What is a Partnership?

A partnership is the easiest type of business entity to form.  So easy in fact that partnerships are occasionally unintentionally formed.

A partnership is formed when two or more people engage in a business enterprise for profit. Partnerships are the only type of business entity that do not require any form of paperwork to be filed as part of its formation.

For purposes of this post, when I refer to a "partnership" I mean a general partnership. Limited partnerships will be discussed in the next post.

Although not required to form a partnership, I would recommend talking to a business transactions attorney anytime you are considering going into business with another person.

In some ways, a partnership is the opposite of a corporation (see What is a Corporation?).  Whereas there is a legal fiction that a corporation is a separate and distinct person, a partnership can be viewed more as an aggregate of all the partners.  For example, property can be owned in the partnership's name but really that means that each partner owns a portion of that property.

Also, as previously mentioned, a partnership does not have to follow any type of formalities to be formed.  It is created simply by two or more people engaging in a business enterprise for profit.  It can be a very informal arrangement.  There are no requirements that even a partnership agreement be created, although for practical purposes it is very useful to have a partnership agreement in place.

While partnerships are required to file tax returns, it is simply an "informational" tax return.  The partnership itself does not pay any taxes, and thus unlike a corporation it is not subject to double taxation.  The partnership's taxable income instead flows through to its individual partners who are responsible for reporting the income on their individual tax returns and paying tax on their share of the partnership's income.  The purpose of the partnership tax return is simply to notify the IRS and the relevant state tax collection agencies of the amount of income that the individual partners should be reporting on their tax returns.

The informational tax return that a partnership files is Form 1065.  Form 1065 will show all of the business' revenue, expenses, gains, losses, and tax credits that get passed through to the partners. Each partner, and the relevant tax collection agencies, will then be provided with a Form K-1.  The purpose of the K-1 is to inform the partner of how much income, losses, and other tax attributes have to be reported on the partner's individual tax return and the nature of the income and losses.

There are several disadvantages to operating your business as a partnership.  The first is that your partners must consent to you transferring your ownership interests in the partnership to someone else. Because the defining characteristic of a partnership is that there are two or more people choosing to work together in a business enterprise, it is impossible to have a partnership if the other person refuses to be engaged in a business enterprise with another person.  Therefore, if you want to sell your ownership interest in a partnership to another person your partners have to agree to it.

Another disadvantage of partnerships is that you are jointly and severally liable for the actions of the partnership, yourself, your partners, and your employees.  Effectively, this means that your partner, while conducting business for the partnership, could cause injury to another person and you could end up being the one sued for it even though you had nothing to do with the situation other than being a partner in a partnership.

If you would like a referral to a business transactions attorney or would like more information on how partnerships and other forms of businesses entities are taxed, please send me an e-mail.

Triple Taxation?!?!

In the last blog post, Would You Rather Be Taxed Once or Twice?, we discussed that the major disadvantage of corporations is that its profits are taxed twice: once at the corporate level, and once at the shareholder level.   But what if a corporation owns another corporation?  Would the income from the second corporation be subject to triple taxation?

Image borrowed from hudsonvalleynewsnetwork.com

The answer is... maybe and to a certain extent.

Does that clarify things?

In order to lessen the potential impact of triple taxation, within the Internal Revenue Code there is a corporate tax deduction known as the "dividends received deduction."

What the dividends received deductions does is allow a corporate shareholder to deduct from its income a certain percentage of the dividends it receives from other corporations that it owns based upon its ownership percentage.

If a corporate shareholder owns less than 20% of another corporation, it is entitled to deduct from its income 70% of the dividends it receives from that corporation.  If the corporate shareholder owns between 20% and 80% of another corporation, then it is entitled to deduct 80% of the dividends it receives from that corporation.  Finally, it a corporation owns greater than 80% of another corporation, it is entitled to deduct 100% of the dividends it receives from that corporation.

There are several limitations placed upon the dividends received deduction, including the: taxable income limitation, the holding period limitation, and the debt-financed dividends received limitation.

