Chapter 9
Structuring Your Business and Protecting It
In This Chapter
• Structuring your business
• Knowing the laws
• Insurance decisions
You will need to pick a legal structure for your business and its retail stores. Deciding on a sole proprietorship, for example, instead of a corporation structure or other legal structure will impact your operating costs, tax obligations, and your personal liability. In addition, you need permits, registrations, and a business license. If you don’t follow all the rules, your store could be shut down.
In this chapter, I review the pros and cons of each legal structure from a cost, taxation, and liability perspective. I also discuss the key permits, registrations, and licenses you need.
Structuring Your Business
Not all businesses are structured the same way. You have a number of types to choose among—sole proprietorship, partnership, limited liability company, and corporation. Let’s take a closer look at each.
Sole Proprietorship
If you’re just opening your store and will own a 100 percent interest in the store, a sole proprietorship is the easiest form of business for both tax purposes and record keeping. As a matter of fact, the IRS will assume a sole proprietorship if your business has only one owner unless you’ve actually incorporated the business under state law. In other words, you don’t have to do anything legally or financially to get started as a sole proprietor in the eyes of the federal government.
Better Not!
The biggest downside of sole proprietorship is that it isn’t a separate legal entity and all debts or claims are made against the individual who owns the business. To protect your personal assets, you may want to get business liability insurance.
In fact, the sole proprietorship isn’t a separate taxable entity. All your business assets and liabilities belong directly to you—the business owner. You report the business on a Schedule C, “Profit or Loss from Business,” or Schedule C-EZ, “Net Profit from Business.” Both forms actually become part of your individual tax return. The net profit or loss is reported on the first page of your 1040, and you pay taxes on the income based on your current individual tax rate. You also must pay Social Security and Medicare taxes on your net profit.
Partnerships
If you plan to open your store with one or more partners, you can set up your business as a partnership. There are two types of partners—general partners and limited partners. The IRS considers any business with more than one owner a partnership unless you have incorporated under state law or you elect to be taxed as a corporation by filing IRS Form 8832, “Entity Classification Election.” We talk more about corporate tax issues later in this chapter.
Partnerships file their own tax returns using IRS Form 1065, “Partnership Return.” These forms are actually information returns that show income, deductions, and other tax-related business information. This return must also include the names and addresses of each partner and each partner’s distributive share of taxable income. The return must be signed by a general partner. If the partnership receives no income and doesn’t pay or incur any expenses in any particular tax year, Form 1065 does not have to be filed.
def·i·ni·tion
General partners, who actively run the business, are subject to the same personal liability for partnership debts and claims as sole proprietors, even if the act that caused the claim to be filed was carried out by one of the other partners. Be careful who you partner with, especially if you plan to be the general partner with all others being limited partners.
Limited partners don’t take an active role in the management of the partnership. Their liability is limited to their investment in the business plus any obligations they may have to make additional investments in the business. For example, a partnership agreement may specify that each partner put a set amount of money into the business each year for the first five years.
In addition to filing the information Form 1065, partnerships must file a Schedule K-1, “Shareholder’s Share of Income, Credits, Deductions, etc.,” for each partner. This form is used to report the income or loss of each of the partners, which will then be taxed as part of each partner’s individual tax return. Like a sole proprietorship, the partnership itself is not a tax entity. Even if the partnership doesn’t actually distribute the cash and decides to hold some of the money for future company needs, the individual partners—not the partnership—will still have to pay taxes on the income.
Partnerships are the most flexible form of ownership if more than one person is involved in the business, because income and losses can be distributed as determined by the owners, such as 40 percent to one owner and 60 percent to the second owner. Any split is okay, as long as it is based on a business purpose and not solely for the purpose of tax avoidance. Other business entities, such as corporations, must distribute their income and losses based on the percentage of ownership or investment in the business. We’ll talk more about this later when we explore the other types of business entities.
