What You Need to Know About Incorporations, LLCs, and Other Business Formats
The Dangers of Sole Proprietorships and General Partnerships
While it may seem like a very simple way to organize your business, a Sole Proprietorship offers you no protection and exposes all of your personal assets, including your home, cars, and other belongings, in some states, to creditors and other opportunistic individuals. Running a business as a Sole Proprietorship is like swimming through a shark tank with a steak strapped to your head. And it’s just as stupid, because organizing a business is so simple.
One way people believe that they can protect themselves is with a DBA (Doing Business As) or an “assumed name”. These are very easy to obtain, usually at the county clerk’s office, and allow you to use a fictitious business name as if it were your own. A bank will let you open an account and cash checks made out to that name. And if you get sued or owe someone money, you are treated as a Sole Proprietorship. Just as if you didn’t file a DBA, your house, car, and other belongings are up for grabs, unless you live in a state that offers ample homestead exemptions. And even then, your PERSONAL and business bank accounts can be garnished after a creditor obtains a judgment. That’s right – even if the judgment is against your DBA, the creditor can get to the money in YOUR PERSONAL bank account.
Worse even still than a Sole Proprietorship is a General Partnership. And, surprisingly, you can ACCIDENTALLY form a General Partnership.
Let’s say you and a couple buddies decide to open a business. You buy the URL, you set up a website, you sell some items on eBay. One of the other guys, unbeknownst to you, gets drunk on the way to pickup a boxes of the stuff you are selling on eBay. He runs over a med student. Not only is he in trouble, but that individual can sue your business, and each and every one of you in the Partnership for his damages. Yep, PARTNERSHIP. Under the laws of most states, you can accidentally form a de facto Partnership simply by doing business with other people. And in a Partnership, each individual is jointly AND severally liable, meaning, that all of you are liable for everything that happens. And if you are the one with the most money, guess who the plaintiff’s attorney is going to pick to sue. If the suit against you is successful, all of the horrible things that can happen to you as the owner of a Sole Proprietorship can happen to as a Partner in a Partnership. DO NOT DO THIS.
So if it’s obvious that you shouldn’t accidentally form a partnership, then for goodness sake, don’t do it on purpose! There are plenty of forms out there on the internet for setting up a General Partnership. The people positing them should literally be shot. If you still think it would be a good idea to set a business up that way, just stop reading this right now, because you are beyond help. I am serious, I would not want you to waste your time.
The way you gain protection from a legal entity is that as you conduct business as that entity, you separate yourself from that entity. You are now an employee of a company, not just yourself in the marketplace. If the business owes money or causes some damage, then the business has to pay. Not you. This is important as you become successful. When you become prosperous, grow your business and customer base, and start paying yourself a large salary, that money is now out of the company and therefore outside of creditors’ grasps. This is where you want the assets. Instead of coming after you, someone comes after the company. If you have paid yourself and your investors properly, no one can come after you personally. This is the largest benefit to forming a legal entity.
For a more in-depth legal analysis of these dangers there are many online resources, including http://www.nvinc.com/danger_of_sole.htm.
How to Set Up a Business
Ok, so if you’ve gotten this far, it is clear that to you that you need to form some type of legally recognized entity to protect yourself from liability. First, though, you need to know that each entity we talk about below will have different tax consequences. If you already have an accountant, they can advise you on the best entity for your particular needs. However, if you are just starting a business with few assets, the difference in tax consequences will be minimal, and you can select your entity using the material provided here.
Decide the Best Format for YOU
If you are like most small business owners just getting started, you will have had at least one know-it-all tell you what form of business you need. They will not tell you why or give you any particular reason, usually, but they will be very authoritative about it. For now, forget whatever that person told you. They are probably wrong.
The most important factor in determining what form of business you need is how many people will own the business with you. If it is just yourself, then you probably need to choose from an S Corp (S Corporation) or an LLC (Limited Liability Company). If there are more people, then the other formats might be advisable.
If you are reading this, then a C Corp (C Corporation) is probably NOT what you need. If you have the need to form a C Corp, then the advice contained herein is probably not for you. C Corp’s are for businesses that retain earnings, pay passive investors, issue stock to be sold on the floor of the New York Stock Exchange, etc. If you truly believe you need to be a C Corp because of advice given to you by a tax accountant, then you should heed that advice. They are very similar in nature to the S Corps described here, but have significantly different tax treatment. Suffice to say, if you elect to be a C Corp, you may find yourself paying twice as much income tax as any of the others!
