The
Different Ways of Doing Business
There
are several legal structures or forms under which a business can operate,
including the sole proprietorship, partnership, limited liability company and
corporation. In addition, two of these structures have important variants. The
partnership form has spawned the limited partnership and the registered limited
liability partnership. And the corporation can be recognized, for tax purposes,
as either the standard C corporation, in which the corporation and its owners
are treated as separate taxpaying entities, or as an S corporation, in which
business income is passed through the corporate entity and taxed only to its
owners on their individual tax returns.
Often,
business owners start with the simplest legal form, the sole proprietorship,
then move on to a more complicated business structure as their business grows.
Other business people pick the legal structure they like best from the start,
and let their business grow into it. Either way, choosing the legal structure
for your business is one of your important decisions when starting a business.
A sole proprietorship is the legal name for a
one-owner business (spouses can co-own and help run a sole proprietorship, too).
When people think of a “mom and pop” or a home-based business, they are
usually thinking of a sole proprietorship. A sole proprietorship has the
following general characteristics:
Ease of Formation.
The sole proprietorship is the easiest to establish legally. Just hang out your
shingle or “Open for Business” sign, and you have established a sole
proprietorship. Sure, there are other legal steps you may wish to take — such
as registering a fictitious business name different from your own individual
name by filing a “dba statement” with the county clerk — but these steps
are not necessary to establish your business legally.
Personal Liability for Business Debts,
Liabilities and Taxes. In this
simplest form of small business legal structures, the owner, who usually runs
the business, is personally liable for its debts, taxes and other liabilities.
Also, if the owner hires employees, she is personally responsible for claims
made against these employees acting within the course and scope of their
employment.
Simple Tax Treatment.
All business profits (and losses) are reported on the owner’s personal income
tax return each year (using Schedule C, Profit or Loss From Business,
filed with the owner’s 1040 federal income tax return). And this remains true
even if a portion of this money is invested back in the business — that is,
even if the owner doesn’t “pocket” business profits for personal use.
Legal Life Same as Owner’s.
On the death of its owner, a sole proprietorship simply ends. The assets of the
business normally pass under the terms of the deceased owner’s will or trust,
or by intestate succession (under the state’s inheritance statutes) if there
is no formal estate plan.
DON’T LET BUSINESS ASSETS GET STUCK IN
PROBATE
The court process necessary to probate a will
can take more than a year. In the meantime, it may be difficult for the
inheritors to operate or sell the business or its assets. Often, the best way to
avoid having a probate court involved in business operations is for the owner to
transfer the assets of the business into a living trust during his lifetime;
this permits business assets to be transferred to inheritors promptly on the
death of the business owner, free of probate.
Sole Proprietorships in Action
Many small, one-owner or spouse-owned businesses start small with very little
advance planning or procedural red tape. Celia Wong is a good example — Celia
is a graphics artist with a full-time salaried job for a local book publishing
company. In her spare time she takes on extra work using her home computer to
produce audio cassette and CD jacket cover art for musicians. These jobs are
usually commissioned on a handshake or phone call. Without thinking much about
it, Celia has started her own sole proprietorship business. Celia should include
a Schedule C in her yearly federal 1040 individual tax return, showing the net
profits (profits minus expenses) or losses of her sole proprietorship. Celia is
responsible for paying income taxes on profits, plus self-employment (Social
Security) taxes based on her sole proprietorship income (IRS Form SE is used to
compute self-employment taxes; Celia attaches it to her 1040 income tax return).
A partnership is simply an enterprise in which
two or more co-owners agree to share in the profits. No written partnership
agreement is necessary. If two people go into business together, and do not
incorporate or form a limited liability company, they automatically establish a
legal partnership.
Partnerships are governed by each state’s
partnership law. But since all states have adopted a version of the Uniform
Partnership Act (for example, the California Uniform Partnership Act, beginning
with Section 15001 of the California Corporations Code), laws are very similar
throughout the U.S. Mostly, these laws contain basic rules that provide for an
equal division of profits and losses among partners and establish the
partners’ legal relationship with one another. These rules are not mandatory
in most cases, and you can (and should) spell out your own rules for dividing
profits and losses and operating your partnership in a written partnership
agreement. If you don’t prepare your own partnership agreement, all provisions
of California’s Partnership Law apply to your partnership.
