Chapter 6

Starting with the Right Legal Structure

IN THIS CHAPTER

Introducing legal business categories

Using the sole proprietorship

Choosing the partnership

Electing the corporate form

Selecting the best legal structure

Choosing the legal form for organizing your business is one of the important decisions you must make before launching the business. Because of changing laws, entrepreneurs today have many more choices regarding how to structure their companies. Your need for capital and protection from liability are just two reasons why understanding the options available to you is so essential.

Those changing laws are also a good reason for seeking the advice of a good attorney or certified public accountant (CPA) to make sure you’re making the best choice for you and your type of business.

This chapter gives you a solid background on what you need to think about before choosing a legal form of business and what you need to understand about of the various forms available to you.

Introducing the Legal Business Classifications

All companies operate under one of four broad legal classifications:

• Sole proprietorship
• Partnership
• Corporation
• Limited Liability Company (LLC)

Many entrepreneurs assume that the best entity is always one that lets profits pass through to the owners at their personal tax rate. They further assume that incorporating in your home state is always best. These assumptions can be wrong for some entrepreneurs and for some businesses.

For example, if you know that you want to do an IPO (initial public offering) within two years, you should probably form as a C Corporation, because that form is required to go public. If you’re going to use venture capital, you probably also want a C corporate form, and you may want to incorporate in California or Delaware. Why? Those states have a substantial body of law in the area of corporate governance. Choosing the wrong entity when speed is of the essence (consider the case of Internet start-ups) can mean costly delays and lost opportunities.

Understanding the various factors that come into play when you choose a particular form of legal structure is important. Seven factors affect your choice of structure. A summary comparison of these factors appears in Figure 6-1.

© John Wiley & Sons, Inc.

FIGURE 6-1: This chart shows a summary comparison of legal categories of business organization.

Here the factors are presented in the form of questions you can ask yourself:

1. Who will be the owners of the company?

   If more than one individual owns the company, you can eliminate sole proprietorship as an option. If many people own the company, the C Corporation form is often the choice because it has an unlimited life and free transferability of interests. If you intend to have many employees, the C Corporation also lets you take advantage of pension plans and stock option plans.

2. What level of liability protection do you require, especially for your personal assets?

   Some forms protect you; others don’t. It’s a sad fact that too many businesses ignore the risks they face and don’t acquire the correct forms of insurance. Just as you want to seek the advice of an attorney and accountant as you develop your business, you also want to consider the advice of an insurance broker.

3. How do you expect to distribute the company’s earnings?

   If you choose an entity allowing pass-through income and losses (partnership, S Corporation, or LLC), tax items at the entity level are allocated immediately without additional taxation, although cash may or may not be distributed. But in a C Corporation, only a salary or other forms of compensation are paid out pretax from the company to an owner.

4. What are the operating requirements of your business and the costs of running the business under the particular form in question?

   If you own a manufacturing company that uses a lot of machinery, you have different liabilities than a service company.

5. What are your financing plans?

   How attractive is the form to potential investors? Are you able to offer ownership interests to investors and employees? In general, as already mentioned, if you’re going to use venture capital, you need a corporate form. Most venture capitalists raise their money from tax-exempt entities such as pension funds, universities, and charitable organizations. These organizations can’t invest in companies that have pass-through tax benefits.

6. What will be the effect on the company’s tax strategy and your personal tax strategy?

   This includes everything from minimizing tax liability, converting ordinary income to capital gain, and avoiding multiple taxation to maximizing the benefits of startup losses.

7. Do you expect the company to generate a profit or loss in the beginning?

   If you think your company will lose money for the first few years (this is often true with biotech or other companies developing new products), then a pass-through option can be justified because you get to deduct your losses on your personal tax return.

Going It Alone: The Sole Proprietorship

Most businesses operating in the United States are sole proprietorships. A sole proprietorship is a business where the owner essentially is the business; that is, he or she is solely responsible for the activities of the business and is the only one to enjoy the profits and suffer the losses of the business.

