Organizing, Part 2: Corporations

The creation of a corporation is the creation of an artificial person. For legal and tax purposes, a corporation is a separate entity from its owners. A corporation can make purchases, enter into contracts, pay taxes, and sue and be sued.

For our purposes, by “corporation” we mean “an S-Corp, a C-Corp or a Nonprofit Corporation.” Each of these types of corporations has its own pros and cons, and we’ll do our best to address those.

An LLC is NOT a corporation. It is a company. In fact, LLC stands for Limited Liability COMPANY. We’ll get to these eventually, but not today.

Corporations must be established in compliance with state requirements. Each state has its own set of guidelines governing corporations. In general, a corporation will have more requirements concerning things like filings, annual reports and registered agents than will a sole proprietorship or a partnership.

Shareholders own a corporation. A board of directors, who may or may not be shareholders, are responsible for managing a corporation. Income, expenses, and losses of the business are filed on the corporation’s tax returns.

A corporation protects shareholders from business debts and responsibilities in most cases. Unlike the business options previously discussed, a corporation’s creditors may not seek to collect debts from the owners, or shareholders, of the corporation. However, owners of a new corporation may be required by financial institutions to give personal financial assurances in order to receive funding through loans.

There is continuity of a corporation regardless of individual shareholder status. Even if several shareholders sell their shares in a business or a principal stockholder dies, the existence of the corporation is not affected. A corporation may also sell stock or shares in its business to raise capital. Corporations may have several types of stocks or shares available, such as voting shares and nonvoting shares.

One drawback of a corporation is double taxation. The corporation pays taxes on its profits before paying dividends to the shareholders. Shareholders must then pay tax on their dividends received from the corporation. But, as with almost anything in US Tax Code, there are exceptions, and we’ll get to those.

For smaller businesses this double taxation can be a big turn off. When coupled with the extra paperwork most states require for corporations, many entrepreneurs choose a sole proprietorship or partnership instead of a corporation.

Subchapter S Corporation

A Subchapter S corporation derives its name from a section of the Internal Revenue Code. Under Subchapter S in the Internal Revenue Code, a corporation that meets certain requirements may be treated as a corporation for liability purposes but treated as a partnership for taxation purposes. Shareholders of a Subchapter S corporation receive limited liability protection, and their profits from the business are included on their individual income tax return.

The requirements of a Subchapter S corporation typically include:

  • No more than 100 shareholders
  • Shareholders must be natural persons (not corporations or partnerships)
  • Shareholders must be US Citizens and cannot be nonresident aliens
  • One class of stock

After a business has incorporated, all shareholders must consent to Subchapter S treatment. The election to be treated as a Subchapter S corporation must be filed with the Internal Revenue Service in a timely manner.

Nonprofit Corporation

In order to be considered nonprofit, a corporation must have been formed for a purpose other than the financial benefit of its shareholders. Also, a nonprofit corporation cannot pay any dividends or other financial rewards to its shareholders. To receive tax exempt status, an organization must first incorporate as a nonprofit corporation. After incorporation, applications for tax exempt status must be filed with the Internal Revenue Service and the state’s  Department of Revenue. In order for contributions to the organization to be tax deductible, other requirements must be met.

Other resources

Click & Inc has a nice chart showing the differences between corporation types. They also have a Basic Incorporation: FAQs page that you might find valuable.

December 4th, 2009 | Matt | Tags: , , , , , | 2 Comments »

Organizing Your Business

There are several ways to organize a business, and the option selected depends on various factors. A small, family‑owned and operated business will likely choose a different structure than a larger company with several owners and many employees.

Each option has benefits and drawbacks. The option selected by a business may change over time as the business’s needs, identity, size, budget, and liabilities change. A person may start out as a sole proprietor but decide to incorporate years later after growing their business and hiring a staff.

But with so many business types out there, how do you choose? Should you set yourself up as a sole proprietor? Should you incorporate, and, if so, do you do so as an LLC, an s-corp or a c-corp?

We’ll try to sort through some of the confusion with these next few posts. First, we’ll look at Sole Proprietorships and Partnerships. These have a few commonalities, including the important fact that debts and liabilities are tied to the individuals (either the sole proprietor or the partners).

Another commonality is that to operate as a business, you will need to secure a Federal Tax Identification Number and you will also need to register your business name. Depending on your state, the business name registration may be known as a DBA (Doing Business As), Fictitious Business Name or FBN, Assumed Business Name or ABN or a Trade Name.