CALIFORNIA LIMITED PARTNERSHIPS
Most smaller partnerships are general
partnerships — this means that all owners agree to manage the partnership
together, and each partner is personally liable for debts of the partnership.
However, there are two other fairly common types of partnerships: limited
partnerships and registered limited liability partnerships (RLLPs). Each of
these is quite different from a general partnership
THE LIMITED PARTNERSHIP The limited
partnership structure is used when one or more of the partners are passive
investors (called “limited partners”) and another partner (called a
“general partner”) runs the partnership. A Certificate of Limited
Partnership is filed with the Secretary of State to form a limited partnership,
and a filing fee must be paid. The advantage of a limited partnership is that
unlike a general partnership, where all partners are personally liable for
business debts and liabilities, a limited partner is allowed to invest in a
partner ship without the risk of incurring personal liability for the debts of
the business. If the business fails, all that the limited partner can lose is
her capital investment — the amount of money or the property she paid for an
interest in the business. However, in exchange for this big advantage, the
limited partner normally is not allowed to participate in the management or
control of the partnership. If she does, she can lose her limited liability
status and can be held personally liable for partnership debts, claims and other
obligations.
Typically, a limited partnership has a number
of limited partner investors and one general partner (there can be more, but
there must be at least one) who is responsible for partnership management and is
personally liable for its debts and other liabilities.
THE REGISTERED LIMITED LIABILITY
PARTNERSHIP The registered limited
liability partnership (RLLP) is a special legal structure designed for persons
who form a partnership in California to perform the licensed professional
services of attorneys, accountants or architects. An RLLP is formed by filing a
Registration of Limited Liability Partnership form with the California Secretary
of State.
The point of an RLLP is to relieve
professional partners from personal liability for debts, contracts and claims
against the partnership, including claims against another partner for
professional malpractice. However, a professional in an RLLP remains personally
liable for his own professional malpractice.
A general partnership has the following
characteristics:
Each Partner Has Personal Liability.
Like the owner of a sole proprietorship, each partner is personally liable for
the debts and taxes of the partnership. In other words, if the partnership
assets and insurance are insufficient to satisfy a creditor’s claim or legal
judgment, the partners’ personal assets can be attached and sold to pay the
debt.
The Act or Signature of Each Partner Can
Bind the Partnership. Each partner is
an agent for the partnership and can individually hire employees, borrow money,
sign contracts and perform any act necessary to the operation of the business.
All partners are personally liable for these debts and obligations. This rule
makes it essential that the partners trust each other to act in the best
interests of the partnership and each of the other partners.
Partners Report and Pay Individual Income
Taxes on Profits. A partnership files
a yearly IRS Form 1065, U.S. Partnership Return of Income, which includes a
schedule showing the allocation of profits, losses and other tax items to all
partners (Schedule K). The partnership must mail individual schedules (Schedule
K-1s) to each partner at the end of each year, showing the items of income,
loss, credits and deductions allocated to each partner. When a partner files an
individual income tax return, she reports her allocated share of partnership
profits (taken from the partner’s Schedule K-1), and pays individual income
taxes on these profits. As with the sole proprietorship, partners owe tax on
business profits even if they are plowed back into the business, unless the
partners decide to elect to have the partnership taxed as a corporation.
PARTNERSHIPS CAN CHOOSE TO BE TAXED AS
CORPORATIONS
Unincorporated co-owned businesses, including
partnerships and limited liability companies (discussed below), can choose to be
taxed as a corporation by filing IRS Form 8832, Entity Classification Election.
Most smaller partnerships will not wish to make this election, preferring
instead to have profits divided among the partners and then taxed on their
individual tax returns. But this is not always true. For example, some
partnerships — especially those that want to reinvest profits in expanding the
business — may prefer to keep profits in the business, and have them taxed to
the business at the lower initial corporate tax rates. Your tax advisor can tell
you if this tax strategy makes sense for your business.
Partnership Dissolves When a Partner Leaves.
Legally, when a partner ceases to be associated with carrying on the business of
the partnership (when he withdraws or dies), the partnership is dissolved.
