Starting Your New Business — Types of Business Entities
Before you go out and start working your way to fame and fortune, it is important that you first consider your back office. You have to make a series of key decisions about how you are going to operate your business. Where you are going to conduct your business? Are you going to create a formal office (i.e., a place outside of your home)? One of the key decisions in this process is the type of business entity under which you plan to operate. The following is a review of the various business entities available to you.
WARNING: The following is designed to introduce you to the various business entities, as well as their individual advantages and disadvantages. Because laws vary from state to state and because tax laws are constantly changing, it is very important that you discuss these matters with your attorney and accountant before choosing the entity that is right for you. Do not rely solely on this overview to make your business decisions.
The most basic business entity is a sole proprietorship. All this means is that you are doing business in your own name. Although you will want to keep a separate set of books for your business when you operate this way, you will ultimately file all of the business information on a Schedule C in your personal tax return. Unless you have employees, you will operate the business under your own social security number and will not be required to obtain a federal ID number.
As a sole proprietor, you are totally responsible for everything and anything that happens to your business. If you have employees working for you, you are also personally responsible for all of the actions of those employees.
Usually the key decision as to whether or not one wishes to operate as a sole proprietorship regards the amount of risk you will undertake in your business. Since you are personally liable for the business, you must be aware at all times of what kind of damage you may be able to inflict on others. The sole proprietorship does not provide you with any type of protection against lawsuits.
For example: if you are operating a construction firm, you would definitely wish to be a corporation or a limited liability company because there is the potential for an employee to cause damage to someone’s property or person. You would want to protect your personal assets from such a lawsuit.
As a start-up business, even if you operate as a corporation or limited liability company, the bank or financial institution would make you personally guarantee any financing you may obtain for your business. As such, there is no true protection from creditors.
You are always responsible for your own actions and/or representations, even if you are operating as a corporation or limited liability company. These entities would only protect you from the actions and/or misrepresentations of employees or agents who are working for you. If you do not have any such employees and/or agents, this concern is eliminated.
In a partnership situation, you have the same responsibility as that of a sole proprietorship, except that you have one or more people working with you. The partnership entity files a partnership return with the IRS and all of the profit or loss is distributed among the partners in accordance with their percentage interest in the company.
The major danger of the partnership is that every partner is responsible for the actions of every other partner. In other words, if one partner goes out and commits the partnership to a large note and mortgage, as a partner, you would also be responsible for that note and mortgage. Given the other alternatives discussed here, it is not a preferred way to operate and I would strongly advise against operating as a partnership.
Limited partnerships were all the vogue in the 1970s and 1980s for investments in real estate. In this type of entity a general partner was responsible for everything, just like a regular partnership, but another individual or individuals were “limited partners” in the venture. Limited partners were normally people or entities who had invested money in the limited partnership, but who were not involved in the day-to-day management of the company.
In this form of business entity, if a problem arose in the future, the general partner would be personally responsible for all the losses or problems, but the limited partner could only lose the amount of money they had invested in the company. The personal assets of the limited partner were protected from any of the debts or claims of the partnership as a whole.
The limited partnership became an excellent vehicle for individuals who wished to invest in real estate but who did not want to be involved in the management of the property. Normally, most large limited partnerships had a corporation as the general partner so that all of the individuals were able to limit their overall liability.
With the creation of limited liability companies it is questionable how many limited partnerships will be formed in the future. A major disadvantage of the limited partnership was that a limited partner could not have any involvement in the day-to- day management of the company. Most times, if you invest a considerable amount of money in a transaction, you do not want to “sit on the sidelines”.
The most recognized business entity is the corporation. In the eyes of the law the corporation is a “non-natural person”. This means it is a separate and distinct person. For example: A corporation can be the subject of criminal charges. It files its own tax return and is set up so it can exist forever.
There are two recognized types of corporations: a stock corporation and a non-stock corporation. A non-stock corporation is used for charitable and non-profit organizations. Since you certainly do not plan to be non-profit, the type of corporation you would be involved with is a stock corporation.
In order to be legally recognized as a corporation, you must register a Certificate of Incorporation (or similar document) with the Secretary of State of the state in which you plan to be incorporated. Each corporation has shareholders who actually own the corporation. The shareholders elect directors who make the major decisions for the corporation. The directors elect officers who run the corporation on a day-to-day basis. If desired, the same person may be a shareholder, director and officer.