Sole Proprietorship

A sole proprietorship is the simplest form of business organization. One person owns, manages, and controls the business. A sole proprietorship may have employees, but only the owner is in charge of the business. The owner receives the business profits and losses. This person is also responsible for any debts the business may incur. Income, expenses, and losses are reported on the business owner’s individual tax return.

A sole proprietorship is relatively easy to organize. The business owner must acquire the appropriate licenses, if any, a tax identification number and must register the business name.

The benefits of the sole proprietorship include having complete control over the business, ease of the initial set‑up and having business profits taxed at the individual taxpayer rate, which is lower than the rate charged to corporations.

The drawbacks to sole proprietorship include being personally liable for debts and liabilities of the business. For example, if a business owner has debts that are not being paid, the creditors can reach the personal assets of the business owner, such as a personal checking account. A business owner may obtain insurance to minimize this drawback. Other drawbacks include lack of continuity—when the business owner dies, the business ceases to exist—and generally not being able to deduct benefits like health, dental, and life insurance on a sole proprietor’s income tax return as business expenses.

A sole proprietor business is a great choice for independent consultants with fixed costs or small side businesses. If you don’t foresee your business having much financial liability tied up in things such as inventory and leases, consider a sole proprietorship.

Partnership

A partnership is a business owned by two or more parties. There are two types of partnership: general and limited.

General Partnership

A general partnership occurs when two or more persons own, manage, and control a business. Persons in a general partnership share the rights, duties, and responsibilities. Partnerships may also have employees; however, only the partners have control of the business activities.

A partnership has more issues to address than the sole proprietorship. Besides obtaining the appropriate licenses and registering the business name, partners must agree on the treatment of business profits, expenses, losses, and other business concerns. Typically, there is a written agreement between the partners to address these issues. Individual states have statutes that specifically govern partnerships.

The benefits of a general partnership include the owners’ control of a business. However, unlike the sole proprietor who has exclusive control, partners share control and responsibilities. Partners have the advantage of having more than one resource for finances, ideas, and sharing the work load. The formation of a general partnership can be less complicated than other business formats, such as limited partnerships and corporations. Finally, profits from the partnership are included on the partners’ individual tax returns and taxed at the individual taxpayer rate, which is lower than the rate charged to corporations.

The drawbacks to a general partnership include being personally responsible for the debts and liabilities of the partnership just like a sole proprietorship. A partner can be liable for debts incurred by other partners in furtherance of the business. A partnership may obtain insurance to minimize this drawback. Business partners are treated like sole proprietors with regard to deducting benefits provided to themselves. Benefits like health, dental, and life insurance may generally not be deducted on partners’ income tax returns as business expenses.

In a general partnership, a business can continue after the departure or death of a partner. State laws govern how to deal with the death of one of the partners. In general, a partnership agreement may detail how a partnership interest may be sold, transferred, or handled upon the death of a partner. Addressing potential issues in an agreement may be one way to prevent disputes from occurring.

Limited Partnership

A limited partnership is similar in many respects to a general partnership. However, in a limited partnership, there are two types of partners—general and limited. Some states require that a limited partnership have at least one general partner and one limited partner. The principal difference between a general and limited partner is that the limited partner can limit his personal liability for partnership debts to the amount he invests in the partnership. The limited partner, in exchange for the reduction in liability, does not control or manage the business. The general partner controls and manages the business and is personally liable for partnership debts.

Because limited partnerships must meet specific statutory requirements, they can be more complicated to establish and often require regular public filings. A limited partnership must also receive appropriate licenses, tax identification number and register the business name.

The benefits of a limited partnership depend on whether one is a general or limited partner. The general partner enjoys control and management responsibilities. The limited partner receives limited personal liability. Profits for both types of partners are included on the partners’ individual tax returns and taxed at the individual taxpayer rate, which is lower than the rate charged to corporations.

The drawbacks for a limited partnership also depend on whether one is a general or limited partner. A general partner is personally responsible for the business debts while the limited partner is only liable for debts up to the amount invested in the partnership. The limited partner does not participate in the management or the control of the business. Business partners are treated like sole proprietors with regard to deducting benefits provided to themselves. Benefits like health, dental, and life insurance may generally not be deducted on partners’ income tax returns as business expenses.

Unlike a sole proprietorship or general partnership, when a limited partnership wishes to dissolve, it typically must file such intent with the state Secretary of State. As mentioned previously, there are laws which apply to limited partnerships specifically which make this format more time consuming and complex.

We’ve gone over some of the simpler forms of business organization. Next, we’ll tackle different types of corporations, including S-Corps, C-Corps and LLCs.

December 2nd, 2009 | Matt | Tags: , , , , , | 1 Comment »