However, a properly written partnership agreement provides in advance for these
eventualities, and allows for the continuation of the partnership by permitting
the remaining partners to buy out the interest of the departing or deceased
partner. Of course, if one person in a two-partner business leaves or dies, the
partnership is legally dissolved — you need at least two people to have a
partnership.
WHY YOU NEED A WRITTEN PARTNERSHIP
AGREEMENT
Although it’s possible to start a
partnership with a verbal agreement — or even with no stated agreement at all
— there are drawbacks to taking this casual approach. The most obvious problem
is that a verbal agreement can be remembered and interpreted differently by
different partners. And having no stated agreement at all almost always means
trouble. Also, if you don’t write out how you want your partnership to be
operated, you lose a great deal of flexibility. Instead of being able to make
your own rules in a number of key areas — for example, how partnership profits
and losses are divided among the partners — California state partnership law
will automatically come into play. These state-based rules may not be to your
liking (for example, state law generally calls for an equal division of profits
and losses regardless of partners’ capital contributions).
Another reason why you should prepare and sign
a written partnership agreement is to avoid disputes over what happens when a
partner wants to leave the business. Here are just a few of the difficult
questions that can arise if a partner wants to leave the partnership:
· If
the remaining partners want to buy the departing partner out, how will the
interest be valued?
· If
you agree on value, how will the departing partner be paid for her interest —
in a lump sum or installments? If in installments, how big will the down payment
be; how many years will it take for the balance to be paid; and how much
interest will be charged?
· What
happens if none of the remaining partners wants to buy the departing partner’s
interest? Will your partnership dissolve? If so, can some of the partners form a
new partnership to continue the partnership business? Who gets to use the
dissolved partnership’s name and client or customer list?
California law does not necessarily provide
helpful answers to these questions, which means that if you don’t have a
written partnership agreement, you may face a long legal battle with a partner
who decides to call it quits. To avoid these and other problems, a basic
partnership agreement should, at a minimum, spell out how much interest each
partner has in the partnership, how profits and losses will be split up between
or among the partners and how any buyout or transfer of a partner’s interest
will be valued and handled. The aftermath of the dissolution of the partnership
also should be considered, and rules set out for a continuance of the
partnership’s business by ex-partners if desired.
The limited liability company (LLC) is the new
kid on the block of business organizations. It has become popular with many
small business owners, in part because it was custom-designed by state
legislatures to overcome particular limitations of each of the other business
forms, including the corporation. Essentially, the LLC is a legal ownership
structure that allows owners to pay business taxes on their individual income
tax returns like partners (or, for a one-person LLC, like a sole
proprietorship), but also gives the owners the legal protection of personal
limited liability for business debts and judgments as if they had formed a
corporation. Or, put another way, with an LLC you can simultaneously achieve the
twin goals of one-level taxation of business profits and limited personal
liability for business debts.
CAN YOUR PROFESSIONAL BUSINESS FORM AN LLC?
The
California LLC Act prohibits certain professionals (the same professionals —
such as doctors, lawyers and accountants — who must form a professional
corporation if they want to incorporate) from forming an LLC. If you are a
licensed professional and you want to form an LLC, contact your state licensing
board (most are in Sacramento) and ask whether the law allows you to form one.
If not, you’ll have to incorporate your professional practice to protect
yourself from personal liability for the debts of your business. Accountants,
architects and lawyers have another option: They can register their general
partnership practices as registered limited liability partnerships (RLLPs) to
protect themselves from personal liability in many situations. (RLLPs are
discussed in Section A2, above).
Here are some of the most important LLC
characteristics:
Limited Liability.
The owners of an LLC are not personally responsible for its debts and other
liabilities. Specifically, Section 17101 of the California Beverley-Killea
Limited Liability Company Act says that members are not personally liable for
any debt, obligation or liability of the LLC, whether that liability or
obligation comes from a contract dispute, tort (injury to other persons or
damage to their property) or any other type of claim. This type of sweeping
personal legal liability protection is the same as that enjoyed by shareholders
of a California corporation. In short, the LLC and the corporation offer the
same level of limited personal liability protection.
Pass-Through Taxation.
Federal tax law normally treats an LLC like a partnership, unless the LLC elects
to be taxed as a corporation (by filing IRS Form 8832 — see Section A2,
above). The California Franchise Tax Board treats a California LLC for state
income tax purposes as it is treated for federal income tax purposes. An LLC
with an annual gross income of $250,000 or more must pay an additional annual
fee, based upon a graduated fee schedule that is adjusted from year to year.
