CHOOSING A BUSINESS ENTITY

CHOOSING A BUSINESS ENTITY

Choosing a Business Entity

An important, but often misunderstood, decision in the life of a business is the entrepreneur’s or existing business owner’s choice among the different forms of legal entities under which the business can operate.  The decision is determinative regarding the tax treatment and legal liability of both the business and its owners.  This Legal Update addresses the basic characteristics, advantages, and disadvantages of the various business entity options.

The Sole Proprietorship

The Sole Proprietorship is the simplest to form of all the business entities.  It consists of one person who owns all of the assets of the business and is created by default whenever one person forms a business without selecting a different form of entity.  There is no distinction between the business owner and the business itself for legal liability, tax and other purposes.  On the plus side, a Sole Proprietorship can be formed with little formality or expense.  Owners of Sole Proprietorships do not have to file separate tax returns for their businesses; all business income and expenses are reported directly on the owner’s personal income tax return.  Thus, the Sole Proprietorship is, in some cases, an attractive option for start-up businesses and for businesses without employees.  This form, however, provides its owner with unlimited personal liability for the debts and risks of the business and less tax flexibility than any other entity.  For tax purposes, all business profits and losses are personal to the business owner.  For liability purposes, creditors of the business can collect on unpaid debts and liabilities of the business from the owner’s personal assets.  Additionally, an individual’s ownership interest in a Sole Proprietorship is non-transferable except upon liquidation of the business.  Most states require individuals who conduct or transact a business under any name other than the real names of the owners to file an “assumed name” notice with the County Clerk in the county in which the business is located.

The General Partnership

The General Partnership is conceptually similar to the Sole Proprietorship with one major distinction: a General Partnership is formed whenever two or more people co-own a business and share in its profits and losses.  Like a Sole Proprietorship, a General Partnership requires little formality to get started, and it is formed by default whenever two or more people form a business together without selecting another form of entity.  Business partners should, however, create ground rules to govern their business relationship through a partnership agreement.  Absent such an agreement, decision-making authority is shared by all partners, and the business entity will not survive beyond the lives of its owners.

A General Partnership is taxed in a manner similar to a Sole Proprietorship, with profits and losses flowing through directly to the owners.  The most significant concern in operating a General Partnership is that each co-owner is liable for the debts incurred by other co-owners acting in furtherance of the business.  A co-owner’s personal assets are at risk for the wrongful acts of all other co-owners in connection with the business, making the General Partnership potentially the riskiest of all business entities.  For this reason and a variety of others, when a General Partnership or other kind of partnership is formed, it is advisable to have a written agreement among the partners.

The Limited Partnership

Because of the potential exposure created by shared liability of co-owners in a General Partnership, the Limited Partnership is an attractive alternative. In a Limited Partnership, certain co-owners are designated as “limited partners.” Limited partners are often passive investors who do not participate in the management of the business. Limited partners are liable for business debts only to the extent of their capital investment; however, they can lose their insulation from liability by involving themselves in management or through their own improper conduct. A Limited Partnership must be owned by at least one “general” (managing) partner. The general partner(s) retains personal liability for partnership debts. Like General Partnerships and Sole Proprietorships, profits and losses of the business flow through directly to the owners for tax purposes. Limited Partnerships can only be formed through compliance with certain formalities, which vary from state-to-state.

The Limited Liability Partnership

A Limited Liability Partnership (“LLP”) requires the filing of a “statement of qualification” or similar application with a state office in the state in which it is formed.  The basic difference between an LLP and a General Partnership is the allocation of liability among co-owners.  In an LLP, all partners are liable for business debts only to the extent of their capital investment, but each partner remains liable for his or her own improper conduct.  Unlike Limited Partnerships, there is no distinction between “general” and “limited” partners in an LLP.  In most other respects, LLPs are treated similarly to Limited Partnerships and share many of the same advantages and disadvantages.

