Robert D. Gillen, Esq., is happy to share the insights he
has developed in business planning. Click on the Frequently
Asked Question you wish to learn more about:
What Type of Entity Should I Form for
My New Business?
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.
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Can You Explain “Sole
Proprietorship” to Me?
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.
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My Partner and I Will Both Want a
Say in the Business; Will a Partnership Provide this
Equality?
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.
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I Like the Concept of Limited
Liability, But Want Some Management Control; What Are My
Options?
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.
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Do Limited Liability Companies
Really Limit My Financial Exposure AND Let Me Run My
Business?
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.
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LLCs Sound Good, But How Are
Management Decisions Made?
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.
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Do LLCs Have Record Keeping
Obligations Like Corporations?
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.
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How are LLC Tax Election and
Tax Decisions Made?
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.
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I Think I Understand LLCs
Better, But How Are Corporations Created?
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.
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What Are the Advantages of
Conducting Business as a Corporation?
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.
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What Happens If I Don’t Follow
the Corporate Formalities?
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.
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Will the Corporation
Provide the Same Creditor Protection as an LLC?
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.
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I Own Rental Properties; What Type
of Entity Should They Be Held In?
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.
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