If an LLC is treated as a partnership at the
federal and state levels, it files standard partnership tax returns (IRS Form
1065, Schedules K and K-1) with the IRS and state, and the LLC members (owners)
pay taxes on their share of LLC profits on their individual income tax returns.
An LLC that elects corporate tax treatment files federal and state corporate
income tax returns.
Ownership Requirements.
California allows one owner (member) to form an LLC. Members need not be
residents of California, or even the U.S. for that matter. Other business
entities, such as a corporation or another LLC, can be LLC owners.
Management Flexibility.
LLCs are normally managed by all the owners (members) — this is known as
“member-management.” But state law also allows for management by one or more
specially appointed managers (who may be members or nonmembers). Not
surprisingly, this arrangement is known as “manager-management.” In other
words, an LLC can appoint one or more of its members, one of its CEOs or even a
person contracted from outside the LLC to manage its affairs. This setup makes
sense if one person wishes to assume full-time control of the LLC while the
other owners act as “passive” investors in the enterprise.
Formation Requirements.
Like a corporation, LLCs require paperwork to get going. Articles of
Organization must be filed with the California Secretary of State. And if the
LLC is to maintain a business presence in another state, such as a branch
office, it also must file registration or qualification papers with the other
state’s Secretary or Department of State. California’s LLC formation fee is
$70. California LLCs, like California corporations and limited partnerships,
must pay an annual minimum $800 tax to the Franchise Tax Board. There is an
additional LLC annual tax, with a tiered rate structure, for LLCs with annual
gross incomes of $250,000 or more (the additional tax may be anywhere from $900
to $11,000).
Like a partnership, an LLC should prepare an
operating agreement to spell out how the LLC will be owned, how profits and
losses will be divided, how departing or deceased members will be bought out and
other essential ownership details. However, preparation of an LLC operating
agreement is not legally required. If it is not prepared, the default provisions
of California’s LLC Act will apply to the operation of the LLC. Since LLC
owners will want to control exactly how profits and losses are apportioned among
the members rather than following the default rules set out in the LLC Act,
preparing an LLC operating agreement is a practical necessity.
Now, let’s look at the basic attributes of
the corporation, the type of business organization this book shows you how to
organize.
A corporation is a statutory creature, created
and regulated by state law. In short, if you want the “privilege” — as the
courts call it — of turning your business enterprise into a California
corporation, you must follow the requirements of the California Business
Corporation Law.
What sets the corporation apart from all other
types of businesses is that it is a legal entity separate from any of the people
who own, control, manage or operate it. The state corporation and federal and
state tax laws view the corporation as a legal “person” — it can enter
into contracts, incur debts and pay taxes separately from its owners.
Like the owners (members) of an LLC, the
owners (shareholders) of a corporation are not personally liable for the
corporation’s business debts, claims or other liabilities. This means that a
person who invests in a corporation (a shareholder) normally only stands to lose
the amount of money or the value of the property which he has paid for its
stock. As a result, if the corporation does not succeed and cannot pay its debts
or other financial obligations, creditors cannot seize or sell the corporate
investor’s home, car or other personal assets.
BEWARE OF EXCEPTIONS TO THE RULE OF PERSONAL LIMITED LIABILITY PROTECTION
In some situations, corporate directors, officers and shareholders of a
corporation can be held responsible for debts owed by their corporation. Here
are a few of the most common exceptions to the rule of limited personal
liability (these exceptions also apply to other limited liability business
structures, such as the LLC):
Personal Guarantees.
When a bank or other lender makes a loan to a small corporation, particularly a
newly formed one, it often requires that the people who own the corporation
agree to repay it from their personal assets should the corporation default on
the loan. Shareholders may even have to pledge equity in a house or other
personal assets as security for repayment of the debt. Of course, shareholders
can just say no — but if they do, their corporation may not qualify for the
loan.
Federal and State Taxes.
If a corporation fails to pay income, payroll or other taxes, the IRS and the
California Franchise Tax Board are likely to attempt to recover the unpaid taxes
from “responsible employees” — a category that often includes the
principal directors, officers and shareholders of a small corporation.