The C Corporation

The C Corporation derives its name from subchapter C of the Internal Revenue Code.  The C Corporation  (as well as the S Corporation discussed below) is a legal entity distinct from its owners.  In general, the corporation, and not its shareholders, is responsible for business debts and obligations.  Provided that, among other things, requisite corporate formalities are followed, the owners’ liability for business debts is limited to their capital contributions.  Generally, a corporation is managed by its officers and directors.  Corporate officers and directors can be held liable for business debts only in limited circumstances.  Additionally, one’s ownership interest in a C Corporation is freely transferable unless specifically precluded by agreement.

The C Corporation is a separate U.S. taxpayer.  The shareholders/owners do not pay any income taxes on corporate profits until the profits are distributed to them.  This form of entity can be advantageous for investors in businesses that will reinvest profits rather than pay dividends because the corporate tax rate is generally lower than the personal income tax rate.  A major drawback of this form, however, is that distributed profits are subject to double taxation – once at the corporate level when the profits are earned, and again at the shareholder level, when (and to the extent that) profits are distributed.  In contrast to other forms, such as Sole Proprietorships and Partnerships, C Corporations can deduct 100% of the health insurance and other employee benefit costs paid for employees who are also shareholders of the corporation.  These advantages make a C Corporation an attractive option for some small business owners whose compensation as employees of the business may result in little or no excess profit, and therefore little or no double-taxation.  Owners of existing C Corporations should be forewarned that conversion to an S Corporation or an LLC will subject the business to limited corporate level taxation.  For this reason, it is often imprudent to convert.

The S Corporation

In order to avoid the double taxation applicable to distributed profits of C Corporations, certain corporations may elect to be taxed under Subchapter S of the Internal Revenue Code (so called “S Corporations”).  The S Corporation is taxed similarly to a partnership – profits and losses flow directly through to the owners – but the S Corporation retains the advantages of limited liability for its owners.  For start-up businesses expecting business losses during the first few years of operation, the tax characteristics of an S Corporation are quite appealing because owners can freely offset business losses against their personal incomes, so long as they are active in the business.

Because of statutory restrictions, the S Corporation form is not an option for all businesses.  For example, in order to qualify for S Corporation status in Illinois, corporate stock can be held by no more than 35 persons; generally shareholders must be individuals; and there can only be one class of stock issued.  The failure to maintain compliance with these eligibility requirements can cause termination of the entity’s status (and resulting tax complications).  Both S Corporations and C Corporations are formed through application to the Secretary of State of the state of incorporation and compliance with various statutory provisions, including various requirements and restrictions with respect to the structure, management and documentation of the entity.

The Limited Liability Company (“LLC”)

The LLC is a flexible business form designed to combine the limited liability benefits of a corporation with the flow-through tax advantages and reduced structural formalities and restrictions available through Partnership forms.  An LLC is formed through application to the appropriate office of the state of organization and compliance with various statutory provisions.  LLC owners, however, have much more flexibility than shareholders of corporations to define and control various aspects of their businesses’ structure, management and ownership rights – through an operating agreement.  Ordinarily, the LLC operating agreement will determine whether the business will be managed by specially designated managers or else the members themselves.  Like a corporation, an LLC is a distinct entity from its owners and holds property in its own name.

An LLC can be a more attractive business form than an S Corporation because it does not require as many formalities.  The most obvious advantage of the LLC over the Limited Partnership is that every member (not just limited partners) may limit his or her personal liability without sacrificing the ability to participate in management. LLC owners, however, generally do not enjoy some of the tax-favored fringe benefits available to C Corporations such as group term life insurance, disability insurance, medical expense reimbursement plans, and cafeteria plans.  These benefits are often similarly unavailable to owners of S Corporations.  Additionally, one hundred percent of LLC business income is subject to Medicare tax.  An existing LLC can usually convert to the C Corporation form without paying any taxes.

Conclusion

Determining the most appropriate form of entity for your business is an intensely individualized process, taking into account, among other things, the entrepreneur’s/owner’s specific interests and goals, the nature of the business, and the number and identities of the present and potential future investors in the business.  Because choosing among the different types of business entities is a fundamental decision with important and lasting consequences, entrepreneurs and owners need to make careful and informed choices up front with the advice of experienced legal counsel.

