternatively, if your spouse has an active ownership role in the company, the IRS treats the business as a partnership (which means that both of you are taxed separately on the income). However, some tax advisors suggest that you can still file as a sole proprietor even if your spouse participates in the company. When you file a Schedule C on your joint tax return, all business income is viewed as one sum for both of you, although the IRS still views your business as belonging to a single owner.
To avoid paying payroll taxes, you may choose to classify your spouse as a volunteer. Your spouse is then only occasionally active in the business and doesn’t get credit toward Social Security.
If the IRS determines that your spouse works regular, consistent hours, it could mean instant classification as an employee. At that point, you might be responsible for paying a hefty sum of back taxes and penalties. Always consult a professional tax advisor to ensure that you’re operating within the allowable classifications designated by the IRS.
Sharing the Load with a Partnership
In some ways, a general partnership is similar to a sole proprietorship: It’s relatively simple and inexpensive to form. Issues of liability and taxes reside fully with its owners. The primary difference with a partnership is that it allows you to have multiple owners.
Although the terms of this type of partnership can be based on a verbal agreement, you should spell out the conditions in writing, for two reasons:
- Dispute resolution: Having the specific details of your original agreement in writing is handy if a dispute arises between you and your partner (or partners).
- Proof of partnership: If something happens and a written document cannot be produced, you and your partners are assumed to share equally in all aspects of the business. Proving otherwise in a court of law, or to the IRS, could prove difficult.
When you define your partnership, the basic agreement should address these areas:
- Structure: Shows what percentage of the company is owned by each partner
- Control: Defines which partner is responsible for which part of the daily management of the company
- Profits: Details the division of profits and losses and the time frame for distributing profits to the partners
A partnership arrangement brings up certain questions that you must consider at the beginning of a partnership:
- How much money and time will each partner contribute, and how will decisions for the company be made?
- What happens if one partner stops contributing, can no longer be actively involved, or wants out of the partnership?
- Can you buy out the interest of another partner, or will the partnership be dissolved automatically when a dispute cannot be settled?
- How will ownership be transferred if one partner dies or is involved in a divorce (especially if the partners are married to each other)?
- How will an owner’s share in the company be redistributed?
These questions are tough to answer. You probably don’t want to believe that anything will go wrong between you and your partners. Unfortunately, for one reason or another, partnerships go sour all the time.
The most successful partnerships are those in which issues such as these were openly discussed and agreed on up front. Likewise, individual owners who have survived a failed partnership have done so because a written agreement was in place. Considering that you and your partners are personally liable for the actions of your company, a formal partnership agreement is your best chance for avoiding problems.
Limited Liability Company
If you prefer entering into a business using an entity that offers a bit more legal protection to you and your partners than a partnership, a limited liability company (LLC) might interest you. (Although some states also recognize a limited liability partnership, or LLP, the LLC is more common.)
The LLC combines the flexibility of a partnership with the formal structure and legal protection provided by a corporation. As in a general partnership, income is passed through to the individual partners, and profits can be distributed according to your agreement. (Note that profit doesn’t have to be split equally among partners.) An LLC allows you to have an unlimited number of partners, and permits you to raise money for the business by taking on investors (including other corporations) as members. Additionally, members or partners of the LLC aren’t personally liable for the actions of the corporation.
If you choose to form an LLC, you have to file with the state, although the requirements typically aren’t as stringent as they are in a corporation. (You’re not required to maintain bylaws or keep minutes of annual board meetings, for example.) However, the requirements for forming an LLC vary by state, so you have to research those requirements for the state in which you file.
Making It Official with Incorporation
One option to consider when you’re establishing a business is whether to incorporate. A corporation is a legal entity that’s separate from the individuals who create or work for it. Stock in a corporation is issued to individuals or to other business entities that form the ownership of the company.
Different flavors of corporations
Depending on your situation, you can choose one of two types of corporation:
- C corporation (or C corp): This traditional form of a corporation typically offers the most flexibility when you’re seeking investors. A C corp is allowed to have unlimited shareholders, usually with no restrictions on who they are. The downside is the way in which this status of corporation is taxed. In a concept commonly referred to as double taxation, the business is taxed first on its income and then its individual shareholders must also pay tax.