Unlawful or Unauthorized Transactions.
If you use the corporation as a device to defraud third parties, or if you
deliberately make a decision (or fail to make one) that results in physical harm
to others or their property (such as failing to maintain premises or a work site
properly, manufacturing unsafe products or causing environmental pollution), a
court may “pierce the corporate veil” and hold the shareholders of a small
corporation individually liable for damages (monetary losses) caused to others.
Fortunately, most of the problem areas where
you might be held personally liable for corporate obligations can be avoided by
following a few commonsense rules (rules you’ll probably adhere to anyway):
First, don’t do anything which is dishonest or illegal. Second, make sure your
corporation does the same, by having it obtain necessary permits, licenses or
clearances for its business operations. Third, pay employee wages and withhold
and pay corporate income and payroll taxes on time. Fourth, don’t personally
obligate yourself to repay corporate debts or obligations unless you fully
understand and accept the consequences.
Let’s now look at a few of the most
important tax characteristics of the corporation. We’ll start with the dual
level of taxation built into the corporate business structure.
1. Dual Taxation and Income Splitting
The corporation is a taxpayer, with its own
income tax rates and tax returns separate from the tax rates and tax returns of
its owners. This double layer of taxation allows corporate profits to be kept in
the business and taxed at the initial corporate tax rates, which are generally
lower than those of the corporation’s owners. The result of this type of
business income splitting between the corporation and its owners can result in
an overall tax savings for the owners (compared to pass-through taxation of all
business profits to the owners, which is the standard tax treatment of sole
proprietorships, partnerships and LLCs).
CORPORATE TAX RATES MAX OUT AT 34% FOR MOST
CORPORATIONS
Even though corporate tax rates can go up to 39%, all corporate net income below
$10 million is subject to an effective flat tax rate of 34%. (See Chapter 4,
Section B.)
LLCS AND PARTNERSHIPS CAN ELECT CORPORATE TAX TREATMENT
Dual taxation and income splitting are no longer unique to corporations.
Partnerships and LLCs can elect to be taxed as corporations if they wish to keep
money in the business and have it taxed at corporate rates. (See the sidebar in
Section A2, above.)
HOW SMALL CORPORATIONS AVOID DOUBLE TAXATION OF CORPORATE PROFITS
What
about the old bugaboo of corporate double taxation? Most people have heard that
corporate income is taxed twice: once at the corporate level and again when it
is paid out to shareholders in the form of dividends. In theory, the Internal
Revenue Code says that most corporations are treated this way (except S
corporations, whose profits automatically pass to shareholders each year — see
below). In practice, however, double taxation seldom occurs in the context of
the small business corporation. The reason is simple: Employee-owners don’t
pay themselves dividends, which are taxed at the corporate rate when earned and
at the individual shareholder level when paid to them. Instead, the
shareholders, who usually work for their corporation, pay themselves salaries
and bonuses, which are deducted from the profits of the corporate business as
ordinary and necessary business expenses. The result is that profits paid out in
salary and other forms of employee compensation to the owner-employees of a
small corporation are taxed only once, at the individual level. In other words,
as long as you work for your corporation, even in a part-time or consulting
capacity, you can pay out business profits to yourself as reasonable
compensation. Your corporation won’t have to pay taxes on these profits.
2. Corporations Can Elect Pass-Through
Taxation of Profits
Just as partnerships and LLCs have the ability
to request corporate tax treatment, corporations can change their built-in dual
income tax treatment to the type of pass-through taxation of business profits
which normally applies to partnerships and LLCs. A corporation accomplishes this
by making an S corporation tax election with the IRS.
MANY MAY SAY WHEN JUST STARTING OUT, FORM AN LLC INSTEAD? Be Leary of that!
An LLC, like an S corporation, gives its owners pass-through taxation of
business profits plus limited personal liability for business debts. It also is
more flexible than an S corporation for technical reasons (see below).