Partnerships offer a major tax advantage for new businesses because you can write off losses. Generally, new businesses have losses rather than net profits due to start-up expenses and the time it takes to build a client or customer base. Partnerships provide a mechanism to write off these losses against other income. There is one catch, though. You can’t write off a loss that exceeds your personal investment in the business; however, if you increase your investment in future years, you can then write off the loss.
Partnerships face the same liability issues as sole proprietorships because the managing owners can be fully liable for any debt or claims. The rest of the business structures limit the liability of the owners.
Limited Liability Companies
A partnership or sole proprietorship can be set up as a limited liability company (LLC). This is actually a hybrid somewhere between a corporation and a partnership or sole proprietorship. An LLC is a state entity organized under state laws, so any protections against liabilities depend on the state in which the company is formed. However, generally an LLC is given the same protection from liability given to traditional corporations.
LLCs are treated as partnerships or sole proprietorships (if only one person owns and runs the company) when it comes to filing federal income tax forms, unless a Form 8832 is filed to classify them as corporations. State laws for filing tax forms vary on a state-by-state basis.
While limited liability may sound great because it protects individuals from many business liabilities, when it comes to borrowing money, sole proprietors or partners may still be required to give personal guarantees to get the money, especially if the business is first getting started. Few financial institutions will make loans to new businesses that don’t have much in the way of business assets.
Liability limitation may be helpful when it comes to protecting yourself or your partners from claims of malpractice or other related issues. Again, this will depend on your state and how it set up its LLCs.
Corporations—C and S
Your greatest liability protection as a small business owner comes from using the business structure known as a corporation. A corporation is a separate legal entity, and individuals are protected from getting sued for the corporation’s actions or facing collections from the corporation’s creditors.
Many legal advisors recommend that a sole proprietor or partners incorporate if the business is particularly “risky”—in other words, if it faces a strong possibility of being sued. Corporate structures can also make it easier to raise needed investment capital to grow the business.
There are actually two types of corporations for tax purposes—C and S. The C corporation is the standard kind of corporation that most large businesses are structured as, and it is subject to corporate income tax. A small company just getting started can avoid corporate taxation by filing with the IRS as an S corporation. Whether you file as a C corporation or seek the special IRS designation as an S corporation, it is still the same legal entity.
All corporations have a board of directors (even if it’s just you alone, or you, your wife, and your children) and shares of stock that represent ownership. Most small businesses have privately held stock that is not traded on any public exchange.
To qualify as an S corporation, you must meet all of the following conditions:
• Your corporation must be organized under the laws of the United States or one of its states or territories that is taxed as a corporation under local law.
• All shareholders must agree to the S corporation election.
• Your corporation may have only one class of stock. C corporations may have common and preferred stock for example.
definition
Common stock is a portion of ownership in a corporation that includes the right to vote on key corporation issues and entitles the owner to share in the company’s success, usually through dividends or increase in stock value.
Preferred stock usually has a specific dividend that must be paid prior to the dividends paid to common stock holders. This type of stock usually has no voting rights. If the company fails, these shareholders will get their share of the assets before common stock holders.
• Your corporation may not have more than 75 shareholders (corporations formed before 1997 were limited to 35 shareholders). So S corporations are only for small business entities.
• Shareholders may not include a nonresident alien or a nonhuman entity, such as another corporation or partnership. There are some exceptions to this. A share-holder can be a trust or estate authorized as an S corporation under tax laws. Also, certain tax-exempt organizations, such as qualified pension plans, profit-sharing plans, or stock bonus plans, can be shareholders.
The S corporation is treated similarly to partnerships for tax purposes. Profits and losses are passed through to the owners and taxed at their individual income tax rates. The key difference when it comes to taxes is that the profits and losses of an S corporation must be allocated based on actual stock ownership.
Better Not!
The biggest disadvantage for a C corporation is that income is taxed twice, once at the corporate level and again at the individual level for any distributions to the corporation’s stockholders. In other words, if you are a small business owner, you could end up paying taxes twice on the same money.