Why do so many businesses start this way? Sole proprietorship is the easiest and least expensive way to form a business. If you’re using your own name as the name of the business, all you need is a business license, some business cards, and you’re in, uh, business.

Deciding to use another name for your business is only slightly more complex. For example, in the case of ABC Associates, you apply for a DBA, which is a certificate of Doing Business under an Assumed name. You can secure a DBA at your local government office. Securing a DBA ensures that two businesses don’t operate in the same county with the same name.

Advantages of sole proprietorships

Besides being the easiest to start and least expensive form of organization, sole proprietorship also gives the owner complete control of the company. You make all the decisions and suffer all the consequences, but the income from the business is yours and you’re taxed only once at your personal income tax rate.

Many professionals, such as consultants, authors, and many home-based business owners, operate as sole proprietors.

Disadvantages of sole proprietorships

For many entrepreneurs, the sole proprietorship form of organization isn’t satisfactory, for several reasons:

• As a sole proprietor, you have unlimited liability for any claims against the business. In other words, you are putting your personal assets at risk — your home, car, bank accounts, and any other assets you may have. So, having business liability and errors and omissions insurance is extremely important. If you’re producing a product, you’ll need product liability insurance to protect you against lawsuits over defective products. If your company does work for other people (such as a construction company), you may be required to have bonding insurance to ensure that you complete the work specified in your contract. Because there are so many areas of liability and so many different types of insurance, you should talk to a good insurance broker.
• Raising capital is difficult, because you’re relying only on your financial statement. You are, for all intents and purposes, the business, and most investors don’t like that situation.
• You probably won’t have a management team with diverse skills helping you grow your business. You may have employees, but that isn’t really the same thing. Putting together an advisory board of people with skills you need may help compensate for the skills you lack.
• Because the survival of your company depends on you being there, if something happens to you or a catastrophe strikes, the company doesn’t survive. Legally, if the sole proprietor dies, so does the business, unless its assets are willed to someone.

If you intend to really grow your business, organizing as a sole proprietorship may not be a good idea, unless you’re taking advantage of income and control benefits during the early stages of your business — for example, through product development.

Choosing a Partner: The Partnership

A partnership is two or more people deciding to share the assets, liabilities, and profits of their business. Partnering is often an improvement over the sole proprietorship because more people are sharing the responsibilities of the business and bouncing ideas off each other. Additionally, you now have multiple financial statements on which to rely and an entity that usually survives if one of the partners dies or leaves.

In terms of liability, though, you’re raising the stakes, because each partner becomes liable for the obligations incurred by other partners in the course of doing business. This doctrine of ostensible authority works like this: Suppose one of your partners enters a contract on behalf of the partnership, purchasing certain goods from a supplier. That partner has just bound the partnership to make good on a contract even if the rest of the partners knew nothing about it. The one major exception is that personal debts of an individual partner can’t attach to the rest of the partners.

On the positive side, each partner uses any property owned by the partnership and shares in the profits and losses of the partnership unless otherwise stated in the partnership agreement. Partners don’t have to share equally in the profits and losses. Ownership in the partnership can be divided in any manner the partners choose. The biggest issue with partnerships is that they often are fraught with conflict in much the same way as family businesses. However, when you think about it, any business that includes a team of entrepreneurs, whether a corporation or limited liability company, has similar issues. The partnership agreement, therefore, becomes important from the beginning.

Forming a partnership

You don’t have to have a written agreement when forming a partnership; a simple oral agreement works. In fact, in some cases, the conduct of the parties involved implies a partnership.

Accepting a share of the profits of a business is prima facie (legally sufficient) evidence that you are a partner in the business, meaning that you may also be liable for its losses.

Partnerships come in several flavors. In most partnerships, entrepreneurs are general partners, meaning they share in the profits, losses, and responsibilities, and are personally liable for actions of the partnership. But other types of partners have more limited liability, including the following:

• Limited partners: These partners’ liability generally is limited to the amount of their investment.
• Secret partners: These partners are active in the ventures but are unknown to the public.
• Silent partners: These partners are usually inactive with only a financial interest in the partnership.