Therefore, it usually makes more sense to form an LLC when you are just starting
to organize your business. If you are already doing business as a corporation,
switching over to S corporation tax status — by making an S corporation tax
election — makes sense if you wish to keep your corporation intact, but decide
that pass-through taxation of profits will save you tax dollars. This might be
true, for example, for a corporation that no longer wishes to keep profits in
the business, but can’t pay all of them out to shareholders as salaries (if
some shareholders don’t work for the corporation or if the payout of all
profits as salaries would render them “excessive” and subject to IRS attack,
for example). The only other way an existing corporation can get the limited
liability protection and pass-through tax treatment of the S corporation is to
dissolve, then reorganize as an LLC. This can be costly from a tax
LLCS AND PARTNERSHIPS HAVE TECHNICAL TAX
ADVANTAGES OVER S CORPORATIONS
LLC owners and partners can split profits
disproportionately to their ownership interests in the business (these are
called “special allocations” of profits and losses under the tax code); S
corporation shareholders can’t. Also, the amount of corporate losses that may
be passed through to S corporation shareholders is limited to the total of each
shareholder’s “basis” in his stock (the basis is the amount paid for stock
plus and minus adjustments during the life of the corporation) plus amounts
loaned personally by each shareholder to the corporation. Losses allocated to a
shareholder that exceed these limits can be carried forward and deducted in
future tax years if the shareholder then qualifies to deduct the losses. In
contrast, LLC owners and partners may be able to personally deduct more business
losses on their tax returns in a given year than S corporation shareholders. The
reason is that an LLC member and partner gets to count her pro-rata share of all
money borrowed by the business, not just loans personally made by the member or
partner, in computing how much of any loss allocated to her by the business she
can deduct in a given year on her individual income tax return.
U.S. corporations that have 75 or fewer
shareholders who are U.S. citizens or residents can elect federal S corporation
tax treatment (by filing IRS Form 2553). Once an S corporation election is made
with the IRS, the corporation can make the same election with the California
Franchise Tax Board. A corporation that files an S corporation tax election has
all its profits, losses, credits and deductions passed through to its
shareholders, who report these items on their individual tax returns. In effect,
this allows the corporation to sidestep corporate taxes on business profits,
passing the profits (and the taxes that go with them) along to the shareholders.
Each S corporation shareholder is allocated a portion of the corporation’s
profits and losses according to her percentage of stock ownership in the
corporation (a 50% shareholder reports and pays individual income taxes on 50%
of the corporation’s annual profits, for example).
Note that these profits are allocated to the
shareholders whether the profits are actually paid to them or kept in the
corporation.
3. Tax Consequences of Corporate
Dissolution
You should consider an additional tax aspect
of forming a corporation before deciding to incorporate — the tax consequences
of ending the corporation when it is dissolved or sold. The general rule is that
when a corporation is sold or dissolved, both the corporation and its
shareholders have to pay capital gain taxes. However, there are ways to minimize
this double tax, if you plan in advance. Check with your tax person on the
eventual tax ramifications of dissolving your corporation right from the start.
One of the most important pre-incorporation services your tax advisor can
provide is to make sure that the future dissolution or sale of your corporation
will not result in an unexpectedly hefty tax bill for your corporation and its
owners.
A key tax characteristic of the corporate
structure is that business owners who also work in the business become
employees. This means that you, in your role as an employee, become eligible for
tax-deductible corporate fringe benefits, some of which you would not qualify
for as a sole proprietor, partner or LLC member.
Perhaps the most unique benefit of forming a
corporation is the ability to divide management, executive decision making and
ownership into separate areas of corporate activity. This separation is achieved
automatically because of the separate legal roles which reside in the corporate
form: the roles of directors (managers), executives (officers) and owners
(shareholders). Unlike partnerships and LLCs, the corporate structure comes
ready-made with a built-in separation of these three roles, each with its own
legal authority, rules and ability to participate in corporate income and
profits.
Board of Directors:
The management team, which meets once each quarter to analyze and project
financial performance and review store operations, consists of the three
founders, Myra, Danielle and Rocco, and one of the other three investors. The
investor board position is a one-year rotating seat. This year Tony has the
investor board seat; next year, Collette; the third year, Aunt Kate. This
pattern repeats every three years. Directors have one vote apiece, regardless of
share ownership — this means the founders can always outvote the investor vote
on the board, but this also guarantees that each of the investors will have an
opportunity to hear board discussions and give input on major management
decisions.
Executive Team:
The officers or executive team charged with overseeing day-to-day business;
supervising employees; keeping track of ordering, inventory and sales
activities; and generally putting into practice the goals set by the board are
Myra (President) and Danielle (Vice President). Rocco fills the remaining
officer positions of Secretary/Treasurer of the corporation, but this is a
part-time administrative task only.
