Business Planning FAQs

Such a simple question with no simple answer! First, a determination has to be made regarding the individual business owner(s), the type of business transacted or contemplated, the amount and type of any business financing, the potential for business liability, the type and value of assets owned or to be owned by the business, as well as many other tangential issues related to the business.  Instead of providing a “one answer fits all” solution, let's review the different types of business entities so that you can determine the type of entity which may best fulfill your primary business goal. Business can be transacted in one of four possible forms: (1) sole proprietorship; (2) partnership; (3) corporation or (4) trust. A single owner business could also be created as a corporation or limited liability company. When two or more owners are contemplated, the entity becomes more complex and could be organized as a partnership, limited liability company (LLC) or as a corporation. Corporations may be created as “for profit corporations” being a business that was organized to earn a profit for its owners or “not for profit corporations” such as a church, food pantry or other charitable organization. Many years ago the use of a trust to transact business was quite common; however, entities such as the Massachusetts Business Trusts are still permitted but seldom seen, as corporations, partnerships and LLCs have more advantages to business owners than were available with business trusts.

Sure! The simplest and least expensive type of business entity to create and maintain is the sole proprietorship. The sole proprietorship is normally a one owner, unincorporated business that reports its taxable income and activities on Schedule C of the owner's personal Form 1040 income tax return. This type of business entity does not have to pay incorporation fees, does not have to make complex business income tax filings, does not have to hold annual meetings for shareholders or directors, and does not have to have bylaws or other agreements to govern business operations as the single owner is responsible for all decisions. The sole proprietorship is therefore preferred by a single owner who isn't really sure if their new business will be a success and they just want to inexpensively “test the waters” before making a larger financial commitment. A simple and inexpensive filing is usually required if the business will be operated under a name other than the name of the owner. Some of the shortcomings of the sole proprietorship include the exposure of the owner's personal assets (i.e. house, investments, bank accounts) to all business claims, the inability to add more owners, partners, shareholders or investor owners in the future, the risk that someone else may set up a corporation using the same business name and the perception by those dealing with your business that you are “small” and won't be able to properly service their needs.

Well, it could. Whenever more than one owner is involved in the business, the next step up from a sole proprietorship would be a partnership. Unfortunately, partnerships come in different shapes and forms. At the turn of the century before corporations were used to transact business, most business was transacted in the form of partnerships. The partners wanted equal say in the operation of the business so a general partnership was used and all business decisions were made by agreement of a majority of the general partners and the profits and losses were typically allocated to the partners based on their ownership percentages. One of the shortcomings of partnerships is the fact that each general partner has unlimited liability for partnership operations. Over the years, some potential partners weren't willing to risk all of their assets in a new business venture and the use of limited partnerships became more common. Every limited partnership is required to have one or more general partners, who will each have unlimited liability. The limited partners do not have this liability exposure and their losses are typically limited to the amount of their investments thus protecting their houses and other investments from partnership risks. This limited liability protection comes at a relatively high cost as the limited partners must forego a voice in the operation of the business as the general partners who do have the unlimited financial exposure don't want anyone else operating the partnership business in any manner that may put them financially at risk. The limited partners therefore have no voice in the operation of the partnership business. Whenever partners want equal control over business decisions, a general partnership would be the answer, but seldom are they willing to take on the liability for all partnership debts and liabilities. So, when asset protection or minimizing financial risk is of concern, then the limited partnership would be a viable partnership solution, with the tradeoff that the limited partners would have no control over the partnership operations.

Most people are not willing to assume unnecessary business risk which could jeopardize their financial security, so one of their top business planning goals is to obtain the highest degree possible of creditor protection to protect their houses and investments from business claims. The two most common business planning goals are creditor protection and management control. Fortunately these can both be met by using either a corporation or a limited liability company. Even a business with just one owner can take advantage of either of these forms of ownership which offer far more protection than the previously discussed sole proprietorship.

