BUSINESS LAW: Company Formation & Guidance

CHOOSING THE RIGHT BUSINESS FORMAT

QUESTION: How do I choose a business format?

ANSWER: Owners of small businesses often choose a business format when they first open their doors, but this is a decision that should be reevaluated at regular intervals throughout the business' existence. What worked when you started may be costing you in taxes, or liability exposure later.

QUESTION: What are the basic choices for a business Entity?

ANSWER: The most basic form is a sole proprietorship. This is a business owned directly by one person. It legally and financially coincides with its owner. This means that it is invisible for tax purposes - whatever comes in, or goes out, appears on the owner's personal tax returns. It also means the owner is totally liable for all debts. Next, there are general partnerships. A general partnership is a business owned directly by two or more people. Like a sole proprietorship, it is legally and financially equated to its owners. Financially, all of the profit or loss passes through to its owners, regardless of whether they take that money out of the business or not. And legally, all of the partners are liable for 100% of the business debts.

QUESTION: Can you agree with your partners that only one of you will be liable for your share of the debts?

ANSWER: Yes, you can, but that agreement isn't binding on the creditors. They can look to you for 100% of the debt, and you have to find, and collect from your deadbeat partners. After all, you picked them.

QUESTION: Why would anyone form a partnership?

ANSWER: A partnership does not have the formality requirements of a corporation of limited liability company. If personal liability is not an issue in the business, a partnership is an easy, natural, flexible business entity, and sometimes has good tax consequences.

QUESTION: What are the rest of the choices?

ANSWER: There is a variation on the general partnership, and that is a limited partnership. In a limited partnership there is at least one general partner, who has full liability, and one or more limited partners who are only liable up to the extent of their investment. In other words, if the company becomes insolvent, the limited partners will lose their investment, but no one can come after them for any more money. The general partners, on the other hand, are fully liable for all debts. Often a corporation will be the general partner, thereby insulating the shareholders from personal liability.

QUESTION: That sounds a lot better than a general partnership. Why wouldn't you always use that?

ANSWER: First you would have to decide who was going to be the general partner, with all the exposure. More significantly, the limited partners can only have a limited role in the operation and management of the business. If they overstep the legal limitations, they become general partners and have full liability. Also, there are special costs and filing requirements for limited partnerships.

QUESTION: What about corporations?

ANSWER: Corporations are separate entities, legally and financially distinct from their owners. The shareholders of a corporation are generally not liable for its debts, although there are some exceptions to that general rule. Tax wise, corporations can be treated two different ways. The "default" setting is a Internal Revenue Tax Code Subchapter "C" , which is a totally separate tax paying entity. The owners are only taxed on money they receive from the corporation, in the form of salary, rents, royalties, dividends or whatever. The corporation is taxed on the rest of the corporate income. A coarporation that elects to be taxed under Internal Revenue Code Subchapter "S" is taxed somewhat like a partnership. Its profits and losses are passed through to the owners, in proportion to their ownership interest. However, a corporation taxed under Subchapter "S " is not taxed exactly like a partnership when it comes to adjustment in basis, or liquidation. Corporations electing Subchapter "S" tax treatment also have limitations on who can be a shareholder, and how many shareholders there can be.

QUESTION: What are the exceptions to shareholder liability in a corporation?

ANSWER: There are several exceptions. First, the corporate form does not protect its owners or managers from their own actions. If you, as an individual, do the thing that causes the damage, you are going to be personally liable, along with the corporation. What the corporate entity can do is insulate you from the actions of the other owners and managers, as well as from your employees. Second, a shareholder can be held liable for the debts of the business if the proper corporate formalities are not followed. These formalities include maintaining corporate records, and keeping the corporate finances scrupulously separate.

QUESTION: What is a Limited Liability Company?

ANSWER: California adopted a Limited Liability Company law in late 1994. An LLC is an entity which offers its owners limited liability, but is taxed more like a partnership.

QUESTION: Isn't that what a corporation taxed under Subchapter "S" is?

ANSWER: No, corporations electing to be taxed under Subchapter "S" are taxed in their own unique way. An LLC, if set up in a certain way, they are taxed on the Federal level just like partnerships. Before we get to the tax implications, it must be understood that there are non-tax differences between the Sub-S corporation and an LLC. Sub-S corporations may have only 35 shareholders, and the holders must be individuals or certain trusts. Other business entities, like corporations, and nonresident aliens may not be shareholders of a Subchapter "S" corporation. There are no such limitations on the owners of a LLC. Sub-S corporations may only have one class of stock, so all of the owners must have the same rights and privileges, whereas in an LLC you have flexibility in fashioning the relationship among the owners.

QUESTION: What are the tax differences between an LLC and a Sub-S corporation?

ANSWER: First, both entities pass the business' profits and losses through to the owners. But taxation under Subchapter "S" requires that all allocations must be made strictly according to ownership interests. In an LLC, the profits and losses can be specially allocated in any manner agreeable to the parties. Another major difference is how appreciated assets are treated in a liquidation. Partnerships, and consequently LLC's, will almost always offer the best tax results on the sale of assets or complete liquidation. For this reason, LLC's are often recommended for enterprises where assets will be obtained, or created (e.g. intellectual property) and subsequently sold after they have appreciated.

QUESTION: Are LLC's difficult to form?

ANSWER: Yes and no. The filing requirements are not complicated, and are accomplished using forms from the Secretary of State. However, LLC's require an agreement among the members, and those agreements can be very complex.

QUESTION: Is there any easy way to determine the best entity for a particular business?

ANSWER: First, think about what your goals are. It is not enough to know what kind of business you are operating. You also need to think about whether you are going to use the business to defer income; are you going to bring in other investors; are you planning on selling the business or its assets? You should meet with both your attorney and your accountant to review both legal and tax issues.

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