An LP (Limited Partnership) is a more complicated vehicle, but it comes in handy in the situation where you have a handful to a dozen passive investors and one or more individuals that will actually control the business. It allows the Limited Partners to not share in the liability, except up to the amount they invested, and to enjoy the profits generated by the Limited Partnership. The managing group will have the only liability associated with the LP and have full authority to act on behalf of the LP. This is explained in more detail below.
Other entities include Professional Corporations, Limited Liability Limited Partnerships, Limited Liability Partnerships, Professional Limited Liability Companies, and others. These are generally used by doctors and lawyers and will not be covered here.
Of course, there are also Non Profit Companies and Organizations, and they are also not covered here.
LLCs (Limited Liability Companies)
One of the most popular forms of small businesses is the LLC (Limited Liability Company). If you are still considering your options, an LLC (Limited Liability Company) may be the best format for you. It combines the liability protection of a traditional corporation with the ease of management and record keeping of a small partnership or Sole Proprietorship. Some people believe that you are not as protected with an LLC (Limited Liability Company) as you are with a corporation. THIS IS NOT TRUE. An LLC (Limited Liability Company) is just as good for liability protection as a corporation, and probably better, since it is easier to maintain, and thus easier not to screw up the day-to-day paperwork. And the best part is, there is minimal recordkeeping requirements – one of the best benefits of such an entity.
In an LLC (Limited Liability Company) in most states, the owner or owners are called Members. They own Membership Interest which is measured in percent ownership of the LLC (Limited Liability Company).The LLC (Limited Liability Company) can be Member-Managed or Manager-Managed. This means that the Members can keep control in themselves or hire Managers to run the business for them. If you are familiar with a corporation, the Members are like Shareholders and the Managers are like Directors. A huge advantage to an LLC (Limited Liability Company) is that the Members can simply vest control in themselves, taking out an unnecessary level of hierarchy.
Most of the time, a Member-Managed LLC is the right decision for a small business. It is the simplest solution and requires the least amount of headache and paperwork. Most of the time, only one or two documents a year need to be singed by the Members.
One specific instance when it might be wise to set up a Manager-Managed LLC is when you have two or three owners and one person who will own AND manage the business. Setting up a Manager-Managed LLC and vesting control in that individual will allow him or her to run the business without getting approval from the others when their approval would just be perfunctory anyway.
The federal income tax treatment of an LLC (Limited Liability Company) is also very important. In an LLC (Limited Liability Company), the entity is ignored. This means that the profit generated by the LLC (Limited Liability Company) is attributed to the individual Members. Most importantly, this avoids being taxed twice, as in a C Corporation. Traditionally, this was the largest problem to individuals forming entities – dealing with double taxation. Now, with an LLC, you can enjoy limited liability with the benefit of being taxed as a partnership. In fact, Members will receive a K-1 form, just like Partners in a Partnership, from whoever prepares the LLC’s tax return. Be sure to prepare for the tax liability of these distributions!
In an LLC (Limited Liability Company), the Members or Managers can appoint Officers, just as in a Corporation where the Board of Directors appoints Officers. In this way, you can have a President, Secretary, Vice President of Marketing, CFO, Sergeant at Arms, etc. A LLC (Limited Liability Company) is not limited in the way it operates.
Like all of the other entities discussed, an LLC (Limited Liability Company) is registered and formed with the Secretary of State in the state in which you live. Many states allow you to do this online now, however, it is not advisable to set any of these entities up without the help of an attorney. While forming the entity and filing the initial paperwork is fairly simple, setting up the organizational documents should be done by a professional attorney who specializes in entity formation within the state in which you live. Websites that offer forms cannot help you fill them out, and these forms are not a place where you want to guess and hope you got it right. You can literally destroy any of the liability protections that you are trying to obtain with one wrong move on an internet form. Be safe and use a local attorney.
S Corp (S Corporation)
An S Corp is similar to an LLC, but is more complicated and has a taller hierarchy. It served the same purpose as LLCs do today for many years prior to the widespread adoption of Limited Liability Company Acts by most of the states. It provides the same liability protection of an LLC, but offers more flexibility in the types of controlling positions you can create, as described below.
In a Corporation, there are the Shareholders who own Shares and are passive investors. You can be a Shareholder and have no responsibilities whatsoever. Most people are familiar with this role through experience or knowledge of the various stock exchanges. If you own 100 shares of Dell, you are a Shareholder of Dell, but they don’t invite you to help them make important decisions in the boardroom.
In most small Corporations, S Corps or C Corps, the Shareholders are the people that run the business as well. The Shareholders technically appoint the Board of Directors. Usually in an S Corp, all of the Shareholders also appoint themselves to the Board of Directors. Then they are Shareholders and Directors. The Directors then appoint Officers. This is really their only function, aside from several duties that include approving purchases of real estate, the sale of all or substantially all of the assets of the company, dissolution of the Corporation, etc.