Yes! The LLC is the most flexible business entity in existence and the ability to obtain creditor protection and retain management control are two of the reasons why limited liability companies have become so popular. The state in which the LLC is created can make a huge difference in the amount of creditor protection available to the owners or “members” of the LLC and this decision needs to be carefully considered by both the client and the attorney. LLCs usually cost a little more to create and maintain, but this additional cost is not significant when compared to the liability protection which is obtainable. From an income tax perspective, nothing comes close to the four tax treatment options available to the LLC. The LLC may, for income tax purposes, elect to operate as a sole proprietorship and become a “disregarded entity” thereby avoiding the double taxation inherent with some corporations. The LLC can also opt for the favorable “pass through” tax benefits available to partnerships. In the event that it would be desirable to be taxed as a corporation, the LLC can elect to be taxed as either a “C” corporation or as an “S” corporation.

Two alternatives for management decisions exist. The LLC can be “member managed” or “manager managed”. When management is reserved to the members or owners, the operating agreement should provide what percentage of owners needs to agree for each type of decision. It is common to require a simple majority for day-to-day decisions and a super majority of two-thirds or seventy-five percent for major decisions like selling the business, taking on large amount of debt, increasing salaries or paying bonuses. Manager managed LLCs are also quite popular and with this form of management the members decide who the manager or managers will be and how often and what the procedure will be for determining new managers. The operating agreement can require that the manger be a member of the LLC or may permit outside managers to serve. The members would typically reserve the right to hire and fire the managers and to set compensation for the mangers.

LLCs are not corporations and therefore are not mandated to hold shareholder and director meetings, or to maintain minutes of shareholder's or director's actions and decisions. In general, LLCs are able to maintain any type of management records that are desired, but the government does not require the same type of record keeping that a corporation would be obligated to maintain. Having said that, it would be prudent for most LLCs to maintain records of management decisions for their own protection and to ensure that whatever was decided has been properly recorded and those who were involved in the decision have signed off and approved the course of action. No penalty exists for failing to maintain records of LLC management decisions.

The tax attorney and/or accountant are usually instrumental in guiding the owners as to how to obtain the desired tax results. The operating agreement then empowers the LLC Manager or tax partner member to timely make these tax elections and decisions. The election concerning how the LLC will be taxed is made on IRS Form 8832 and this form determines if the LLC will be taxed as a disregarded entity, as a partnership or as a corporation. If corporate taxation is desired, then an additional election may have to be made if taxation under Subchapter S of the code is sought and the filing of IRS Form 2553 would then be required to be filed no later than seventy-five days from the date of formation.

Corporations are the creation of state law and must be organized under one of the business or corporation acts of a specific state. Most states have many different corporation acts that permit organization as a general business corporation, a professional corporation, a medical corporation, a close corporation, as well as many other similar type of professional corporate entities. The process itself is not complicated once all of the decisions have been made to proceed with establishing a corporation under the laws of a certain state. Articles of Incorporation need to be prepared, pre-organizational subscription agreements may be required to avoid certain SEC filing requirements, publication in local newspapers is usually required, organizational minutes for both the shareholders and the board of directors will be required, as will bylaws, issuance of stock certificates and perhaps other agreements between shareholders, such as buy-sell agreements which direct when a shareholder has to sell their stock and to whom, medical reimbursement plans, banking resolutions, purchase of major assets and setting of salaries are all part of the organizational process for most properly formed corporations. Once the owners have determined that it would be in their best interest to operate their business as a corporation, then the income tax treatment must be determined. The default rule is taxation under subchapter C of the tax code and if taxation under subchapter S is desired, then IRS Form 2553 will need to be timely filed.

Corporations have been used for many years as a first line of defense against business lawsuits. This corporate veil helps to insulate the shareholders from business liabilities. While not an absolute protection, it does make it more difficult for someone suing the business to seize or attach personal assets like houses, bank accounts or investments. The corporation is a separate entity for both legal and tax purposes and if the corporate formalities are religiously followed, the shareholder owner will normally be protected from business liabilities. Other reasons why corporations are popular are based on the perception that it is easier to sell a corporation since it owns the assets, has an ongoing relationship with its customers, has a corporate name and identity. When a prospective purchaser is looking to buy a business, only the corporate income tax returns need to be provided, unlike the sole proprietorship which would require you to divulge your personal income tax returns. From a marketing perspective, operating as a corporation also appears to make the business sound larger and more successful than when operating under your own name. Tax treatment can also be favorable as the corporation or shareholders have two choices of how the business income will taxed — either under subchapter C or under subchapter S of the tax code. Filing of the Subchapter S election will avoid the double taxation on corporations that is often feared. Other tax benefits are also available which, when coupled with the liability protection, makes the corporation a desirable entity from which to operate a business.

