June 24, 2011

To Incorporate Or Not To Incorporate A General Overview

There are so many issues to deal with when you start up your acquire business. There are the initial basics like naming the business, hours that the business operates, choosing inventory of products and/or services, and then pricing them. There are operational issues like writing a business plan, developing your marketing plan, advertising campaigns, and so on. It just gets crazier and crazier with every phase, and then, just when you thought there was a light at the end of the tunnel, it turns out to be another train. And that train is the LI., A., and T. line — Legal Issues, Accounting, and Taxes.

For the sake of the subject matter at hand, the content obviously deals with the well-known legal issue and that is the type of business that you are going to legally classify yours as. There are so many choices, yet for the most part, only one category that you can choose. It will require tons of due diligence, hours of research, and possibly costly legal counsel to play it good. In fact, I would highly recommend the proper counsel for safety reasons if for no other (only if you can afford it, of course). There are five basic categories that businesses fall under:
— C Corporations
— Sub-chapter S Corporations (S Corporations)
— Limited Liability Companies (LLC’s)
— Partnerships
— Sole Proprietorships

Then there are three other types of businesses — Consumer’s Cooperative, Not-for-Profit (non-profit) corporations, and Trust Companies. There are also 11 sub-categories to be aware of (actually 12, however one of them applies to companies of Norway), as if I hadn’t dumped enough potential brain frying information on you already. Since these sub-categories really get detailed in nature, they may be covered in another article, should I determine to tackle that utter.

C Corporations

A C Corporation is a United States business entity that is subject to federal taxes under the Internal Revenue Code, for lack of a simpler definition. Most of the major companies drop into this category. However some smaller companies are listed as C corporations as well. The tax issue is the most important difference between C and S corporations. Another major difference is that there is no limitation on the number of domestic or foreign shareholders with a C corporation.

Nolo Press of Berkeley, CA is a company that publishes tons of do-it-yourself guides and software so that the average Joe (such as me) does not have to pay for an attorney’s services. Wills and business incorporation issues are Nolo’s two primary money-makers, but there are others. According to Nolo, there are seven steps eager in forming a C Corporation.

First, the name of your business must conform to your state’s corporation rules. Second, if you are going to have a Board of Directors (and it may be required in some states), now’s the time to appoint them. Third, file your “articles of incorporation. Depending on what state your business is located in, this will run anywhere from $100 to $800 (or more). Fourth, you will need to develop the operating rules for your corporation or “bylaws” as they are referred to. Fifth, schedule and conduct your first board of directors meeting. Sixth, if there are other owners, and if they are stockholders, it is time to issue their stock certificates. Finally, go get business licenses and permits that are applicable to your business so you can open your doors (or website) and start earning some revenues.

Sub-chapter S Corporations

An S corporation does not pay federal income tax — its shareholders do. However, it can elect to be taxed under Chapter 1, sub-chapter S (hence the corporation name) of the Internal Revenue Code. If left as an S corporation, then the shareholders must report their income or losses on their individual income tax returns.

To be treated as an S corporation, there are five criteria that must be met in order to be classified as such. First, the corporation must be either domestic or a limited liability company (LLC). Second, the corporation may not have more than 75 shareholders. Under this criterion, there is also a clause about spouses and family members being counted as individual shareholders, but this is only if the family member elects to be treated as such. Third, your shareholders have to be real people. Not only that, but they must be US citizens or residents. In other words, a corporate shareholder or a partnership is excluded from the mix. Fourth, you can only offer one class of stock in the company. And finally, the profits and/or losses must be distributed to each shareholder based on their percent of interest in the company.

Here is a huge caution when it comes to incorporating as this type of corporation. If, at any time, the corporation fails to meet any of these criteria, the status will revert back to a C corporation status and be subject to federal taxation. Also, the issue only applies to federal taxation and does not have anything to do with FICA (Social Security) or federal Unemployment tax issues. You still have to pay this one way or the other for your employees.

Limited Liability Companies (LLC’s)

This type of company offers more flexibility than the corporation (though it is similar to one in nature) in some instances, but it is referred to as “diminutive” in that its owners are offered limited liability where the debts of the entity are concerned. Also, it is a more suitable form of incorporation for smaller companies with a limited number of owners and can be managed by one or multiple members. It can be “member managed” or “manager managed.” If it is member managed, it becomes a partnership structure. If it is manager managed, it becomes a two-level management structure that can be easily converted into corporation status.

