Is an LLC the Right Choice for You?

Your business has reached the point where you are no longer comfortable operating it as a sole proprietor and you know that you need to form a business entity, but which structure is right for you? You thought about a C-corporation, but you do not the double taxation or all of the corporate formalities that would have to be observed. A general partnership does not work for you because you want to have limited liability protection.  A limited partnership sounds great, but you and your partners all want to be actively involved in the management of the business and each partner who is involved in management decisions is then a general partner who does not have limited liability protection.  An S-corporation sounds great because you still have all the protections that C-corporations have, including limited liability, and there is only a single level of taxation.  However, you would still have to follow all of the corporate formalities and that is not appealing to you. What option is left to you?

Image borrowed from bluemavenlaw.com

You could form a Limited Liability Company (LLC).  An LLC can be thought of as a hybrid between a corporation and a partnership.  Like a corporation, an LLC has limited liability protection, can enter into contracts, purchase assets, loan and borrow money, and sue and be sued. However, like a partnership, the taxable income and losses of the LLC flows through to the owners so that the LLC does not have to pay income taxes itself.   (Note: California assesses a "minimum tax" and an LLC fee, as we will discuss in detail in a future post). LLCs also do not have to follow the same corporate formalities that C-corporations and S-corporations do.

To form an LLC in California, you will have to file Form LLC-1 "Articles of Organization of a Limited Liability Company (LLC)".  I would also recommend talking to a business attorney and having that attorney help draft an Operating Agreement between the members (owners) of the LLC.

Unlike an S-corporation, there are no restrictions on the number of owners that an LLC can have. Also, unlike S-corporations, corporations, partnerships, and foreign residents are allowed to be owners in an LLC.

As I previously mentioned, an LLC does not have to follow the same corporate formalities that a corporation does.  However, this does not mean that an LLC does not have any formalities that it has to follow- it is just very relaxed in comparison to a corporation.  A California LLC still has to file Articles of Organization with the Secretary of State, pay taxes and fees assessed by California, maintain adequate business records, and maintain separate bank accounts for the business. However, because the corporate formalities required of an LLC are so relaxed, one of the main factors that will be considered if a litigant is attempting to "pierce the corporate veil" and remove your LLC's limited liability protection is whether the LLC is adequately capitalized.  You will want to speak to a business attorney to determine what is adequate capitalization for your business.

One drawback of LLCs is that not everyone is allowed to form them.  Doctors, lawyers, and accountants are just a few examples of professions that cannot operate their business through an LLC.

There are a number of differences that exist between S-corporations and LLCs that are not addressed here that may affect your tax situation.  We will be discussing them in detail in future posts.  In the meantime, if you have any questions about LLCs please send me an e-mail.

Is an S-Corporation Right for You?

You like the idea of forming a corporation because you want the limited liability protection, but the high cost of being taxed twice on the same income is very unappealing.  So then you thought about operating your business as a partnership so that your share of the business income will flow through to you, but the risk of being sued due to the actions of others is just too great.  A limited partnership doesn't work for you either because you want to be the one actively managing your business, not just an investor.  What other options are available to you?  One option is an S-corporation.

Image borrowed from Pacific
Associates Corporation

Every S corporation starts off as a C corporation, or what you may think of as a "regular corporation."  Then, the corporation will make an election, commonly referred to as an S Election, to be taxed under Subchapter S of the Internal Revenue Code. Basically, what this means to you is that taxes are paid at the owner-level rather than at the business-entity level, just like with partnerships.  But unlike partnerships, because an S-corporation is still a corporation it has the benefit of limited liability protection.

The S Election is made by filing Form 2553 with the Internal Revenue Service.  Once the election is made with the IRS, S corporation status is automatically recognized by California.  The election may be filed anytime during the year prior to when the election is to take effect, or within the first 2 months and 15 days of the year in which the election is to take effect.

However, there are restrictions on what corporations can be S-corporations.  First, the corporation must be incorporated within the United States.  Next, all the shareholders (owners) must be either individuals, estates, and certain types of trusts.  An S corporation may not have partnerships, corporations, or non-resident aliens as shareholders.  Additionally, an S corporation may not have more than 100 shareholders, and there can only be one type of stock issued.  The reason there can only be one class of stock issued is that all the shareholders must have the same rights in the corporation.  Finally, an S-corporation is not allowed to engage in certain types of business, such as finance or insurance.  If any of these restrictions are violated, the S-corporation status will be revoked.