Big problems almost always follow this question. It is usually asked long after the injury occurs or when the corporate records have been subpoenaed. The short answer is that if you don't follow the corporate formalities, you aren't entitled to the protection of the corporate veil and aren't entitled to claim the corporate tax benefits because you are not adhering to the minimum requirements necessary to maintain a corporate existence. If a lawsuit ensues the corporate veil will be easier to pierce and will put your personal wealth at risk. If a tax issue exists, the corporate entity will be treated as a sham and the corporate tax benefits lost. In other words, if you are spending the time and money to set up any entity, you must be willing to make the commitment to properly maintain the entity or don't bother wasting your money in the first place. Failure to file the annual report will result in the involuntary dissolution of the corporation and personal liability for shareholders. Sometimes the dissolution is unintended, such as when the annual renewal notices are sent after the company has moved because most the annual reports renewals aren't normally forwarded. The owners therefore, aren't even aware, sometimes for many years, that the annual reports weren't filed and their corporation was dissolved and no longer exists. For this reason, most business owners name their legal advisors as the registered or statutory agent to ensure that notices are timely received and reports timely filed.

Probably not! Prior to the enactment of LLC legislation, the best protection for business owners was thought to be the corporation. The so called “corporate veil” was largely touted as putting an invisible fence around the owner's house and investments to protect them from business related claims. After years of lawsuits and court cases it became obvious that the corporate veil could be “pierced” and a creditor could go through the corporation and attach the owner's assets in many situations. Since the owner and the corporation were closely related and operated, many shortcuts were taken and corporate formalities were ignored, decisions were made to take profits out of the corporation instead of buying more insurance, creating better products, setting up litigation reserves and the attorneys have used these circumstances to convince courts, judges and juries that they should be able to reach through the corporation and recover the amount of their judgment from the owners who made these decisions that resulted in the corporation being under-funded or under-insured. LLCs, on the other hand, have statutory protection in a small number of states that limit the court's ability to grant certain type of relief and in essence make the LLC far more protective from the owner's perspective from business related claims. These are the states where the LLC should be created. This does not mean that the LLC owner can completely escape business liability because they may still be named in their personal capacity for their own negligence or decisions thus subjecting themselves to potential personal liability. This is why surgeons are named both personally and in their business capacity for acts of alleged negligence. In other words, having an LLC helps to protect from some business claims but does not provide protection for non-business claims or claims directed at the business owner personally instead of the business.

Renting out residential or commercial property is a business and any of the four entities previously discussed (sole proprietorship, partnership, corporation or LLC) are able to legally hold title to rental properties. However, the real question is: “What entity would offer you the best liability protection and tax benefits?” Since you will have other permitted people entering upon your property, whether it is a shopping center, apartment building, single family residence or a condominium you will not be present to ensure their safekeeping and must properly protect yourself from the possibility, no matter how remote, that someone could get injured on your property and will sue you for their injuries. This could be a claim based on lead paint in the house, an accident in the pool, a gas explosion from the furnace or water heater, a fall out of a window or any of the thousand things that could go wrong when children are on the property. The LLC would offer the best liability protection and if you own several rental units, you may wish to have separate LLCs for each rental property to avoid having all of your eggs in one basket. For tax reasons, corporations are not as desirable as LLCs for holding real estate. General partnerships are a disaster for holding real estate since each partner has unlimited liability for all of the claims, including lawsuits and judgments against the partnership. If the LLC is not a viable entity then perhaps a limited partnership would be second best; however, great care must be taken with this type of entity because the general partner has unlimited liability and normally the person putting the most money into the partnership wants to be in charge as the general partner to protect their investment. Prior to the adoption of the LLC Acts most rental property was held in limited partnerships, but with the advent of the LLC, most rental property is now held in LLCs.