To ensure compliance with requirements imposed by the IRS, I must inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter[s].

For more information give the office a call at (951) 226-5294

or visit http://www.menifeelawyer.com/

How to hire an attorney

Below is an excerpt from a article that was printed in the Entrepreneur magazine.

How to Hire an Attorney

Hiring a good lawyer is crucial to any successful business. Here's everything you need to know about finding, interviewing and hiring the very best.

There are two professionals every business will need early on: an accountant and a lawyer. The reasons for hiring an accountant are pretty obvious--you need someone to help you set up your "chart of accounts," review your numbers periodically, and prepare all of your necessary federal, state and local tax returns. The reason for hiring a business attorney may not, however, be so apparent. A good business attorney will provide vital assistance in almost every aspect of your business, from basic zoning compliance and copyright and trademark advice to formal business incorporation and lawsuits and liability. First, some general rules about dealing with lawyers:

• If you are being sued, it's too late. Most small businesses put off hiring a lawyer until the sheriff is standing at the door serving them with a summons. Bad mistake. The time to hook up with a good business lawyer is before you are sued. Once you have been served with a summons and complaint, it's too late--the problem has already occurred, and it's just a question of how much you will have to pay (in court costs, attorneys' fees, settlements and other expenses) to get the problem resolved.

America's judicial system is a lot like a Roach Motel--it's easy to get into court, but very difficult to get out once you've been "trapped." Most lawyers agree that while nobody likes to pay attorneys' fees for anything (heck, let's let our hair down--nobody likes paying or dealing with lawyers, period), but the fee a lawyer will charge to keep you out of trouble is only a small fraction of the fee a lawyer will charge to get you out of trouble once it's happened.

• Big firm or small firm? Generally speaking, the larger the law firm, the greater the overhead, therefore the higher the hourly rates you will be expected to pay. Still, larger firms have a number of advantages over smaller ones. Over the past 20 years, lawyers have become incredibly specialized. If you use a solo practitioner or small firm as your lawyer(s), it's likely that they will not have all the skills you may need to grow your business. I don't know of any solo practitioner, and very few small firms (under 10 lawyers) that could handle your lawsuits, negotiate your lease of office or retail space, file a patent or trademark, draft a software license agreement, advise you on terminating a disruptive employee, and oversee your corporate annual meeting. Sooner or later, these "generalists" will have to refer you out to specialists, and you will find yourself dealing with two or three (or even more) attorneys.

While larger firms are more expensive to deal with, they have two significant advantages: 1) they usually have all the legal skills you need "under one roof," and 2) they have a lot of clout in the local, regional and (perhaps) national legal community. A nasty letter from a "powerhouse" law firm with offices in 30 states is a lot more intimidating than a nasty letter from a solo practitioner who is not admitted to practice in the defendant's state. Also, being connected with a large, well-established law firm may have intangible benefits--they may be willing to introduce you to financing sources or use their name as a reference when seeking partnership arrangements. Certainly if you run a fast-growing entrepreneurial company that plans to go public (or sell out to a big company) some day, you would need to work with lawyers whose names are recognized in the investment banking and venture capital communities.

Types of Attorneys

Like doctors, lawyers are becoming increasingly specialized. Someone who does mostly wills, house closings and other "non-business" matters is probably not a good fit for your business. At the very least, you will need the following sets of skills. The more skills reside in the same human being, the better!

1. Contracts. You will need a lawyer who can understand your business quickly; prepare the standard form contracts you will need with customers, clients and suppliers; and help you respond to contracts that other people will want you to sign.

2. Business organizations. You will need a lawyer who can help you decide whether a corporation or limited liability company (LLC) is the better way to organize your business, and prepare the necessary paperwork.

3. Real estate. Leases of commercial space--such as offices and retail stores--are highly complex and are always drafted to benefit the landlord. Because they tend to be "printed form" documents, you may be tempted to think they are not negotiable. Not so. Your attorney should have a standard "tenant's addendum," containing provisions that benefit you, that can be added to the printed form lease document.