Under the taxable income limitation, the amount of the dividend received deduction cannot exceed a certain percentage of the corporation's taxable income.  For corporations that would be entitled to a 70% dividends received deduction, the amount of the deduction cannot be greater than 70% of the corporation's taxable income.  Likewise, for corporations that would be entitled to an 80% dividends received deduction, the amount of the deduction cannot be greater than 80% of the corporation's income.  However, there is no such restriction for corporations that would be entitled to a 100% dividends received deduction.  Also, the taxable income limitation does not apply if the dividends received deduction either creates or increases a corporation's net operating loss.

Under the holding period limitation, a corporate shareholder must hold the shares of the distributing corporation's stock for a period of more than 45 days.

Under the debt-financed dividends received limitation, the deduction  is disallowed if debt was used to finance the purchase of the other corporation's stock.  Therefore, if a percentage of the stock was purchased using debt, then the dividends received deduction is reduced by that percentage.

If you would like to learn more about the dividend received deduction, please feel free to send me an e-mail.

Would You Rather Be Taxed Once or Twice?

Would you rather pay taxes on the same income once or twice?

I am going to make a wild guess that 99.9% of you do not want to pay any more taxes than necessary, so you would prefer not to pay taxes on the same income twice.

If you read my one of my previous posts, What is a Corporation?, you know that the biggest downside to structuring your business as a corporation is that it is subject to double taxation. You also know that there are benefits to structuring your business as a corporation that may make it worthwhile to you to be subjected to double taxation. In this blog post, I will attempt to give you a more thorough understanding of what double taxation means so that you can make an informed decision.

Being subject to double taxation means that income earned by a corporation is taxed at the corporate level and then again when it is distributed to the shareholders.

To better understand what this means, lets look at an example.  For purposes of this example, lets say that both the corporate and individual tax rate is 15%, there are no state taxes, and there are no personal deductions, exemptions, or credits (or anything that really allows for tax planning).

Alex is the sole shareholder of ABC Inc.  In 2015, ABC Inc. earns a net profit of $100,000.  Because ABC Inc. is a corporation, it has to pay $15,000 in federal taxes.  This leaves ABC. Inc. $85,000 which it distributes to Alex.  Alex then has to recognize that $85,000 as dividend income and pay $12,750 more taxes on it.  This leaves Alex with only $72,250 of the original $100,000.

On the other hand, what if ABC Inc. was not subject to corporate taxes but instead all of its income flowed through to Alex?  In that case, Alex would pay $15,000 in federal taxes and be left with $85,000 instead of only $72,250.

A major reason why many business owners decide to structure their businesses as S-corporations, partnerships, or limited liability companies (LLCs) is that these can be taxed as "flow through" entities.  That means that the income flows through the business entity and is only taxed at the owner level.  There are restrictions and other drawbacks to these "flow through" entities that will be discussed in future blog posts, but the single level of taxation is a benefit that should not be ignored when you decide on what type of entity is right for your business.

If you have any questions about how various types of business entities are taxes, please feel free to send me an e-mail.

Protect Your Liability Shield!

You set up your business and made sure that you have limited liability protection.  That means you do not have to worry about someone suing you personally for something that happened through your business, right?  Wrong!

Picture borrowed from the Indiana Business Law Blog

(www.michaelsmithlaw.com)

Plaintiffs will try to get around your liability shield through a legal concept known as "piercing the corporate veil." You will want to talk to a business attorney to get a thorough understanding of this, but this blog post will attempt to give you an overview.

Essentially, a plaintiff will attempt to sue you personally instead of suing your business by claiming that your business is really your "alter ego" and not truly its own separate entity.  This tactic is known as "piercing the corporate veil."  Courts will look at a number of different factors to determine whether or not to pierce the corporate veil and allow the plaintiff to proceed to sue a business owner personally.  These factors, and how they are interpreted, vary significantly from state to state as case law in each state continues to evolve.  Therefore, I would again like to emphasize that you should talk to a business attorney to make sure that you are operating your business in a way that will protect your liability shield under the state laws that your business is operating under.

One factor that courts will generally consider is whether the corporation or limited liability company (LLC) engaged in fraudulent behavior.  This should be common sense; you cannot expect to use your business to defraud others and then expect to escape personal civil liability just because it was done through a corporation or LLC.