With an LLC, the members are the owners, although the percentages of ownership are not always in equal amounts. The LLC can also lose its tax advantage without a partnership structure being in place. In addition to the articles of organization, it is also common to have an “operating agreement” that is designed by the members. This is basically a form of contract between the members of the LLC, and mandates such things as distribution of income, management, membership, and operation issues of the LLC.

Most of the states require that the name of the company contains one of three terminologies — Petite Liability Company (LLC or L.L.C.), Limited Company (LC or L.C.), or Ltd. Co. Conversely, the company may not use terms such as Company (Co.) and Limited (Ltd.). The Petite terminology is reserved for corporations located in Texas, with the sole exception of Nevada which allows the consume of the term Limited or Ltd.

Partnerships

This type of business entity is exactly what the name implies in that it is owned and operated by two or more partners. However there are four different degrees of partnerships — General Partnership, Limited Partnership, Limited Liability Partnership, and Limited Liability Puny Partnership.

I’ll try to explain the differences as clearly as I can and not bustle the risk of embarrassing myself in the process.

Basically, in a GP, there are two or more partners as previously mentioned and they all share in the company’s profits and losses. The major incompatibility with a Runt Partnership is that like the GP, they have general partners wherein the LP, there are one or more limited partners. They are only liable for the firm’s debts based on the percentage of their investment out of the total.

The LLP is similar to a Corporation in that it contains some of the same elements. The partners in a LLP are somewhat protected by a limited degree of liability in much the same way that shareholders in a corporation are. But in this case, the partners all have equal management rights and can manage different levels of tax liability, unlike with a corporation.

The LLLP is new on the legal scene for all practical purposes. Recognized under U.S. Commercial Law, the LLLP like the LLP has general and limited partners. The disagreement is that the general partners manage the LLLP, while the limited partners manage the financial waste of the business. There is also a disagreement in the way the debts and liabilities are managed. In the LP, the general partners are “jointly and severally” liable for the debts of the company. The limited partner’s liability ends where the debts have equaled what they have contributed in the way of capital. With all four, there are very puny but critically distinct differences.

Sole Proprietorship

In this type of business, unlike Corporations and Partnerships, the business and the owner are joined at the hip, so to speak. They do not exist separately and neither do the debts, liabilities, and other obligations. It is called a sole proprietorship in that there is only the single owner and no partners. It also means that business is done in the name of that sole owner as well, hence the “dba” connotation and a trade name.

Since it is not considered a corporation, the SP does not pay any corporate taxes. Instead, the owner files his business taxes on his bear 1040 doing the long form with all the proper attachments. Best of all, the SP does not have the exertion of double taxation unlike the corporation. The use of the dba enables the owner to conduct the business in a name other than their own, and also makes it easier to open a business account with most financial institutions.

Before closing, I wanted to cloak one more area about the different types of businesses. There have always been contentions between the General Corporation and the Sub-chapter S Corporation. The advantages of the General Corporation are:
— Any deductions for plans such as insurance, retirement, or travel are TAX FREE
— The ownership is easily transferred.
— The ownership has no effect on the current management.
— Personal assets of the owners are protected from debts, liabilities and subsequent legal action should any arise.
— Raising capital/funds through the sale of stock options is simplified for all parties concerned.
— The life of the corporation extends beyond the death(s) of any of the owners. In other words, it is perpetual.

The only three disadvantages that I could accept were that the corporation is more expensive to form than the partnership or sole proprietorship, the corporation must abide by Federal and State regulations and rules, and there are additional legal formalities.

As mentioned earlier, the main difference between a General versus a Sub-chapter S Corporation is in the area of tax liability. But there are five restrictions with the Sub-chapter S Corporation. They are:
— Every one of the stockholders must be a citizen of the United States. This type of business entity is the only one listed in this enlighten that carries that stipulation.
— Only individuals can be classified as stockholders.
— There cannot be more than 75 stockholders.
— There can only be one class of stock offered or one type of option.
— The corporation can only be domestic — not foreign.

In closing, my recommendations are be very thorough and cautious as to the type of business entity that you eventually define yourselves as. More often than not, business owners, partners, and others have suffered disappointments in their choices of partners, types of businesses they chose to be, etc. Just remember that the decision could be a costly one if not belief through properly and with due diligence and popular sense.

Sources:

Incorporate U.S.A. http://www.inc123.com/index.html

Incorporate.com http://www.incorporate.com/business_structure_comparison_chart.html

Share and Enjoy: