Craig Jennings

Small Business, Legal Structures, Part 1

Posted by: craigj under Uncategorized

Mission: To remove the obstacles to your success, whether you own a small business, are self-employed, or are planning a venture. To Incorporate or Not to Incorporate if that were the only question, this would be a lot simpler. There are several legal structures available for your business. How do you choose the best one? For the person planning a startup, this is a big question. For the entrepreneur in business, this is a question which is occasionally worth revisiting. Note from my attorney who looked over this document: “CJ, I know you want to make this simple and straightforward, but remember, any time you are dealing with legal issues, nothing is simple, clear, straightforward or easy.” Let’s have a look at what’s available, and the pros and cons for each. Sole proprietorship. You are the company. Partnership - both (all) of you are the company. S Corporation - an incorporation process much used by small business. C Corporation - The chosen instrument for larger corporations. LLC - Limited Liability Company - a flexible tool, works well with complex structures. In this newsletter, we’ll have a look at Sole Propetorships and Partnerships, along with their pros and cons. In the next, we’ll deal with the balance. Like so many questions and answers around small business, there’s no perfect solution, despite advice you may get to the contrary, usually from people selling a solution! You are a sole proprietor. No formation document is required. You are personally liable for all debts. Unless you close it beforehand, the business lives as long as you do, ends when you die. It cannot survive you. (Be careful not to die before you’ve finished with your Sole Proprietorship!) Tax goes on your personal return - Income on Schedule C. You can go to almost any bank and ask them for a (free) checking account for your new business. Give them your name and social security number. Make a deposit, get some checks, and, one hour later, you’re in business! THAT’S IT! If you buy bricks for a dollar each and sell them for two, you can pay for the bricks out of your new checking account, and deposit the payments, in cash, or in checks made to you, in the same account. When you pay income tax, your income less expenses is the fundamental measure of the success of your business. A net loss may reduce your tax payables. Features: Pros and cons (for both versions) Pros: Simple & Flexible, minimal paperwork, just say “I’m open for business!” (Foreign nationals are astounded at how easy it is to start a small business in the U.S.A.) Cons: You, your assets, your house, your savings account, are totally at risk if your business gets in trouble. All the business obligations are your personal obligations. Since you are your business, you can be sued for what your business does, and if the other guys win, they can get your savings and your house! Sole Proprietor Summary: A great way to get started - you can test your business concept without a lot of tedious preparation. You can switch from this to another option any time you like. Suggestion: if you’re planning a skydiving business, or something else where a lawsuit is possible, you’ll probably make that different choice right at the start  !  (And some insurance might not be a bad idea…) A second form of sole proprietorship is one you register with the County Clerk. You can register it under your name or under a new name you thought up. The clerk will search to uncover any naming conflicts - then charge you a fee. In Nassau County, this cost me $39.75 including notarizing costs; in the boroughs of New York City, it runs about $120. You’ll hear the term DBA. It means you’re Doing Business As - whatever name you chose. You’re protected against someone nearby (same county) opening up a business with your business name. Sole Proprietorship - Version 1 - Your answer to the question: When Can I Start? Sole Proprietorship, Version 2 - The DBA You two are the proprietors. No formation document is required except DBA. You two are personally liable for all debts. Unless you close it beforehand, the business lives as long as you two do, ends when one of you dies. Either partner can exit by providing written notice to the other. The partnership cannot survive you both. In the absence of a written agreement, state partnership law governs. Tax goes on your personal return - Income on Schedule C. A partnership is a multiple proprietorship, and it can be set up as a Multiple Proprietorship, following the steps for Sole Proprietorship Plan B, above. (First version means that one partner has sole control of the money, so second, registered version is probably going to be your choice.) You’ll probably ask the bank to honor either partner’s signature on the partnership’s checking account. Alternatively, you can ask the bank to require both signatures for higher dollar amounts. Features: You two have agreed to combine your talents, and your capital. It’s now up to you both! Pros and con - Partnership Pros: You’ve agreed to combine your talents and your resources with someone else. You have someone to talk to, to plan with, who’ll share your successes and commiserate with your failures. You’ve created a team. Your record-keeping needs are modest. Income goes to Schedule C, divided by half, of course. Cons: You and your partner are fully liable for the obligations of the business. This is not a 50-50 deal, it’s 100-100 - what the lawyers call “joint and severally liable.” If your partner buys a Mercedes with partnership funds, the partnership gets to pay for it, even if he decides to drive to Canada and stay there. Either partner can withdraw from the partnership by giving the other written notice. Ah, but now how do we divide the assets and liabilities? BIG PARTNERSHIP RULE! Never enter a partnership without a written agreement which includes strategies for dissolving the partnership!!! Why is this one of the most difficult pieces of advice to take? I think it’s because at the outset, you’re operating out of the same ego - the business is “ours,” and you see that you’ve just acquired an enormous asset in your partner. The whole agreement concept seems mean and stingy, and both of you are working so smoothly that a dissolution agreement sounds like a pre-nup. Ah, but behind the traits that you admire in your partner are the traits that make him/her human, and you will discover them later. And he/she will discover your “other” traits, also later! When one ego becomes two, you have new and unsuspected dynamics coming forward. I’ve saved the worst news for last. One partner can hold the business hostage and paralyze the business process as long as he/she wants! Or, alternatively, clean out the checking account. Personal note - I’ve done this wrong myself more than once. Made the mistake I’m describing above. One ended in bad feelings between myself and someone I respected. A second ended in personal bankruptcy. Not fun, not recommended. Partnership: We’ve reviewed the options you can enter and exit quickly, and cheaply. But in each of them, there’s no inherent protection from liability. It would be great to have our own sky-diving business, but what if a client’s chute doesn’t open, and we get sued? There are 3 additional structures, all involving incorporation, which have significant set-up costs, significant tax consequences and significant record-keeping consequences, but, if something goes horribly wrong, allow the business to take the fall rather than you. There’s one more legal term you (and I) should know about - a UPL. A UPL is the unauthorized practice of law, giving what might be construed as legal advice! Please note that this is not legal advice; it is intended to promote or spark thought and discussion from a business perspective, possibly to be followed by obtaining legal advice and assistance from a lawyer!

Read post | No comments yet | August 2nd, 2004

To Incorporate or Not to Incorporate, Part II

Posted by: craigj under Uncategorized

The Corporation. Corporations come in three flavors, C Corp, S Corp and LLC. The three have much in common

1. The major virtue that the Corporation brings to the table is its “persona.” Whether it’s General Motors Corp. or “You” Corp., it stands as a legal entity or person, protecting its owners and participants from personal exposure to legal liability as a consequence of activities of the Corporation. The U.S. Supreme Court calls it “an artificial being, invisible, intangible and existing only in contemplation of the law.”

This is a great vehicle for that Skydiving venture we spoke about before - let’s now call it Skydiving Inc. If one of your clients has a dysfunctional parachute and ends up a splotch on the pavement, his grieving relatives will find it difficult to collect from you personally. They can sue Skydiving Inc., and, if successful, take all its assets, but you have interposed this legal entity between them and you. Skydiving is an extreme example - but if someone slips on your stairs or drops your hot coffee in their lap, and you have to answer in court, it’s preferable that it’s your company’s assets, not your own, that are at issue. This protection has been called “the corporate veil” and allows the entrepreneur to compartmentalize his risk. He is not personally liable for debts and obligations of the corporation, beyond the extent of his investment in the corporation. (Oh yes, the IRS and State Tax authorities can come after you for certain unpaid taxes, including payroll. But if the business fails or loses a lawsuit, the general creditors cannot attach your home, your car, or personal property.) My attorney-reader points out that this doesn’t make you totally safe in all circumstances. What it does mean is that the path to your assets is much more difficult for a creditor than it would be if you were running a sole proprietorship.

2. The Corporation has the ability to raise capital by issuing shares of stock, either publicly or privately. Public stock offerings are highly regulated by federal and state governments; but private transfers must simply follow the rules of the stockholder agreement. If someone wants to give you $60,000 for a 30% interest in your company, you will have to issue him enough shares so that he has 30% of the total shares issued. Then you can put the $60,000 in the bank.

3. Incorporated businesses allow their owners to deduct certain fringe benefits such as pensions, retirement plans and other profit-sharing plans. These deductions can reduce the amount of taxable income that the business declares, and increase the net benefits to the owners

4. Unlike the sole proprietorship, the corporation’s life can exceed yours. This may produce an asset for your heirs which could be lost under the terms of the sole proprietorship.