Another major factor that courts will generally consider is whether the business followed the required formalities.  In California, this primarily applies to corporations because the formalities for LLCs tend to be relaxed.  As I mentioned in a prior post, What is a Corporation?, these formalities generally include, but are not limited to:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

The general concept is that if you want your business to be treated as a separate legal entity by others, then you have to treat it as a separate legal entity yourself.  That means that even if you are the sole shareholder in the corporation, you must hold a Board meeting at least once a year (and maintain minutes of the meeting) to make major decisions for the corporation.  It is not enough that you make the decision because you are not the corporation- the Board must be the one to make the decision (even if you are the only Board member).

Likewise, you must be sure to not commingle funds. Have a separate bank account for your business (corporation, S-corporation, or LLC), and only pay business expenses out of that bank account.  If you put all of your personal funds and business funds in the same bank account, it strongly indicates to a court that you do not consider your business to be its own separate entity.  Similarly, if you pay personal expenses out of your business bank account, such as your mortgage, it gives a court the impression that it is just another personal account.

Another major factor that courts will evaluate when determining whether to allow a plaintiff to pierce the corporate veil is whether the business is undercapitalized.  This means that when you are first contributing money to the new business it must be a reasonable amount.  For example, if you expect your business to have $5,000 of operational expenses a month, an initial capitalization of $1,000 does not appear to be reasonable.

Finally, a factor that will be considered is the amount of control you are able to exert over the business.  For example, if you are the sole owner of the business you are fully in control of the business, and it would be easier for a plaintiff to argue that the business is really just an extension of yourself, your "alter ego".  On the other hand, if you are one of 100 co-owners each owning 1% of the business, it would be very difficult for a plaintiff to argue that the business is your alter ego.

So, as you see forming an entity that has limited liability protection is great, but you must protect your liability shield.  That means you must maintain all the required formalities, including maintaining separate bank accounts and not commingling funds, and you must adequately capitalize your business.

I would strongly recommending talking to an attorney to determine what specifically your business will have to do to protect your liability shield.  If you would like a referral, please send me an e-mail.

Limited Liability Protection

It has been promised for the last few blog posts, and at long last it is here: a detailed discussion of limited liability protection!

While this will be a more detailed discussion of limited liability protection, it is not possible to cover everything and all situations in one blog post.  I strongly recommend that you talk to a business attorney to learn more about this topic.

One of the main advantages of the corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) is limited liability protection.

What protection limited liability provides varies from state to state, so we will focus on California law.  As the name implies, the protection offered is limited to certain types of liabilities.  It primarily applies to protection from personal liability for the entity's debts and protection from personal liability for the actions of co-owners or employees of the business.

So what type of liability is not covered?  Personal liability for your own actions.  If you, for example, personally injure another person you are the one potentially liable.  While I would recommend having insurance anyways, this is another reason to look into purchasing insurance.

Lets go back to what is covered.  Limited liability protection means that you are not personally liable for the entity's debts.  So, for example, let's say that Jason has a corporation, ABC Inc.  ABC Inc.  has been in business for a number of years, but recently business hasn't been good for ABC Inc.  It borrowed $100,000 from XYZ Lending, but burned through its cash and no longer has any money left to repay XYZ Lending.  ABC Inc. has $20,000 worth of other assets.  XYZ Lending can sue ABC Inc. to seize the $20,000 worth of other assets, but cannot go after Jason's personal assets.  Unfortunately for XYZ Lending, they are unable to recover the remaining $80,000.

As previously mentioned, limited liability protection also means that the business owner is protected from personal liability for the actions of his or her co-owners and employees.  Let's look at another example.  Steven owns Delivery, Inc., a successful package delivery corporation.  Delivery, Inc. has hired several drivers to deliver packages.  One day, Rob, one of Delivery, Inc.'s drivers ran a red light while delivering packages and hit a pedestrian.  That pedestrian sued Delivery, Inc. for $500,000.  Delivery, Inc. only has $200,000 in cash and other assets, so the pedestrian is only able to seize that $200,000 worth of assets and cannot go after Steven's personal assets.  On the other hand, if Steven had decided to run the business as a sole proprietorship instead of forming a corporation he could have been held personally liable and had his personal assets seized due to the reckless behavior of his employee.

As you can see limited liability protection is a great benefit to business owners.  However, plaintiffs will try to get around this liability shield by "piercing the corporate veil."  I will explain that legal concept, and how you can maintain your liability shield, in the next blog post.

If you would like a referral to a great business transactions attorney, or you would like to talk to me about your tax situation please send me an e-mail.