Remember, partnerships have more flexibility because their distributions can be done by any formula the business owners decide makes business sense. For example, if one partner has a lot of cash to put up front while the other partner is primarily offering his or her unique knowledge, a partnership could more easily adjust for this difference. S corporations can pay out salaries to owners as a business deduction. Partnerships cannot pay salaries to owners. Any pay-outs to owners are a distribution of profits.
Business write-offs and salaries may offset the negative of double taxation, though. Corporations are taxed as a separate tax entity and the shareholders are taxed on dividends or other distributions from the business. Business owners are allowed to pay themselves a reasonable salary (reasonable based on industry standards within the industry that the company operates) and avoid the corporate tax level on the money paid as salary.
I’m not going to delve deeply into C corporations because their tax rules are complicated and go beyond the scope of this book. If you’re thinking of establishing your business as a C corporation, you definitely should seek good legal and financial advice—don’t try to go it alone!
Just so that you have an idea of corporate tax rates, here’s a table that shows the current rates:
2007 C Corporation Tax Rates
Making Your Choice
Now that you know the choices for structuring your business, let’s look at what might make sense for you. Of course, every situation is unique, and I strongly suggest that you seek guidance from legal and financial advisors to figure out what is best for your company.
Most small business structures are taxed at your individual tax rates, even S corporations, but they offer different levels of liability protection. The key difference as you move from sole proprietor to partnership or corporation is how earnings and distributions are treated for tax purposes. Also, when you get to the highest level, a traditional C corporation, you must pay both corporate and individual taxes on dividends paid to shareholders.
Basically, if you’re a sole proprietor and want to keep things as simple as possible, there are very few tax advantages to organizing as anything other than a sole proprietor. Your lawyer may see some reasons to incorporate from a legal perspective if you would be subject to frequent lawsuits. If that’s the case, a limited liability company might be the best solution for you, but be sure you consider your state laws and state tax provisions for LLCs before going that route.
A sole proprietor may consider establishing an S corporation as a way to limit liability, but taxes will never be simple to file again; be certain that you understand the liability advantages before taking that step. Although you may be able to pay yourself a salary and avoid employment taxes on your share of corporate income above a reasonable wage, you need to be certain that the tax savings are worth the additional legal, tax, and other financial expenses of maintaining corporate status. Perhaps business liability insurance, discussed later, would be more cost-effective and offer the protection you need.
Selling Points
The government runs two excellent websites for small business owners. One is the main site for the Small Business Administration (www.sba.gov), and the second is a website for women business owners (www.sbaonline.sba.gov/ womeninbusiness). Both websites offer a wealth of information about starting up and running a small business.
If you have partners, setting up as a limited liability partnership (LLP) probably makes the most sense. It provides the maximum amount of flexibility, allows a single level of taxation, and gives you liability protection as well. Organizing as a corporation is a good choice if you plan to produce or manufacture a product and want to build the company into a major nationwide or worldwide business. You don’t have to make the decision right away. You can wait a year or two or elect S corporation status initially before taking the plunge into the more complicated tax structure that requires you to pay taxes twice.
Don’t try to make the decision about business structure on your own. You definitely should seek advice from an attorney or tax advisor before making major business decisions, and take it slow.
Laws and Regulations
Anyplace you want to set up your retail business, you’ll find there are registrations, licenses, and permits you must have before you can open for business. In all cases, these involve the desire of local, state, or federal government entities to put in place protections for the public from unqualified or unscrupulous businesses.
• Registrations involve filling out government paperwork so the public knows who owns the business and what type of business it is. How you register your business will depend upon the type of business you open. The registration process for a corporation is much more difficult than that for a sole proprietorship.
• Licenses involve proving that you have the professional credentials to operate your business. For example, a hairdresser must get a license to open a shop and cut hair.