S corporations have to comply with the same formalities that their C corporation counterparts do. Some of these formalities are:

• 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.

However, this is not an exhaustive list and you should talk to a corporate law attorney to see what other formalities have to be observed.

In future blog posts, we will discuss in more detail the distinctive characteristics of S-corporations and specifically how they differ from other types of entities.

If you would like to talk about the unique tax rules that govern S-corporations and how they may impact your business, please send me an e-mail.

What is a Limited Partnership?

How is a limited partnership different from a general partnership?

In the last blog post, What is a Partnership?, I gave you an overview of general partnerships and some of the advantages and disadvantages of using that type of business entity.  In an attempt to make partnerships a more beneficial business structure, limited partnerships were created.

In a general partnership, every partner is a "general partner."  That means that each partner can be held personally liable for not only his or her own actions, but for the actions of the partnership as a whole, the other partners, and the partnership's employees.

In a limited partnership, there must be at least one general partner but there are also limited partners.  Limited partners have limited liability (see Limited Liability Protection) so they can only be held personally liable for their own actions.

In exchange for having limited liability protection, the limited partners are not allowed to take any active role in the management of the partnership.  I would advise talking to a business attorney about what activities specifically qualify as management activities.

Why would a General Partner want to be in a Limited Partnership?

At first, it does not seem like there would be any advantages to a general partner to being in a limited partnership.  The general partner is still fully liable for the actions of the others, just as in a general partnership.

However, there are two main benefits to this arrangement for general partners.  The first is that it makes it easier for general partners to raise funds for the business through investors.  Many investors would not be interested in becoming a partner with full personal liability for the actions of the other partners.  The second benefit is that this arrangement leaves the general partners in full control of the daily operations of the business and all major business-related decisions.

What are the other benefits of Limited Partnerships?

Limited partnerships, like general partnerships, are pass-through entities for tax purposes meaning that they are not subject to double taxation (see Would You Rather Be Taxed Once or Twice?).  Also, the limited partners only have the amount that they invested in the business at risk.  Creditors cannot attempt to seize their personal assets, and as previously mentioned they are not personally liable for the actions of others in the business.

What are the negatives of Limited Partnerships?

While the limited partners being barred from participating in the management of the business may be a benefit to the general partners, it can be frustrating for the limited partners.  The limited partners invested their money in the business and may have strong opinions about how the business should be run.  However, if they become involved in the management of the business they lose their limited partner status and their limited liability protection.

Another disadvantage to limited partnerships is that the passive activity rules may affect the limited partners ability to deduct business losses.  The passive activity rules will be the subject of a future blog post.

If you would like to learn more about the tax implications of using the limited partnership structure for your business, or the tax implications of any other business decisions, please 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.

What is a Corporation?

Your friends keep telling you that you should incorporate your business, but you brush them off. You own a small business; corporations are giant entities like GE and Apple.

The truth is, you can incorporate your business regardless of its size.  The question is instead whether it makes sense for you and your business to incorporate.

Picture borrowed from www.cgglobal.com

You have to answer that question for yourself, perhaps with the help of a trusted adviser, but in order to make an informed decision you need to have a general understanding of what a corporation is and what the tax implications are to incorporating your business.

The goal of this blog post is to give you an overview of what a corporation is.  I strongly recommend talking to a business transactions attorney if you are considering forming a corporation as there are many important details not discussed here.

As opposed to a sole proprietorship, a corporation is a legal entity that is separate and distinct from you as its owner (shareholder).  There is, essentially, a legal fiction that a corporation is its own person.  What exactly that means has been the subject of many Supreme Court cases and continues to evolve, but for purposes of our discussion it means that the corporation can: enter into contracts, purchase assets, loan and borrow money, sue or be sued, and pay taxes.

Corporations are organized under state law, and must recognize certain formalities.  These vary to some degree from state to state, and for purposes of this discussion I will be discussing the formalities that California corporations are subject to.  Again, this is a very general discussion and I strongly recommend discussing this with a business transactions attorney.   Some of the formalities include:

• 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.

This is not an exhaustive list of the corporate formalities that must be followed by a California corporation.

As mentioned in my previous post, Why Form a Business Entity?, one of the primary benefits of forming a corporation is that it has limited liability protection.  Because of the importance of limited liability, it will be discussed in the next blog post.  For now, the general rule is that your financial risk is limited to the amount of your investment.