Each state has different rules about the minimum required numbers of directors and officers. In the State of Nevada, for example, one (1) individual can fill all three roles. In Connecticut you can have one shareholder and one director, but you must have at least two officers – a President and a Secretary. Needless to say, the second officer does not need to be a shareholder. Additionally, in Connecticut, if there is more than one shareholder you need to have an equal number of directors, up to a minimum requirement of three. Check with your attorney regarding the specific requirements for your state. You may also wish to review the advantages and disadvantages of registering in different states.
A corporation which has been created in one state, but is doing business in another, must file with the Secretary of State of the other state as a “foreign” corporation. The main purpose of this registration process is to have a “statutory agent” appointed in each state; the statutory agent is the person authorized to be served in the case of a lawsuit.
The key advantage of the corporation is the fact that it can protect the individual shareholders, directors, and/or officers of the corporation from personal liability. Remember, you are always personally liable for any action that you yourself undertake. As such, the corporation will only protect you from creditors of the corporation which you have not personally guaranteed and the actions of employees or agents of the corporation in situations in which you had no involvement.
Earlier we discussed the decision-making process you must go through regarding the risks you are exposed to in carrying out your activities. If you are personally exposed to very minimal risks in undertaking your business, then the liability protection of the corporation is not really going to do you much good.
If you are not concerned about the protection from liability aspect of the corporation there are three other advantages which you should keep in mind:
You will be able to coordinate all of your business activities through one business entity. This gives you the opportunity to bring in other shareholders or investors at some point in the future with a minimal amount of confusion.
You will be able to use the marketing advantage of having a corporation. Think about it – if someone comes up to you and tells you they are the President of XYZ Corporation, you create a mental picture of a company with offices and an ongoing operation. It may only be a matter of form over substance but, to the rest of the world, if you operate your business as a corporation, you will appear to be much larger than you may really be. In some negotiating situations this could be a very big advantage.
You will be able to protect your corporate name. If you have created a unique or “catchy” name for your corporation, you may wish to protect that name from use by others. The Secretary of State will not allow the registration of “similar” names for registration in that state. As such, the registered name of the corporation (or limited liability company) will provide legitimacy to your claim of ownership for that name.
NOTE: The registration of a name with any given state will not protect you from a name that has been federally trademarked. If you wish or plan to operate outside of the state(s) where you have registered your corporation, you may wish to undertake a federal trademark search so that, several months or years later, you do not find yourself being challenged for the use of that name.
In the eyes of the Internal Revenue Service, there are two main types of corporations: “C” corporations and “sub S” corporations. This corporate designation deals only with how these entities will be taxed and how the profit or loss from those entities will be distributed to the shareholders.
In the “C” corporation, the corporation pays its own tax on profits that the company earns. Monies may be distributed to the employees in the form of salary and bonuses and any “profit” can be distributed to shareholders as a “dividend”. The payment of a dividend can result in double taxation if a shareholder is also the owner of the corporation. Additionally, in a “C” corporation losses may not be passed through to the shareholders. One of the major advantages of investing in real estate is the tax losses that will be generated in the form of depreciation. As such, the “C” corporation is not the preferred entity for real estate investment.
In a “sub S” corporation, the corporation also files a tax return but all of the profits or losses are passed through to the individual shareholders in accordance with their percentage ownership of the business in the form of an IRS Schedule K-1. NOTE: A special form must be filed with the IRS to request the “sub S” corporation recognition. This filing must occur within a short time after the filing of the corporation. It is very important that you make sure your attorney or accountant makes this filing so that you can obtain this recognition.
LIMITED LIABILITY COMPANIES
The limited liability company is a brand new entity (relative to legal history) in the eyes of the law. It was first created in Wyoming, of all places, back in 1977. After a ten-year struggle with the IRS regarding the tax recognition of this entity, there was finally a regulation published by the Internal Revenue Service that would allow the limited liability company to be taxed as a partnership rather than as a corporation as long as it met certain requirements in its formation. Those requirements are usually met in the Operating Agreement provided it is properly created.
The limited liability company (or as it is commonly referred to, the “LLC”) is somewhat of a crossbreed between a corporation and a partnership. The LLC has the liability protection of a corporation. In other words, you cannot be sued personally for actions undertaken in the name of the limited liability company unless you yourself are personally responsible for that action. As such, it becomes an appropriate alternative to the creation of a corporation. For tax purposes, the LLC is normally treated as a partnership ) although, under current law, you may choose to have it taxed as either a “C” corporation or a “Sub-S” corporation). If you choose taxation as a partnership all of the profits or losses of the company will be passed through to the individual “members” in accordance with their percentage interest in the company. (Note: Special arrangements can be made in the Operating Agreement providing for different percentages of management control versus different percentages for economic benefits but, normally, they are one and the same). In a single member LLC, the member reports the LLC financial activity on their Form 1040 Schedule C.