- S corporation (or S corp): Electing to have Subchapter S status, or to become an S corp, is an option for your company if you have a limited number of shareholders (as few as just you and usually no more than 35). The shareholders must all be individuals (they cannot be corporations or other business entities), and they must be legal U.S. residents. You also have to agree to operate the business on a calendar year for tax purposes. The advantage of becoming an S corp is that you avoid double taxation. (Profits and losses are passed through to shareholders.)
The choice to incorporate
The biggest advantage to incorporating is that it offers legal protection to its owners. As an individual shareholder, you’re not personally liable, as you are with a sole proprietorship or general partnership. You might find that a corporation offers significant tax advantages, too. If you’re seeking investment capital or plan to take the company public with an initial public offering (IPO), a corporation gives you the most flexibility to do so. Even if you have no plans to go public, being incorporated provides the opportunity to build your personal wealth in the form of an individual or one-participant 401(k) plan, which is also referred to as a solo 401(k) plan. Saving for retirement using a traditional 401(k) plan can be a big advantage of incorporating as an S corp.
Incorporating has a few disadvantages, too. For starters, you must file or register your corporation with your state. This process involves a large amount of paperwork, which takes some time. To file, you have to submit articles of incorporation that state (among other information)
- The purpose of your business
- The name of the company
- The name of the owner
- The company’s location
You also have to submit bylaws, which describe how the company is run, and a list of officers, or the people who direct the company in its daily decisions, such as a president, secretary, and treasurer.
After your corporation is approved by the state, your responsibilities don’t end there. To maintain the corporation’s status, you’re required to issue stock, hold annual board meetings (with its officers), and record minutes of these meetings. These formal requirements of a corporation can be cumbersome for you, especially when you’re starting a new business. In addition, a corporation has to file separate tax forms, which are typically more complicated than an individual return. You could be doubling your efforts — and your expense — while trying to comply with taxes.
If the corporate veil is pierced, you can be held personally responsible for the debts and legal concerns of your corporation. This situation happens when you don’t properly uphold the requirements of your corporation. Any protection offered by the corporation is therefore forfeited.
Forming a corporation isn’t the cheapest method of starting a business, either. If you hire an attorney to file the necessary paperwork with the state, expect to spend close to $1,000 or more in legal expenses and filing fees. Even if you elect to incorporate yourself or do it through an online service, it can still cost several hundred dollars. You pay, at the least, an initial filing fee with the state and then an annual fee to maintain your status.
Changing Your Organization as It Grows
Just because you select one form of structure when you’re starting your business doesn’t mean that you’re stuck with it forever. As with other decisions you make along the way, you might find that your growing company warrants a different legal structure at some point. The ideal situation is to select a structure that gives you the most flexibility at the time you start up. Sometimes, though, that’s not reasonable. The next-best plan of action is to understand when and how you should change your organization.
Perhaps the best indicators are those related to money and ownership. As a small-business owner, if you use your money better through different tax strategies, waste no time making the transition. Many businesses start out as sole proprietorships because that option is simple. When the owner hits a certain level of income, however, it makes sense to incorporate based on the amount of self-employment taxes being paid. The advantage of saving several thousand dollars outweighs the compliance burden of incorporation. As they say, it’s a no-brainer!
Then there’s the matter of owner status. As a sole proprietor, if you take on an additional owner, you have to convert to a partnership or some form of corporation. Similarly, if you’re operating a general partnership and then decide to seek out other owners for investment purposes, forming a corporation and offering stock might make sense.
You can much more easily switch from a sole proprietorship or partnership to a corporation than vice versa. After you incorporate a business, you’re expected to meet payroll and wage-related tax requirements as defined by the IRS, and you’re expected to hold shareholder meetings. If you decide that you cannot maintain a formal corporation or that it’s no longer the best structure for your company, you cannot simply stop meeting these requirements. Instead, you must follow certain procedures to legally dissolve the business.
Before changing the status of your business, always consult with your certified public accountant, attorney, or other trusted business advisor. Consider your options carefully!