Starting a Business
Information regarding starting the business structuring process is provided in the following subsections:
- Structure Selection Process
- Comparing the features of typical structures
- Starting the Process
This process should be approached in a very systematic manner. Care and attention to detail are critical components of success. You should attempt to gather as much information as possible about all of the components that might affect choosing the optimal mechanisms and structures for your business venture. There are many variables that must be examined and considered. Most often these considerations are very specific to the industry and environment your business operates within.
So let's begin the process!
We recommend a process similar to the following:
- Determine your personal and business goals for the next two and five-year periods
- Understand the valuation of your personal and business assets
- Determine and understand the liabilities and risks associated with your business
- Gather as much information as you can about typical structuring in your business's industry
- Determine how many business partners will control your company
- Understand how you intend to distribute the generated business tax liability
- Determine if your company will need to obtain investment capital
- Compare the features of typical structures
- Review the structures and mechanisms presented on our website
- Develop a list of issues and concerns for your company's structuring
- Contact our Account Managers to discuss structuring for your business
What's Good About a Sole Proprietorship?
- You don't need a lawyer to set up a sole proprietorship; no startup costs.
- The only piece of legal paperwork is a "trade name" or "fictitious name" certificate - and this only if you are doing business using a name other than your own name (you file this in the City Clerk's or Town Clerk's office in each town or city in which you maintain an office).
- Taxes are easy too - you fill out Schedule "C" on your Form 1040 and pay taxes at your individual rate.
What's Bad About a Sole Proprietorship?
- Unlimited personal liability for every business, mistake to make - you breach a contract, you lose your house; you get into a traffic accident (that's not covered by insurance, you lose your house; you bake cookies that get people sick, you lose your house.
- You can limit this risk by buying an umbrella liability policy, but this can get expensive depending on the nature of your business.
- A general partnership is formed when two or more "sole proprietors" agree to pool their resources and - this is the key - share profits and losses from the business (i.e. if two or more lawyers share office space and refer clients to each other but render separate bills for their services and keep what the client pays them, this is not a partnership; if they render a joint bill for their services and split the profits 50/50, that's a partnership).
What's Good About a General Partnership?
- Easy to form and no startup costs; you don't need a written partnership agreement (legally) to form a general partnership - you can do it with a handshake (of course, if you do so there will be a lot of unresolved questions that may have to be resolved in the courts, which is why most people have a written partnership agreement even if the law does not specifically require one).
- Taxes are easy, too - the partnership files an information return on Form 1065 but pays no taxes - each partner pays taxes on his/her "pro rata share" of the partnership's profits at his/her individual tax rate.
What's Bad About a General Partnership?
- Unlimited personal liability, the same as a sole proprietorship, but with a twist - if A and B are partners, and B runs someone over with his car while on partnership business, both A and B lose their houses even though A had nothing to do with the accident. Lawyers call this "joint and several" liability.
- Partnerships have what tax lawyers call a "phantom income" problem, in that the partners have to pay taxes on their "pro rata shares" of the partnership's profits even though the partnership did not pay them cash to pay the taxes with.
- A limited partnership is a partnership with two tiers or classes of partners -- general partners who have unlimited personal liability for the things they do (or don't do) while in partnership business and "limited partners" who are liable only for the money which they contribute (or pledge to contribute) to the partnership.
- Because relatively few "operating" businesses - businesses which provide products or services - use the limited partnership form, this outline won't go into the details (the limited partnership is, however, an excellent vehicle for certain "passive investment" types of business, such as real estate investment or oil and gas exploration).
What's Good and Bad About a Limited Partnership?
The Good and Bad aspects of limited partnerships are the same as they are for general partnerships, except for the following differences:
- Only the general partners have unlimited personal liability
- Limited partners cannot participate in the management or operation of the limited partnership's business without becoming a general partner (and therefore "going naked" for anything bad that happens)
- Limited partnerships are more complex than general partnerships and require more paperwork and legal expense.
- A corporation, unlike a partnership, is a taxable entity - when you form a corporation it is as if you have had a baby, with the difference that the baby pays taxes from the day it's born.
- It's called a "C" corporation because it is taxed under Subchapter C of the Internal Revenue Code of 1986.
What's Good About a "C" Corporation?
- Limited Liability - generally, the owners of a "C" corporation (called "shareholders" or "stockholders") are liable only for the amounts which they contribute (or agree to contribute) as capital to the corporation, but will still be liable for their own negligence.