In the LLC you have “members” as opposed to shareholders of the corporation; you have “managers” instead of officers and directors. As you can see, there are even terminology differences with which one must become accustomed.
There are, however, some key differences between a limited liability company and a corporation:
A corporation may have just one shareholder. In many states, the LLC must have at least two members. Some states now allow for one member limited liability companies. As such, the LLC may not be the right vehicle for your investment business if you are operating in a two member requirement state. Unless you are willing to share at least one percent of the company with some other individual or business entity, you will not be allowed to use the LLC structure in those states.
As I had noted, the corporation can exist forever. In many states, the LLC must have some definite termination date. Some states now allow for limited liability companies with no established termination date. In reality, this provisional requirement does not have any practical effect on the operation of the business. This existed in some states only to meet the original requirements established by the IRS in the resolution of the taxation issue.
The last major difference deals with the transferability of interests in the company. By statute, the shares of a corporation are freely transferable. They can only be limited by a shareholder agreement by and between either all or some of the shareholders of the corporation. In the LLC, (again, to meet the original requirements that were established by the IRS in the resolution of the taxation issue) the terms of the Operating Agreement must establish that one cannot freely transfer your management interest in the LLC. Obviously, you can always transfer your interest as long as you have the agreement of all of the members, but if a sufficient number of members of the LLC oppose your transfer, you will only be able to transfer your economic interest in the company. Normally, in the limited liability companies that I form for unrelated parties, I always add a “right of first refusal” to prepare for this potential situation. Although this would appear to be more of a pain in the neck than anything else, the ability to split the management and economic interest of your membership interest can pose some very interesting estate planning possibilities. It is something to keep in mind after you are rich and famous from investing in financially troubled properties.
WHICH IS THE RIGHT BUSINESS ENTITY FOR YOU?
Obviously, you must review all of the requirements and distinctive characteristics of each of these business entities to determine which may be best for you. I strongly suggest that you operate within either the corporation or the LLC in order to limit the exposure of your personal assets.
The most difficult decision to be made is determining whether to operate as a corporation or as a limited liability company. It will become a fairly close toss-up as to which entity to choose. (This assumes that in the LLC two member requirement states you have an individual or entity with whom you are comfortable transferring at least a one percent interest.) Most particularly, it will come down to a decision between the subchapter “S” corporation and the limited liability company because both of those entities can pass through any losses you may incur in the business, including depreciation.
The most practical differentiation at this point in time between whether to form the corporation or the LLC will be the fees and costs of the formation. Legal fees for the creation of either will be different from attorney to attorney so it is important to check with your attorney, and perhaps others, to determine the range of fees for the creation of these entities. There is also a variance in the amount of fees or costs in the individual states in the establishment and/or operation of these entities. Additionally, the corporation needs to buy a corporate book which will cost you approximately $80 and contains the stock certificates. You may also buy a book for the LLC but it is not required since the interests of the LLC are done in the form of percentages as opposed to certificate ownership.
You also need to check the ongoing fees and costs you will incur after the formation of your business entity. In most states, the Secretary of State will forward an annual report to be completed for the corporation or the limited liability company. That report needs to be filed together with a fee.
In addition to the practical consideration of the fees paid to the Secretary of State, there are also the annual taxes to be paid by the entity to the state. Some states require a corporation to file a tax return for a corporation and pay some minimum fee whether or not the entity has made money. In some states, for a LLC, which is filing a partnership return, there may be no such requirement. Some states tax all “business entities” no matter their form. Obviously, if you are running your business in a situation where it is spinning off tax losses to you as one of its primary benefits, the corporate entity in such states is not the best way to go in order to save those minimal fees.
There are many attorneys and accountants who are more comfortable with the corporation than with the limited liability company. The rules and laws governing corporations have been well established over a long period of time. The limited liability company, as a relatively new legal entity, has not been the subject of much litigation. One must assume that the litigation surrounding limited liability companies will be resolved under the concept of partnership law as opposed to corporate law.
Again, you should consult with both your attorney and your accountant to determine which is the best entity for you. In order to make the right choice you should get all of the advice you can.
THE ABOVE ARTICLE IS FOR GENERAL INFORMATION ONLY. IT SHOULD NOT BE RELIED UPON AS LEGAL ADVICE, AND CANNOT REPLACE CONSULTATION WITH A PRACTICING ATTORNEY !