1. The C Corp.

The C Corp. provides all the useful features listed above. However, there are also some liabilities:
1. “Double taxation” is uniquely a liability of a C Corp. Since such a corporation generates its own profit, it is taxed independently of its members. If the C Corp. passes funds on to its owners as a dividend, profit sharing or other distribution, the recipients must pay taxes on the receipts. So the dollar that ends up in your account has gone through two separate tax machines first.

2. The corporation is a fountainhead of bureaucracy and governmental regulation. Corporate activity is limited and described in law, and the directors must abide by strict regulations. If you overlook the record-keeping regulations or fail to fulfill other requirements such as maintaining separate bank accounts, it’s possible for the courts to set aside your corporate status, “piercing the corporate veil.” Editorial note: You can get Articles of Incorporation from an attorney, accountant or from internet resources. You’ll receive the “Black Beauty” including binder, stock certificates, documentation and corporate seal, and the internet version is usually substantially cheaper. However, the lawyer or accountant should spend some effort on your setup, and provide you with the methodology for maintaining the corporate records successfully. This could turn out to be the far more economical course in the long run, possibly a business lifesaver.

3. What does the state have to do with it? First of all, the corporation is governed by the laws of the state you’re incorporated in. Delaware has been the choice of large corporations for some time. Nevada has become a more interesting choice as the state of incorporation for small businesses recently. For details, your attorney should interpret.

4. One other “state” issue - corporations have to “qualify to do business” in states where they are not incorporated. How important is this if you have a business in New York and you expect some business from Connecticut or New Jersey? Check with your attorney or accountant.

5. Finally, closing down a corporate existence, or even changing the structure, can be complicated, and, where lawyers are involved, complicated usually means expensive and time-consuming.

2. The S Corp. An alternative to the C Corp, the S Corp is frequently preferred by the consultant, sole proprietor, or other small businessperson.

1. Taxation. Do you recall that in the Sole Proprietorship or partnership, income went straight to your personal tax return? Same for the S Corp, so there’s no “double taxation.”

2. The “corporate veil” is maintained.

3. The structure is far less complex; you simply pay taxes on what you make. Paperwork and bookkeeping requirements are less stringent.

4. In addition, there’s another special benefit - you can “carry forward” losses from prior years to offset current earnings. Since most small business startups are not immediately profitable, it sounds as if this structure was made to order for us.

3. The LLC or Limited Liability Company. Finally, the LLC or Limited Liability Company may provide you the best of both worlds. While it is not, strictly speaking, a corporation, it provides similar assets, particularly if you’re planning an organization with more than one owner.

1. Taxation. While the LLC is designed to serve multiple owners, it allows the pass-through tax status of the simple partnership - the members pay the taxes, the company does not.

2. Liability protection. Also, members enjoy limited liability protection - each member’s risk is limited to his/her investment in the business. And a barrier akin to the “corporate shield’ is in place, so personal assets are protected.

3. Some disadvantages - with this structure, you must make public notice before you start, by advertising your intention in the news media.

4. Also, you can’t offer stock to employees with an LLC, significant difference from a C Corp or S Corp. Other advantages and liabilities of the LLC are arcane, and best explained by your lawyer.

5. Cost. Your lawyer will also explain why it may be 3-4 times more expensive to set up an LLC for you than an S Corp or C Corp.

To summarize, we’ve looked at Sole Proprietorships, Partnerships, the C Corp., the S Corp and the LLC. The first is absolutely the quickest and simplest way to get your venture open for business. The second is designed to give multiple owners an equally fast start. The last three offer some important safeguards, are more time-consuming and expensive in setup and in ongoing maintenance, and should not be chosen without some legal counsel.

(If you missed the prior installments, you can access them on my website, www.craigjennings.com under Newsletter Archives. Look for them.

And, if you’d like a little help now and again to get your small business started, or moving forward more powerfully, I’ll talk with you a while (516 944-6454) for free.

That summarizes the available legal structures for our beginning business. Pick one, and let’s get on with it. In the next installment, we’ll talk about sales, a subset of marketing.

We’re tackling sales next for one important reason - without sales, you have no business (or at least, not for very long!)

If you’d like to see how your business would work if you got a little help now and again, explore the possibility of coaching by calling 516-944-6454 or email to craig@craigjennings.com

Read post | No comments yet | August 1st, 2004