EXAMPLE # 1: A and B are shareholders of ABC Corporation. A run over someone with his car while on the corporation's business. The injured party may sue the corporation and win a judgment up to the number of the corporation's assets (because that's all it has). The injured party may sue A in his/her individual capacity and take A's house away. But the injured party cannot sue B in any way unless it can be shown that B contributed actively in some way to his/her injury (for example, by serving A too much liquor which caused A to be intoxicated at the wheel).
EXAMPLE #2: A and B are shareholders of ABC Corporation. ABC Corporation enters into a contract with a supplier to buy 10,000 widgets, and then discovers that it doesn't have enough money to pay for the 10,000 widgets. ABC Corporation breaches and the contract, and the supplier sues. The supplier may sue the corporation and win a judgment up to the amount of the corporation's assets, but the supplier cannot sue either A or B, even if A or B actually signed the contract as an officer or employee of ABC Corporation.
What's Bad About a "C" Corporation?
- Expensive to form - legal expenses and filing fees are usually between $1,000 and $1,500 to form a corporation in most states.
- Expensive to keep active - if a corporation fails to pay taxes for X consecutive years or fails to file a report (and pay a fee) every Y years with the Secretary of State's office, the Attorney General comes along and "dissolves" the corporation (and your limited liability along with it).
- If you don't use the corporation and treat it with respect, you lose the corporation; people suing you for something your corporation did will always try to argue they didn't know they were dealing with a corporation - if you conducted business in your own name, writing checks from your own checking account and accepting money in your own name that should have gone to the corporation, you can't argue it was really the corporation that should be sued and not you personally. Lawyers call this "piercing the corporate veil".
- Lots of paperwork - when you have a corporation, you don't do anything; the corporation does everything. This means that for a corporation to do anything the shareholders (that's you) have to prepare written documents (called resolutions or "minutes") authorizing the directors of the corporation (again, that's you) to do the thing, and the directors have to prepare written documents authorizing the officers of the corporation (again, that's you) to do the thing. Resolutions are a pain in the neck, but if you don't do them you will be tempting the courts to say that you didn't treat your corporation with the proper respect so that creditors are allowed to get at your personal assets.
- Taxes - because corporations are taxable entities, they pay taxes (albeit at a lower rate than you do yourself, in most cases); this means that any income which a corporation earns is taxed twice.
EXAMPLE: XYZ Corporation has two stockholders - A and B - and makes $100 in net income for a particular year. The corporation pays 15% to Uncle Sam as federal income tax, and books the remaining $85 as "net after-tax earnings". XYZ Corporation then resolves (remember those minutes?) to pay A and B the $85 in the form of a dividend, and distributes $42.50 to each of A and B. A and B each has to report that $42.50 as income on their Form 1040 for the year and pay taxes on that $42.50 at their individual rate. The result? If A and B are in the top tax bracket, that $100 in corporate income has dwindled down to about $26 in each of A's and B's hands after federal income taxes. Add state and local taxes to this calculation, and the tax "bite" becomes much larger.
- A "Sub-S" corporation is the same as a regular or "C" corporation with one important difference: it is not taxed by the federal government. This means that the "Sub-S" corporation is taxed just like a general partnership, but with the powerful advantage that stockholders in an "Sub-S" corporation have limited liability.
- Some states, however, do not recognize "Sub-S" corporations. This means that "Sub-S" corporations with offices in such states are taxed twice at the state level.
What's Good About a "Sub-S" Corporation?
- The same things that are good about a regular or "C" corporation.
What's Bad About s "Sub-S" Corporation?
The same things that are bad about a regular or "C" corporation (except the tax part), with a couple of additions:
- Because "Sub-S" corporations are taxed like partnerships, "Sub-S" corporations have the "phantom income" problem (if you've forgotten what this was, look under "What's Bad About General Partnerships" in the "General Partnerships" section of this outline).
- "Sub-S" corporations have lots of icky little rules that you have to comply with if you don't want to be taxed as a regular or "C" corporation (note: if the IRS takes away your "Sub-S" corporation status you don't - repeat don't - lose your limited liability; the worst thing that happens is that you're taxed as a regular or "C" corporation). For example, you can't have anything but natural human beings as a stockholders in an "Sub-S" corporation (forget parent-subsidiary arrangements), you can't have more than 75 stockholders, and so forth.