The partnership agreement

It’s hard to overstate the importance of a partnership agreement. Many a prospective partner says things like “We’ve been the best of friends for years; we know what we’re doing,” or “How can I ask my father to sign a partnership agreement?” Well, how can you not? You must separate business from friendship and family, at least when it comes to structuring your company. This is a serious deal. No matter how well you know your partner, you probably haven’t worked with him or her in this particular kind of situation. You have no way of predicting all the things that can cause a disagreement with your partner. The partnership agreement gives you an unbiased mechanism for resolving disagreements or dissolving the partnership, if it comes to that.

Consulting an attorney is necessary when drawing up an agreement, so that you’re not inadvertently causing yourself further problems by the way a phrase is worded in the agreement or leaving something important out. The partnership agreement addresses the following:

• The legal name of the partnership.
• The nature of your business.
• How long the partnership is to last. As with any contract, it needs a stop date.
• What each of the partners is contributing to the partnership — capital, in-kind goods, services, and so forth. This is the initial capitalization.
• Any sales, loans, or leases to the partnership.
• Who is responsible for what — the management of the partnership.
• The sale of a partnership interest. This clause restricts a partner’s right to sell his or her interest to third parties. It provides, however, a method by which a partner can divest his or her interest in the partnership.
• How the partnership can be dissolved.
• What happens if a partner leaves or dies.
• How disputes will be resolved.

If you don’t execute a partnership agreement, all partners are equal under the law.

Going for the Gold: The Corporation

A corporation is a legal entity under the law and has continuity of life. Chartered or registered by the state in which it resides, a corporation can survive the death or separation of all of its owners. It can also sue, be sued, acquire and sell real property, and lend money.

Corporation owners are called stockholders. They invest capital into the corporation and receive shares of stock, usually proportionate to the level of their investment. Much like limited partners, shareholders aren’t responsible for the debts of the corporation (unless they have personally guaranteed them), and their investment is the limit of their liability.

This chapter covers two major types of corporations: the C Corporation (closely held, close, and public) and the S Corporation. Most corporations are C Corporations and are closely held, which means stock is held privately by a few individuals. A closely held corporation operates as any type of corporation — general, professional, or nonprofit. But in a close corporation, the number of shareholders you may have is restricted, usually to between 30 and 50 shareholders. In addition, holding directors’ meetings isn’t required. Such meetings are a requirement for an S Corporation. The C Corporation isn’t available in every state and doesn’t permit you to conduct an initial public offering. Basically, a close corporation operates much like a partnership.

Doctors, lawyers, accountants, and other professionals who previously weren’t allowed to incorporate use professional corporations. This vehicle now lets professionals enjoy tax-free and tax-deferred fringe benefits. You should be aware that only members of the specific profession can be shareholders in the corporation. In a professional corporation, all the shareholders are liable for negligent or wrongful acts of any shareholder.

By contrast, in a public corporation, stock is traded on a securities exchange like the New York Stock Exchange, and the company generally has thousands (in some cases, millions) of shareholders. For space concerns, and because most people starting a business choose the C Corporation type over the S, the focus here is on C Corporations.

Three groups of individuals — shareholders, directors, and officers — make up the corporate structure. Shareholders own the corporation but they don’t manage it. Shareholders exert influence through the directors they elect to serve and represent them on the board. The board of directors, in turn, manages the affairs of the corporation at a policy level and hires and fires the officers who are responsible for the day-to-day decisions of the company.

Public corporations in most states in the U.S. require only one director, but in some states, the number of shareholders you have determines the number of directors. However, you can always have more directors for many different reasons. If you are forming a corporation in a country other than the U.S., check with the local government to find out the requirements for boards of directors. The rules differ from country to country.

What is surprising for many is in the U.S., corporations comprise a small minority of all businesses, yet they generate most of the sales. Part of this surprising picture is attributable to the fact that most entrepreneurs who intend to grow their companies choose the corporate form for its many benefits.