4. Taxes and licenses. Although your accountant will prepare and file your business tax returns each year, your lawyer should know how to register your business for federal and state tax identification numbers, and understand the tax consequences of the more basic business transactions in which your business will engage.

5. Intellectual property. If you are in a media, design or other creative-type business, it is certainly a "plus" if your lawyer can help you register your products and services for federal trademark and copyright protection. Generally, though, these tasks are performed by specialists who do nothing but "intellectual property" legal work. If your lawyer says he or she "specializes in small businesses," then he or she should have a close working relationship with one or more intellectual property specialist.

Cost-Saving Strategies

For many entrepreneurs, the idea of consulting a lawyer conjures up frightening visions of skyrocketing legal bills. While there's no denying that lawyers are expensive, the good news is there are more ways than ever to keep a lid on costs. Start by learning about the various ways lawyers bill their time:

• Hourly or per diem rate. Most attorneys bill by the hour. If travel is involved, they may bill by the day.
• Flat fee. Some attorneys suggest a flat fee for certain routine matters, such as reviewing a contract or closing a loan.
• Monthly retainer. If you anticipate a lot of routine questions, one option is a monthly fee that entitles you to all the routine legal advice you need.
• Contingent fee. For lawsuits or other complex matters, lawyers often work on a contingency basis. This means that if they succeed, they receive a percentage of the proceeds--usually between 25 percent and 40 percent. If they fail, they receive only out-of-pocket expenses.
• Value billing. Some law firms bill at a higher rate on business matters if the attorneys obtain a favorable result, such as negotiating a contract that saves the client thousands of dollars. Try to avoid lawyers who use this method, which is also sometimes called "partial contingency."

If you think one method will work better for you than another, don't hesitate to bring it up with the attorney; many will offer flexible arrangements to meet your needs. When you hire an attorney, draw up an agreement (called an "engagement letter") detailing the billing method. If more than one attorney works on your file, make sure you specify the hourly rate for each individual so you aren't charged $200 an hour for legal work done by an associate who only charges $75. This agreement should also specify what expenses you're expected to reimburse. Some attorneys expect to be reimbursed for meals, secretarial overtime, postage and photocopies, which many people consider the costs of doing business. If an unexpected charge comes up, will your attorney call you for authorization? Agree to reimburse only reasonable and necessary out-of-pocket expenses.

No matter what type of billing method your attorney uses, here are some steps you can take to control legal costs:

• Have the attorney estimate the cost of each matter in writing, so you can decide whether it's worth pursuing. If the bill comes in over the estimate, ask why. Some attorneys also offer "caps," guaranteeing in writing the maximum cost of a particular service. This helps you budget and gives you more certainty than just getting an estimate.
• Learn what increments of time the firm uses to calculate its bill. Attorneys keep track of their time in increments as short as six minutes or as long as half an hour. Will a five-minute phone call cost you $50?
• Request monthly, itemized bills. Some lawyers wait until a bill gets large before sending an invoice. Ask for monthly invoices instead, and review them. The most obvious red flag is excessive fees; this means too many people--or the wrong people--are working on your file. It's also possible you may be mistakenly billed for work done for another client, so review your invoices carefully.
• See if you can negotiate prompt-payment discounts. Request that your bill be discounted if you pay within 30 days of your invoice date. A 5-percent discount on legal fees can add thousands of dollars to your yearly bottom line.
• Be prepared. Before you meet with or call your lawyer, have the necessary documents with you and know exactly what you want to discuss. Fax needed documents ahead of time so your attorney doesn't have to read them during the conference and can instead get right down to business. And refrain from calling your attorney 100 times a day.
• Meet with your lawyer regularly. At first glance, this may not seem like a good way to keep costs down, but you'll be amazed at how much it reduces the endless rounds of phone tag that plague busy entrepreneurs and attorneys. More important, a monthly five- or 10-minute meeting (even by phone) can save you substantial sums by nipping small legal problems in the bud before they have a chance to grow.