The Officers actually run the day to day operations of the Corporation, and can further delegate these duties to the employees that the Officers hire and fire. The ability to hire and fire can be vested in one Officer or shared by all of them. You must have at least one officer, and can have as many as you want.
The IRS treats an S Corp as like an LLC (Limited Liability Company). In other words, the shareholders of an S Corp are treated, for tax purposes ONLY, as partners. They receive K-1s at the end of each year, and report the income as regular income. You accountant will need to file a Form 2553 with the IRS, which asks the IRS to disregard the Corporation for purposes of federal income tax purposes. By meeting very simple guidelines, you can qualify for this special tax treatment. You accountant can help you with this filing and in meeting the requirements.
Like an LLC (Limited Liability Company), an S Corp is registered and formed with the Secretary of State in the state in which you live. Many states allow you to do this online now, however, it is not advisable to set any of these entities up without the help of an attorney. While forming the entity and filing the initial paperwork is fairly simple, setting up the organizational documents should be done by a professional attorney who specializes in entity formation within the state in which you live. Websites that offer forms cannot help you fill them out, and these forms are not a place where you want to guess and hope you got it right. You can literally destroy any of the liability protections that you are trying to obtain with one wrong move on an internet form. Be safe and use a local attorney.
LP (Limited Partnership)
While someone varied from state to state, the basic information regarding a LP (Limited Partnership) is the same. The purpose is to allow passive investors the ability to simply invest money, without having those individuals have ANY power to vote or appoint board members. They literally have no power. However, the General Partner has a fiduciary duty the Limited Partners. This means, obviously, that the GP (General Partner) cannot steal from the Limited Partners or do anything that benefits the GP over the Limited Partners or the Limited Partnership.
The way an LP (Limited Partnership) is set up is there is at least one Limited Partner and at least one General Partner. It is usually best to have only one General Partner, as having more than one serves no particular purpose.
The Limited Partner(s) have no liability and simply are entitled to receive a portion of distributions according to the particular Limited Partnership Agreement. Usually, the one General Partner is an LLC or an S Corp. The owners of the GP (General Partner) are also usually Limited Partners and derive their income primarily from the distributions made to Limited Partners. However, it is not uncommon for the Limited Partnership to pay the General Partner a management fee. Out of this management fee, the General Partner can pay its owners/employees a salary.
The Limited Partnership itself can own property, run a business, and employ employees, just like any other entity. However, the Limited Partners cannot be involved in the day-to-day operations of the Limited Partnership, unless they are also officers or employees of the General Partner.
As you can see, the complicated nature of this type of arrangement makes it best only in certain specific situations that involve investors who wish to remain silent.
Further, in most states, the sale of Limited Partnership interests or shares is considered a sale of securities and the applicable state and federal disclosure requirements apply. If these are not followed precisely, you can lose all of you investment, and more importantly, be sued by the Limited Partners when they don’t get rich. Because of these considerations, under no circumstances should you attempt to set up or sell shares in an LP (Limited Partnership) without the advice and assistance of counsel.
Limitation of Liability
While tax consequences are certainly important, the most significant benefit to any of the above forms of business is the limitation on liability for individuals. While these are the best ways to limit your liability, they ARE NOT foolproof. However, you can avoid losing your protection by abiding by the following rules. Of course, there are other ways to screw up your protection, but these are the most common. Generally, they are referred to as “piercing the corporate veil.” You don’t want that to happen to you.
Commingling Assets
While you will think of yourself as the “owner” of your business, it is wise not to refer to yourself in this manner. Referring to yourself as your title or official position is wisest. Not only will this prevent others from believing you to be a Sole Proprietorship or Partnership, it will keep you from treating company assets as your own.
Here’s why this is important:
If you commingle your own assets with the company’s assets, in any of the above situations, you can be considered to incur personal liability. So don’t do things like buy groceries for your home with the company card, pay rent from company funds, or pay company bills with personal funds. Be sure to go through the motions of paying yourself either a salary or a distribution, then depositing the check into your personal account, and then using the money for expenses. It all ends up in the same place, but it helps maintain the legal fiction of a separate entity.
Being Thinly Capitalized
Being thinly capitalized means that you don’t have at least enough money to do what you are trying to do. If you have a lemonade stand, then you don’t need a million dollars. However, if you are opening a hazardous mining company and only have $30, then you are certainly thinly capitalized. In some states, there is a minimum of $1000 that you must have in your bank account to get started. Check with your attorney on what this limit is in your state. The bottom line is that if you don’t have enough money to start the business, a court may find that you aren’t a real entity.