Enjoying the benefits of a corporation

The advantages of a corporate form definitely outweigh the disadvantages. For one, the owners enjoy limited liability to the extent of their investment (the one important exception is payroll taxes that haven’t been paid to the IRS). By selecting the corporate form, you also can do the following:

• Raise capital through the sale of stock in the company.
• Own a corporation without the public being aware of your involvement. So, if you want anonymity, it’s the way to go.
• Create different classes of stock to help you meet the various needs of investors. For example, you may want to issue nonvoting, preferred stock to conservative investors wanting to be first to recoup their investment in the event the business fails. Most stock issued is common stock, the owners of which enjoy voting rights and share in the profits after the preferred stock has been paid.
• Easily transfer ownership. In a private corporation, you want assurances that your shareholders can’t sell their stock to just anyone. In other words, you want to know who owns your stock. You can protect yourself by including a buy-sell clause in the stockholder’s agreement. Usually, this clause specifies that the stock must first be offered to the corporation at an agreed-upon price.
• Enter into corporate contracts and sue or be sued without the signatures of the owners.
• Enjoy more status in the business world than other legal forms because corporations survive apart from their owners.
• Enjoy the benefits of setting up retirement funds, Keogh and defined-contribution plans, profit sharing, and stock option plans. The corporation deducts these fringe benefits as expenses that aren’t taxable to the employee.

Weighing the risks

Every legal form has disadvantages and risks, and the corporation is no exception. Here are risks worth considering when contemplating using the corporate form:

• Corporations are much more complex, cumbersome, and expensive to set up.
• Corporations are subject to more government regulation.
• A corporation pays taxes on profits regardless of whether they are distributed as dividends to stockholders.
• Shareholders of C Corporations don’t receive the tax benefits of company losses.
• By selling shares of stock in your corporation, you’re effectively giving up a measure of control to a board of directors. The reality, however, is that the entrepreneur determines who sits on that board of directors in privately held corporations.
• You must keep your personal finances and the corporation’s finances completely separate. You must conduct directors’ meetings, and maintain minutes from those meetings. If you don’t, you may leave your company open to what is known as piercing the corporate veil, which makes you and your officers liable personally for the company.

Where and how to incorporate

You create a corporation by filing a certificate of incorporation with the state in which you do business and issue stock, making your company a domestic corporation. If you incorporate in a state other than the one in which you do business, your company is a foreign corporation.

In general, you want to incorporate in the state where you’re planning to locate the business so that you don’t find yourself working under the regulations of two states. When deciding where to incorporate, consider the following:

• The cost difference of incorporating in your home state versus doing business as a foreign corporation in another state: In general, if you’re doing business mostly in your home state, incorporating there won’t subject you to taxes and annual report fees from both states.
• The advantages and disadvantages of the other state’s corporate laws and tax structure: For example, in some states, a corporation pays a minimum state tax regardless of whether it makes a profit, whereas other states have no minimum state tax. Likewise, if you’re incorporating anywhere other than your home state and find yourself defending a lawsuit in the state of incorporation, you may incur the expense of travel back and forth during that time.

Offering Flexibility: The S Corporation, the LLC, and the Nonprofit Corporation

A number of different legal organizational forms offer flexibility for entrepreneurs in a variety of ways. This section looks at three: the S Corporation, the LLC, and the nonprofit. All the criteria used for making a decision about which form to choose apply to these as well.

Sizing up the S Corporation

An S Corporation is a corporation that elects and is eligible to choose S Corporation status, and shareholders at the time consent to the corporation’s choice. In general, an S Corporation doesn’t pay any income tax. Instead, the corporation’s income and deductions are passed through to its shareholders. The shareholders must then report the income and deductions on their own income tax returns.

An S Corporation can provide employee benefits and deferred compensation plans. To qualify for S Corporation status, you must

1. Form your corporation with no more than 100 shareholders, none of whom may be nonresident aliens.
2. Issue only one class of stock.
3. Ensure no more than 25 percent of the corporate income is derived from passive investments like dividends, rent, and capital gains.