• Permits specify what type of business can operate in a location, as well as the regulation of the buildings a business operates to be certain the business is operating safely.
Business Licenses
Once you know the type of business you plan to operate and where you want it to operate, you should contact your town, city, or county clerk and apply for a general business license. You will need to supply:
• Structure and type of ownership of your business.
• Federal Tax Identification Number (if you don’t have one, you can call the IRS at 1-800-829-4933 to apply for one).
• Business name (DBA—doing business as) or the name the public will see, if different from what you registered your company as.
• Mailing address where you want any licenses, reports, tax returns, and other governmental correspondence to be sent.
• Location of business operations and location of business records. You may have two locations—one for the store and one for where you will keep your business records (in many cases for a small business, this could be your home office).
• List of all owners, partners, and managers.
• Nature of your business, which is a description of your business activities, products to be sold, and services to be offered.
You need to post your business license in a visible place in your store. You may need other specialized licenses as well as a general business license, depending upon the type of store you plan to open. For example, if you plan to serve liquor, you must also get a liquor license.
Permits
Some types of business must also get a permit to operate their store in the location selected or to put up a sign. You also will likely need police and/or fire department permits and building permits. Here are some key permits you likely will need:
• Zoning permits. All local governments have zoning laws that specify how a particular property can be used. If you are opening your store in an established shopping center, you won’t have to worry about getting a zoning permit. But, if you want to set up your store in a location not normally used for business, you need to get a zoning permit. You also may find that the type of business you plan to operate cannot be opened in certain locations. For example, suppose you want to open a convenience store that sells alcoholic products. The zoning ordinance in your town may restrict how close that type of store can be to a church, synagogue, or school.
• Sign permit. Before ordering your signs for you store, check to find out if any special permits are needed for signage. Many towns regulate size, color, type of material or lighting that can be used, and how the sign must be hung. You may also find that certain information is mandatory on the sign, such as your store’s street address. Often neon signs are banned completely. Check with your town, city, or county clerk’s office or building department to find out what type of sign regulations are in place and whether or not a permit is needed for the sign you plan to use.
• Police and/or fire department permits. In most cases, these types of permits involve regulations regarding alarm systems, such as fire alarms and sprinkler systems. If you do put in a security system that automatically alerts the police department, you may get charged after a certain number of false alarms. Check with your local police and fire departments to find out what regulations are in place regarding fire and security systems and whether or not a permit is needed.
• Building permit. Any time you plan to do construction on your store, you need a building permit. This includes remodeling and renovations. You need to get your plans approved by the building department before you start work and the building department will send out inspectors to check on the work during construction. In most situations, the contractor you hire will apply for the building permits. When the work is completed, your contractor must also get the building department to sign off on the work of each trade, such as plumbers and electricians. When the building department has signed off on the work, it will then issue a Certificate of Occupancy (CO). You must have a CO to furnish and open your store.
Better Not!
You may be tempted to save money and hire a contractor who says he can do the work cheaper if he doesn’t go through the hassle of getting a building permit. Don’t do it. Not only would this be illegal, but it can result in your store being closed when the local government entity finds out, and you also may be hiring a nonlicensed contractor whose work is not up to par.
Insure Your Business
You’ll spend a lot of hours building your business and can lose it all in a matter of minutes if disaster strikes. You can protect your assets by being certain that you carry the right types of business insurance. Business insurance falls into three categories: business liability, business property and casualty, and worker’s compensation (if you have employees). All your expenses for insurance are fully deductible as a business expense.
Business Liability
You certainly wouldn’t go without liability insurance for your house in case someone got injured on your property, and definitely not for your car in case of accident. So why wouldn’t you think of getting liability insurance for your store?
I briefly review the various types of liability insurance available, but your best bet is to sit down with an insurance advisor whom you trust and determine what makes sense given your business plans and its liability risks.