Another benefit of the corporate form of business ownership is that your ownership interests can, relative to other forms of business ownership, be easily transferred to another individual.  Your ownership interest in the corporation is represented through shares of stock, and generally there are no restrictions on you in transferring your ownership of the stock to another person.  To be clear, this does not necessarily mean that there is an active market for your stock, but once there is a buyer the sale process is much simpler than, for example, the sale of a partnership interest.

However, one of the main drawbacks to the corporate form of business ownership is double-taxation. As I mentioned, a corporation is a separate legal entity that is subject to taxation.  That means that any income that the corporation earns will be taxed first at the corporate level.  If that income is then distributed to the shareholders, it may be taxed again at the individual level (the taxation of distributions will be discussed further in a future blog post).

It is possible to for a shareholder to take money out of the corporation and only have it be subject to one level of taxation if that owner is also an employee.  An owner-employee is paid wages or a salary, and that is W-2 income to the owner-employee but a valid deduction to the corporation. However, as W-2 income it is subject to payroll taxes.  Any additional distributions (i.e., money taken out of the corporation that is not run through payroll) is again taxable at the corporate and individual level.

This hopefully will give you a general understanding of what a corporation is, what formalities it is subjected to, and some of its benefits and drawbacks.  If you are interested in a referral to a business transactions attorney or if you have any questions about the tax implications of corporate ownership, please send me an e-mail.

Why Form a Business Entity?

Congratulations!  You decided to turn your passion into a business, and you are doing everything you can to make sure that it is a success.  You've heard people talk about incorporating their business or forming a partnership or LLC, and now you are wondering if that is the right thing for your business.

Table borrowed from www.strategicofficesupport.com

The answer is...maybe.  It is a cliche, but every business and every business owner is different and has different needs that must be considered.

However, there are some factors that impact this decision.

One factor is whether you would like your company to have limited liability protection. Corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) all provide limited liability protection.  Sole proprietorships and general partnerships do not.

Limited liability protection will be discussed in great detail in a future blog post, but in very general terms it means that only the entity's assets (i.e., not your personal assets) are at risk of loss.  For example, let's say that your business has $10,000 worth of assets and you have $250,000 of personal assets outside of the business.  If your business is sued, the plaintiffs can only attempt to collect on the $10,000 of business assets and cannot seize your personal assets.

You may feel that it is very unlikely that you will be sued or that if you are that is the reason why you have insurance.  You may be right, but you also want to keep in mind that your business is not only potentially liable for your actions but for the actions of your employees.  For many business owners, the desire to hire employees makes having limited liability protection a more significant factor to consider.

Another factor that you must consider is whether the business will have multiple owners.  The general rule is that if a business has multiple owners and no action has been taken to form a different type of entity (such as a corporation or LLC), it is a general partnership.  In a general partnership, each partner is personally liable for the actions of every other partner, their employees, and the business.  While for various reasons it may make sense to you to be in a general partnership, you want to make sure that it is a conscious decision and not simply the default because your business has multiple owners.  Therefore, if your business has multiple owners generally it will be an entity, so the decision then is what type of entity.

A third factor to consider are the tax implications to either operating your business as a sole proprietorship or as a business entity.  There are a number of different tax implications, not the least of which is whether or not you are then considered "self employed" and subject to the self-employment tax, that are outside of the scope of this blog post.  The important thing to remember is that there are a number of tax implications to how you choose to structure your business.  I would recommend talking to a CPA to discuss the specific impact that operating your business as a sole proprietorship versus a partnership, corporation, S-corporation, or LLC will have on your tax situation.

The final factor to consider when deciding to operate your business as a sole proprietor or as a separate business entity is the likelihood of an IRS audit.  There is a widespread belief among tax professionals, for various reasons, that a sole proprietorship is more likely to be subjected to an IRS audit than a business entity.  This is not to say that business entities are not audited by the IRS- they are all the time- but many tax professionals believe that sole proprietors are audited more frequently.  Of course you will be filing your taxes properly, but an IRS audit can be expensive for taxpayers even if the IRS does not make any changes to your tax return.

I highly recommend talking to a business transactions attorney about whether forming a separate entity for your business makes sense for you.  Please also feel free to e-mail me if you have any questions about the tax implications of how you structure your business.