In addition, your S Corporation can’t be a financial institution, a foreign corporation, or a subsidiary of a parent corporation. If you elect to change from an S Corporation to a C Corporate form, you can’t go back to being an S Corporation form for five years.

In general, S Corporations work best

• When you expect to experience a loss in the first year or two, and owners have other income they can shelter with that loss.
• Where shareholders have low tax brackets (lower than the corporate rate), so the profits can be distributed as dividends without double taxation.
• Where your business may incur an accumulated earnings penalty tax for failure to pay out its profits as dividends.

Comparing the S Corporation to the LLC

The Limited Liability Company (LLC) is the newest legal form of business organization, and although it’s gaining in popularity for many entrepreneurs, it confuses the many choices they already face in structuring their companies. The LLC combines the best of partnerships (pass-through earnings) with the best of the corporate form (limited liability). LLCs have grown in popularity because they

• Limit liability for business debts up to the amount invested.
• Offer flexible management structure that allows the members (the equivalent of shareholders in a corporation) or nonmembers they hire to manage the organization.
• Allow the choice of being treated as a partnership with the benefits of pass-through earnings or as a corporation, whichever provides the lowest tax liability.
• Enable flexible distribution of profits and losses, meaning that you can divide them up any way you want among the members.

So what are the differences between an LLC and an S Corporation? Why would you choose one over the other?

• An LLC provides for an unlimited number of owners, whereas the S Corporation limits you to 100.
• An LLC permits you to include nonresident aliens, pension plans, partnerships, and corporations as members, whereas the S Corporation doesn’t.
• LLCs can have different classes of stock, whereas an S Corporation is generally limited to one class.

The members of an LLC are analogous to partners in a partnership or shareholders in a corporation. If the members self-manage, then the members act more like partners than shareholders, because they have a direct say in what happens within the organization. Stock in an LLC is known as interest.

If you’re looking for more flexibility in what you’re able to do in the long term, you would probably choose an LLC over an S Corporation.

Making profits in a nonprofit organization

Let’s dispel the biggest myth about nonprofit organizations first. You can make a profit in a nonprofit company; in fact, doing so is a good idea. What you can’t do is distribute those profits in the form of dividends the way other legal forms do. A nonprofit (or not-for-profit corporation) is formed for charitable, public (in other words, scientific, literary, or educational), religious, or mutual benefit (as in trade associations).

Like the C Corporation, the nonprofit is a legal entity with a life of its own and offers its members limited liability. Profits that it generates from its nonprofit activities aren’t taxed as long as the company meets the state and federal requirements for exemption from taxes under IRS 501(c)(3). When you form a nonprofit, you actually give up proprietary interest in the corporation and dedicate all the assets and resources to tax-exempt activities. If you choose to dissolve the corporation, you must distribute those assets to another tax-exempt organization — you can’t take them with you. Any profits you make from for-profit activities are taxed the same as any other corporation.

Nonprofit organizations derive their revenues from a variety of sources. They receive donations from corporations (which are tax deductible to the corporation) and others, conduct activities to raise money, or sell services (a for-profit activity). As entrepreneurs, founders of nonprofit, tax-exempt corporations can pay themselves a good salary, provide themselves with cars, and generally do the kinds of things you would do within a normal corporation — except distribute profits.

Most entrepreneurs who start nonprofits do so for reasons other than money — for example, a driving need to give back to the community. James Blackman founded the Civic Light Opera of South Bay Cities, Redondo Beach, California, providing a cultural arts center for the community. The opera became the third-largest musical theater in California and has won many awards. Blackman’s company also provides opportunities for physically and mentally challenged children to experience music and the theater.

Benchmarking Your Best Choice

After you’ve gotten a good overview of what’s available, Figure 6-2 offers a strategy for choosing the best legal form for your new business. Starting with the first question, work your way down, mapping an easy way to find your alternatives and organize your business.

© John Wiley & Sons, Inc.

FIGURE 6-2: Six questions point you in the right direction for choosing your legal organization.