First, there is general liability insurance. This covers a business against accidents or injury that might happen on its premises. If you will be providing professional services as part of your store operations, then you should consider professional liability insurance, which protects you against claims arising from your business activities, including errors or omissions when providing professional services.
Selling Points
If your company has a board of directors, you may want to consider purchasing directors’ and officers’ liability coverage. This protects your top executives and board members from personal liability in case the company is sued.
Business Property and Casualty
Business property and casualty insurance protects you from a loss if you experience loss, damage, or theft in your store. Two kinds of business property and casualty insurance are available:
• Named-peril. This protects against losses that are specifically named.
• All-risk. This is much broader and protects against all perils.
Named-peril insurance is cheaper because the coverage isn’t as broad, but if a loss occurs because of something not named in your coverage, you get nothing. There are also three forms of coverage:
• Basic form. Covers damage from common perils, such as fire, lightning, windstorm, vehicles, aircraft, and civil commotion.
• Broad form. Covers all the basic perils plus others such as water damage; collapse; glass breakage; weight of snow, ice, or sleet; and sprinkler leakage.
• Special form. Covers all perils except those specifically excluded. Exclusions can include flood, earth movement, war, wear and tear, insects, and vermin.
When you buy insurance—whether it is for your business or home—make sure you know what perils are covered. You certainly don’t want to find out that you don’t have coverage after a major catastrophe happens.
You also can select two different reimbursement options:
• Replacement cost reimbursement. This pays you the cost of actually replacing the lost property.
• Actual cash value reimbursement. This pays you based on the replacement cost minus the physical depreciation of the property.
The actual cash value reimbursement option might cost you less upfront, but you’ll also collect a lot less if you have a loss.
Special-named perils that you may want to consider, depending on your specific business situation, include the following:
• Crime. This protects you against burglary, robbery, embezzlement, employee theft, and disappearance or destruction of property because of criminal acts. The cost of this coverage depends on the size of your company and its risks of needing to file claims.
• Cargo. This protects you against loss of inventory or goods while on a company truck.
• Business interruption insurance. This covers losses incurred because your business operations are interrupted by an act beyond your control. It provides resources so that you can continue to pay utilities, payroll, loans, and other obligations until your business is up and running again.
• Product liability insurance. If you produce and sell a product, this insurance covers you if you are sued related to a problem with the product’s performance. Service businesses can also be covered under this type of insurance for services performed.
• Inland marine insurance. This insurance covers high-risk, mobile items that have a high stated value not covered by your other commercial property policies. This can include valuable tools, artwork, or jeweler’s inventory.
• Fire and extended coverage policies. This covers losses from hail, windstorm, vandalism, or fire beyond the normal coverage of commercial liability. This can include protection for your accounts receivable records, computer files, currency, securities, and valuable papers.
• Flood. If your business or home is in a flood zone, you will need a flood insurance policy to be sure your assets are protected.
Worker’s Compensation
If you have employees, you might need worker’s compensation insurance. This insurance pays benefits to your employees if they are hurt on the job. Coverage includes medical bills, a part of lost wages, vocational rehabilitation, and death benefits.
Whether you need to carry this coverage depends on state law. If you fail to carry it when state law requires you to, not only will you be subject to covering an employee’s costs after an accident or injury, but you also may face severe fines and even jail time for violating the law. You can usually purchase this insurance from your state or through various private companies.
Better Not!
Five states require that you purchase worker’s compensation insurance from them: North Dakota, Ohio, Washington, West Virginia, and Wyoming.
Premiums for worker’s compensation are based on the size of your payroll and the risks involved in the work. For most retail businesses risks are low, but if you offer services where there is a high risk of injury, your insurance costs might be higher.
The Least You Need to Know
• You will need to decide on a legal entity. This decision will impact your store operations, your liability, your costs, and the taxes you’ll have to pay.
• Check with your town, city, or county clerk and be sure you get all the registrations, licenses, and permits that are required before you open your store.
• Don’t skimp on insurance. You need to protect the business you build.
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