- "Sub-S" corporations file different forms with the IRS than regular or "C" corporations do, and have to report certain items of income differently; it is virtually impossible to operate as a "Sub-S" corporation without a darned good accountant. Accountants and lawyers both like "S" corporations.
- The limited liability company, or LLC, has become the most popular alternative for small business formations since the IRS approved it in 1988. Virtually all states allow LLCs in some form.
- What is an LLC? Well, it's basically an "S" corporation without all of the cumbersome little rules that make "S" corporations unattractive in a lot of situations.
What's Good About LLCs?
- Owners of an LLC (called "members") have limited liability - if A and B are members of an LLC and B runs someone over with his car while on LLC business, B may lose his/her house, but A will not lose his/her house unless A actively contributed to the injury.
- Like partnerships, LLCs are simple to operate - there is no need to prepare resolutions or minutes to authorize people to do things (although banks and some other folks may still require you to do resolutions because they haven't gotten the idea yet); they just do them.
- The costs of starting up an LLC are likely to be much less than forming a "C" corporation or an "S" corporation.
- LLCs are taxed like partnerships, so there is no "double taxation" of an LLC's income.
- If you are doing a lot of overseas business, the LLC format may give you an edge over your competition. Most foreign business organizations (such as the German GmbH and the Italian S.r.1.) are a lot closer in structure to an LLC than they are to a partnership or corporation; with an LLC you can give your managers the same titles as their European or Asian counterparts (Europeans especially cannot understand that in America one can be a "director" of a corporation and have absolutely no power to bind the corporation; in Europe business organizations are managed by their "directors", not by officers or mere employees).
What's Bad About LLCs?
- Really not a lot - while not perfect, LLCs are the closest thing to a "perfect" business organization the law has come up with to date.
- Because LLCs are taxed like partnerships, they have the "phantom income" problem.
- There are restrictions on what you can and cannot do if an LLC has employees for example, you may not be able to claim 100% deductibility for health insurance premiums.
- It may be difficult for existing businesses to convert to LLC's - corporations and their shareholders incur "double taxation" upon liquidation, while general and limited partnerships formed to acquire or hold title to real estate (as many are) may incur transfer taxes and other fees upon converting to an LLC.
- If your business is "high tech" or will seek outside capital within the first 12 to 18 months of operations, be aware that many investors (wrongly) associate LLCs with "small business, Mom and Pop, no growth potential" — while this perception is unfair, it is widespread, and you may want to consider becoming a "C" corporation instead (preferably in a high visibility state like Delaware).
- LLCs are not recommended for businesses that will have a physical location in New York. When New York adopted its LLC statute in 1994, it included a burdensome "publication" requirement that drives up the costs of forming a New York LLC. While this requirement has been challenged in court, it may be a while before there's a resolution. In the meantime, it is actually less expensive to form a corporation or S corporation in New York than an LLC! Also, keep in mind that LLCs located in New York City are subject to that city's "unincorporated business tax".
- A growing number of states are imposing special taxes or "minimum taxes" on LLCs and other unincorporated business organizations. For example, Connecticut requires both domestic and foreign LLCs to pay an annual tax of $250 whether or not they make money.
- Limited liability partnerships, or "LLPs", are allowed in a growing number of states; while theoretically any business can operate as an LLP, this form of organization is best suited to lawyers, doctors, accountants and other professional practices, and to existing general partnerships that wish to achieve limited liability status with a minimum of legal expense.
- An LLP is a general partnership in which the partners have limited liability for the acts and omissions of the other LLP partners; an LLP partner is always liable for his or her own negligence or willful misconduct.
- An LLP partner also enjoys limited liability for contracts that he or she signs on behalf of the LLP.
- An existing general partnership that converts into an LLP can continue to use its existing partnership agreement, usually without significant modification. This is an advantage for older partnerships that may have lengthy, detailed partnership agreements which the partners do not wish to re-negotiate at the present time.
- In practice, LLPs are best suited to professional practices, particularly those with offices in two or more states (such as the so-called "Big 5" accounting firms). In some states, professionals are not allowed to conduct business in corporate or L.L.C. form. By reorganizing as an LLP in each state where it does business, a multistate professional practice complies with local laws, ensures consistent accounting and tax treatment in all states where it does business, and provides at least some limited liability protection for its partners.
After you have gathered as much information regarding the structure selection process steps listed above contact our office and speak to one of our representatives. Go to our Contact page to reach our representatives.