Editor’s Note: First in a two-part series.
Individuals or groups who have an idea they’d like to turn into a business have a lot of decisions to make. One of the most important decisions a new company must make is what form the business will take.
For tax and legal reasons, companies have to choose between a sole proprietorship, a partnership, a limited liability partnership or corporation, a corporation or an S corporation. The business’ form will affect its exposure to personal liability, how members draw profits and pay taxes, its ability to raise capital and how the business is run.
This area of concern is where professional advisors play a key role. New businesses should consult with an attorney and an accountant before members decide what form to use for their new company. These consultants can advise businesses on tax advantages and can inform companies about which form offers the best protection of personal assets.
Forms of Business
Bill Mahaffey, tax lawyer with Rothgerber, Johnson and Lyons, LLP, says he asks clients a few basic questions prior to advising them how to organize their business. First, he asks them what type of business they are in – whether they are selling products or services and whether the company operates under a formal or informal makeup.
Second, Mahaffey asks clients who the principals of the company are. In other words, is there a single owner or will it be a partnership? Finally, he inquires how they will want to operate if someone wants to withdraw from ownership or how the business will need to be set up if it becomes necessary to force an owner out.
At issue in all organizations is asset protection and protection of liabilities. Each form has different requirements and legal obligations as well.
The first business form Mahaffey leans toward is the limited liability corporation.
“It is very well recognized in all jurisdictions, and nobody has liability for the obligations of the business entity,” says Mahaffey.
To become an LLC, businesses must file articles of organization with the secretary of state and have an operating agreement between owners. Decisions that must be made include who will administer the company (members or managers), how profits are allocated and distributions are made, the duties of members to each other regarding loyalty and competition and the sales or transfer of interest by a member if he/she decides to withdraw or dies.
The second type of company Mahaffey looks at is a general partnership. It requires a partnership agreement that should state each partner has unlimited liability for the obligations of the partnership. Also, each partner can separately enter into contracts for the partnership. Mahaffey says the general partnership is a fairly simple type of organization.
The third form is a limited liability partnership. A business must file a registration statement with the secretary of state and a partnership agreement should be made. Mahaffey often suggests this form to existing general partnerships so partners will not be liable for obligations of the entity.
Next, a limited partnership is a company with one or more general partners and one or more limited partners. Businesses choosing this form must file a certificate of limited partnership with the secretary of state and have a partnership agreement.
In this situation, the limited partners aren’t liable for the obligations of the partnership, but the general partners are, says Mahaffey. This form is ideal, he says, when a third party such as a lender or regulatory agency requires that someone have personal liability for the obligations of the organization.
Family-owned businesses often use this form when the parents want to involve children in the company but want to maintain the decisions about the assets.
A limited liability limited partnership, another business form, also requires registration with the secretary of state. It states that general partners don’t have a liability for the corporation’s obligations either.
All of these forms, says Mahaffey, have the added advantage of being able to treat different owners in different ways. Also, he says, they allow for special allocations of income and taxes.
A corporation is another common type of business form. It is a legal entity that functions somewhat like an individual, legally and for tax purposes. Liabilities are held by the corporation, minimizing the personal liability for owners.
The corporation operates as a business and can be owned wholly or partially based on registered certificates called stock. To set up a corporation, businesses must file an application for a legal name, pay a corporate franchise fee to the state in which they file, appoint a board of directors and corporate officers and keep minutes of periodic meetings of the board.
There’s a unique type of corporation called an S corporation that provides the advantages of a corporation but, unlike a corporation, is treated for income tax purposes as a flow-through entity. Income is reported individually by the owners or stockholders on their personal income tax returns. Also, the owners may deduct the corporation’s losses against other sources of income.
To become an S corporation, businesses must file an article of incorporation with the secretary of state, adopt bylaws and file a form 2553 with the Internal Revenue Service that states the company has elected to be an S corporation. An S corporation can only have 75 shareholders, Mahaffey says. New businesses with fewer than 35 stockholders may want to look into this option.
Some advisors may suggest a business file as an S corporation, Mahaffey says, as a way to reduce an owner’s liability for Social Security taxes for the corporation. Owners in this situation pay themselves a limited salary, pay Social Security taxes on that amount and take the rest of their salary in dividends.
A sole proprietorship is ideal for owners who don’t want to invest capital in their business. Also, they don’t have partners or need asset protection. This form of business doesn’t require a separate tax return for the company – it is all taken care of in Schedule C of the owner’s personal tax return.
Dave Mellinger, owner/agent with American National Insurance, initially organized his business as a sole proprietorship. He didn’t take a salary, but took dividends from what was left over at the end of each year.
In talking with his accountant, Mellinger decided to change over and operate as an S corporation for tax purposes and liability protection. In this case, if he accidentally didn’t insure a client properly, the client could sue the business but not Mellinger or his property.
Mellinger is now an employee of the company drawing a salary, and dividends still go to him as income. He pays taxes on the dividends at the end of the year, but says it’s easier to manage the taxes now that he pays monthly through employee salaries.
“It limits my tax liability and keeps it in check,” says Mellinger. “I don’t end up paying penalties or one large lump sum at the end of the year.”
In next week’s issue, part two of this series will discuss important tax implications for new businesses.