Participation in Profits:
Corporate net profits are used to stock inventory, pay rent on the West End
storefront and pay all the other usual and customary expenses of doing business.
The two full-time executives, Myra and Danielle, get a corporate salary, plus a
year-end bonus when profits are good. Rocco gets a small stipend (hourly pay)
for his part-time work.
To
duplicate this structure as a partnership or LLC would require a specially
drafted partnership or LLC operating agreement with custom language and plenty
of review by the founders and investment group (and, no doubt, their lawyers).
The corporate form is designed to handle this division of management, day-to-day
responsibilities and investment with little extra time, trouble or expense.
Corporations offer a terrific structure for
raising money from friends, family and business associates. There is something
special about stock ownership, even in a small business, that attracts others.
The corporate structure is designed to accommodate various capital interests —
for example, you can issue common, voting shares to the initial owner-employees,
set up a special nonvoting class of shares to distribute to key employees as an
incentive to remain loyal to the business and issue yet another preferred class
of stock (one that gives investors a preference if dividends are declared or the
corporation is sold) to venture capitalists willing to help fund future
expansion of your corporation.
And owners of a small corporation can set
their sights someday on making a public offering of shares. Even if your
corporation never grows large enough to interest a conventional stock
underwriting company in selling your shares as part of a large public offering,
you may be able to market your shares to your customers or to individual
investors by placing your company’s small offering prospectus on the Internet
— something that has now been approved by the SEC (the federal Securities and
Exchange Commission). And the good news is that no matter how you market your
shares, handling your own small direct public offering (DPO) is much more
feasible than it was even a few years ago. The reason is that federal and state
securities laws designed to help smaller corporations raise from $1 million to
$10 million annually by making a limited public offering of shares have been
liberalized.
A corporation is, in some senses, immortal.
Unlike a sole proprietorship, partnership or LLC, which can terminate upon the
death or withdrawal of the owner or owners, a corporation has an independent
legal existence that continues despite changeovers in management or ownership.
Of course, like any business, a corporation can be terminated by the mutual
consent of the owners for personal or economic reasons and, in some cases,
involuntarily, as in corporate bankruptcy proceedings. Nonetheless, the fact
that a corporation does not depend for its legal existence on the life or
continual ownership interest of a particular individual does influence
creditors, employees and others to participate in the operations of the
business. This is particularly true as the business grows.
Just about everything, including the advantage
of incorporating, comes at a price. And, of course, the answer to the question
“How much does it cost?” is an important factor to weigh when considering
whether to incorporate your business. For starters, a corporation, unlike a sole
proprietorship or general partnership, requires the filing of formation papers
— Articles of Incorporation — with the California Secretary of State. The
filing cost is $100. Corporations must pay an annual franchise tax, as explained
in Chapter 4, Section B1. Ongoing paperwork is generally not burdensome, but you
will have to hold and document annual meetings of shareholders and directors and
keep minutes of important corporate meetings.
DOES IT MAKE SENSE TO INCORPORATE OUT OF
STATE?
As an active California business, the answer
is no — it is usually a very poor idea to incorporate out of state.
The big reason is that you will have to
qualify to do business in California even if you don’t incorporate here, and
this process takes about as much time and costs as much money as filing
incorporation papers in California in the first place. You’ll also need to
appoint a corporate agent to receive official corporate notices in the state
where you incorporate — another expensive pain in the neck.
Incorporating in another state with a lower
corporate income tax isn’t likely to save you any money. If your business
makes money from operations in California, even if it is incorporated in another
state, you still must pay California taxes on this income.
One final thought. When your clients complain
about your prices, remind them of this. The rich get everything and
the poor get nothing when it comes to taxes. Sound familiar? I hear it everyday.
What one doesn’t realize is that the tax code applies to everyone, not just
the rich with a exclusion for the poor. So why does the rich get everything and
the poor gets nothing? The rich will pay for advice and the poor do not need
advice. If you are not willing to pay or work for this advice, then you truly
don’t deserve it. You become whom we call, ‘the cheap and cheesy’. We
try not to do ‘cheap and cheesy’ in this office.