Failing to Observe Formalities or to Appoint Officers
If you are running a corporation or an LLC and do not have the appropriate minutes and yearly report filings required the Secretary of State in your state, then you may have your entity ignored. If you fail to have appropriate meetings or have no officers and just run the company as a shareholder, it may not be enough to maintain the corporate fiction. You need to make sure that your attorney is taking care of all the technical details in order to protect yourself and your assets.
Organizational Documents
You need to set up rules for your entity. In a Corporation, these are called Bylaws. In an LLC, they are called Regulations or an Operating Agreement, and in a Limited Partnership, they are usually contained in the comprehensive Limited Partnership Agreement. However, in an LP, the General Partner, which will probably be an LLC or an S Corp, will also need to have these rules.
These documents will go a long way in helping to resolve disputes with other owners before they begin. They address things like deadlock, ties between voting parties, what happens if someone dies, what happens if someone divorces (community property states), and other contingencies that no one wants to think about. When talking with an attorney about these issues, you will learn a lot about what you and your business partners expectations for each other are. Simply going through a standard form may give you hours of material to discuss with your partners that you haven’t yet thought of.
You will also need Organizational Minutes or Unanimous Resolutions for Corporations and LLCs. A Limited Partnership will need to have something similar and it varies from state to state. This document is like the starter pistol in a race and sets everything in motion. It will name the officers and directors, and it will allow you to get a bank account on behalf of the entity. If you are purchasing assets in the very beginning, this document will include this, and other, important directions you will give to the company. It sets out the authority for you to take certain actions.
It is imperative that you maintain and keep these documents. Without these two important pieces of the puzzle, you will certainly not have met your obligation to maintain the corporate fiction.
You will need to file a report once a year, most likely, with your Secretary of State or other governmental entity. Certainly, this will be aside and apart from you state income and sales tax filings, and your federal income tax filings. In some states, it is as simple as a yearly “informational report”. In others, it is more extensive. Consult your attorney as to exactly what is necessary.
Agreements Between Owners
Commonly in a small company, you will want to restrict your partners abilities to sell their interest. It’s one thing to go into business with your brother-in-law, but you probably don’t want him to be able to sell his part of the business to some guy from his office poker game.
In corporations, these agreements can be restrictions on the transfer of shares built into the Bylaws. In an LLC, you can build them into the Regulations. Or you can simply have a separate agreement. You will at least want a Right of First Refusal to purchase shares or interest from your partners. This is a simple provision for an attorney skilled in this arena.
There are very few situations when you will not want this tool. It is important in small businesses to like your partners. If you have no control over who they are, you may very quickly lose interest in the entire enterprise.
There are many other provisions that you can include as well, ranging from key-man life insurance to tax planning and vendor selection.
Ongoing Business Enterprises
If you are purchasing an ongoing enterprise, you should only do so with a newly-formed entity. Purchasing an enterprise by yourself invites suits from past creditors. The best way to do something like this is through a comprehensive Asset Purchase Agreement. Your experienced transactional attorney can craft a document for you that will indemnify and protect you against future claims and keep the creditors of the old business off your back. Also, you want to make sure that you are just buying the assets of the company and not assuming their liabilities.
Business brokers typically have the worst forms for these transactions. They will tell you that the documents are in good order and prepared by attorneys, and this is usually a complete lie. A good rule of thumb is that if an Asset Purchase Agreement isn’t over 5 pages, DO NOT SIGN IT. There are more contingencies and situations that you need to plan for that cannot be covered in less space.
Franchises are a good way to get started if you aren’t very knowledgeable in the particular industry in which you want to break into. However, Franchise Agreements are some of the lengthiest and most complicated legal documents in the business world. Use caution when agreeing to any of them, and always have an attorney review them before execution and closing. Just having a lawyer explain what each section means will go a long way in helping to make sure that you don’t breach the agreement or owe the franchisor certain penalties. Also, franchisors will always want to take more of your profits and control more aspects of your business than you want them to. Their agreements will give them rights and you obligations that savvy business people will be very leery of. One common statement from franchisors or their agents is that the “legal document” (the Franchise Agreement) is just for the lawyers, and it isn’t really enforced. Of course, when the franchisor wants to enforce it, they will do just that. Use caution with any franchisor that makes these kinds of statements. And brokers will tell you the same thing – especially if they have the opportunity to earn a piece of your payments via a brokerage agreement. BE CAREFUL WITH A FRANCHISE.
In parting, this information should get you started in investigating your options in starting a business. Certainly, the information here is NOT enough to allow you to jump right in. You should add to your own business judgment and acumen accounting and legal experts to help bolster your knowledge on your road to success.
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