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As a corporation or LLC, you new venture shields your personal assets from judgments of creditors including damages awarded in personal injury suits. This is a significant advantage to a new enterprise as the tales of runaway jury verdicts are legion. There is the case of a jury awarding a 19-year-old Los Angeles man $ 74,000 for medical expenses and pain and suffering as a result of an injured limb when a neighbor ran over his hand. The neighbor apparently failed to see the young plaintiff because he was crouched down stealing the hubcaps off the neighbor’s car! In Austin, Texas, a storeowner was sued by a woman who fell over her own toddler in an aisle of the store. In that case, the store had to pay the woman, $ 780,000! One can only hope the storeowner was protected by a properly set up corporate entity or LLC!

In order to better understand your options for a new business, each of the four basic types of organization is explained below.

Sole proprietorship
Partnership
Corporation
Limited Liability

Sole Proprietorship

A sole proprietor is an individual person who starts or owns a business with in his or her own name or an assumed name. A sole proprietor holds him or herself out to the world as an individual. If a sole proprietor chooses to conduct business under an aes because a person may simply commence the business. They may set up a separate bank assumed name, they would file an application to do business under an assumed name in the county where the business will principally be conducted and publish notice. The person’s own social security number would serve as the tax identification number of the business, and the individual, may simply file an individual tax return, attaching Schedule C to report the sole proprietorship income. The sole proprietor pays quarterly estimated taxes, as opposed to filing more complicated payroll tax returns and withholding periodic taxes from money earned.

The main advantage of this business entity is efficiency and cost. Obviously the cost and organizational time are minimal. These are important issues to smaller and newer businesses, because often times, cost and efficiency are more important to a very new business.

The main disadvantage of the business organization is lack of liability protection. Any problems that arise in this business will pass directly to the owner personally, without the ability to insulate personal assets from liability issues. There are also important tax matters that would come more prominently into play as the business develops.

Partnership

There are two kinds of partnerships: general partnerships and limited partnerships.

GENERAL PARTNERSHIPS:

A general partnership is any association of two or more persons (defined as human beings or other business entities) who carry on a business as co-owners. A general partnership can come into existence by operation of law, with no formal papers signed or filed; however, it is strongly recommended that the partners enter into a binding legal agreement. A partnership is always a general partnership unless the owners comply with the special requirements for establishing a limited partnership. This entity faces the same advantages and disadvantages as the sole proprietorship.

LIMITED PARTNERSHIP:

A limited partnership can be created only by a written agreement between or among the partners, and a certificate of limited partnership must be filed with the Secretary of State. There are two types of partners in a limited partnership: one or more general partners who are each liable for all the debts of the partnership, and one or more limited partners who are not liable for the debts of the partnership beyond the amount of money they have contributed to the business. In all partnerships, the general partners manage the business of the partnership. Partnerships must obtain a federal tax identification number or FEIN. This number is used in place of a personal social security number for tax and identification purposes. Taxes are treated similarly to the sole proprietorship. A partnership must file a tax return; however, any amount owed is passed through, by way of an IRS form K-1, to each individual’s personal tax return. Partnerships must also file an application for intent to do business under an assumed name and open a separate bank account for the business. The advantage of a partnership, like a sole proprietorship, is lower cost and ease of setup and management, and dissolution. Like a sole proprietorship, the greatest disadvantage of partnerships is their lack of insulation from the personal liability of the general partners.

Corporations

Corporations are the most common form of business entity because, for a reasonable cost, the owner(s) of the business are afforded personal liability protection. A corporation is a business entity totally separate and distinct from its individual members. In a partnership, individual ownership may be established in a partnership agreement by setting forth a person’s percentage ownership interest in the partnership, and management is usually more informal. In a corporation, ownership is designated by how many shares of the corporation a person owns, and management is centralized in a governing body elected by shareholders. A corporation is much more formal than either a sole proprietorship or a partnership, and to ensure liability protection, all the corporate formalities must be strictly complied with. A corporation is formed by filing “ Articles of Incorporation” with the Secretary of State in the state where the corporation is located. Once the Articles of Incorporation are approved by the Secretary of State, they must be recorded (placed on record) in the county where the corporation has its owners, a person must be appointed as a registered agent to receive legal notices on behalf of the corporation. The corporation must also obtain a federal tax identification number or FEIN.

After these preliminary steps are completed, a corporation must have an organizational meeting to complete the corporate book. In the corporate book, accurate details of the organization are set forth. These details, called minutes, include the initial set-up details, formal rules or bylaws of the corporation, the election of a board of directors to manage the company, the election of officers to carry out the board’s directives, and the stock certificates indicating individual ownership in the corporation. Each year, an annual report is completed, the shareholders of the corporation should meet to conduct new elections of directors and officers and to update the minutes in the corporate book.

The main advantage of a corporation is the protection from individual liability. This means that if the corporation is properly established and maintained on a continual basis, the owners (shareholders) are protected from personal liability in the same way that limited partners are protected. While the corporation’s assets may be at risk, the shareholders personal assets are totally protected from creditors. This liability protection comes at a cost, both in terms of time and money, and thus, the disadvantage of the corporation. As discussed, the corporate formalities, even in a single shareholder company, are elaborate and require professional assistance. Taxes also become complicated because a corporation must file a tax return; however, unlike a partnership, a corporation may be individually taxed depending on the type of corporation it is.

All corporations are separate tax paying entities (sometimes referred to as C corporations) unless an election is made (and documents filed) to treat the corporation as a subchapter S corporation. In a C corporation, any retained earnings the company has each year are taxed at a corporate rate. When the shareholders or employees of the company are paid or receive compensation from the corporation, they must also pay tax individually. The result is double taxation. To avoid this apparent pitfall, smaller corporations may elect sub-S treatment. In a sub-S corporation, like a partnership, the corporation files a return; however, all income or loss is passed through to the individual employees or shareholder(s). The decision to elect subchapter S treatment may be complicated based on the type of business and the tax deductions that are available to the company. It is important to discuss these issues with your business professionals prior to making this decision. Employees of a profitable C or sub-S corporation just receive some reasonable salary, as opposed to taking compensation totally as dividends.

Additionally, in any corporation of two or more persons, it is imperative that the shareholders enter into a shareholder agreement (sometimes called a buy-sell agreement). This agreement sets forth important rights and obligations of the shareholders to one another. The agreement places an annually updated value on the company and sets forth the rights and procedures for the sale of and purchase by another shareholder. The agreement, among other issues, also clarifies the procedure and costs of shareholder death or disability. Clearly, there are many important efficiency, liability, and tax issues that must be considered when electing to do business as a corporation.

The information above is a review of the most common features of privately owned corporations. The mere fact that a corporation requires more organization should not deter you from choosing a corporate structure; however, you must be prepared to consult with corporate and tax attorneys or accountants prior to establishing the new business entity.

The Limited Liability Company (LLC) is the newest form of business organization. Legislators realized that business people who desired liability protection in their ventures had the choice between the limited partnership and the corporation. These entities both have disadvantages in terms of tax flexibility and complicated organization requirements. The LLC has the same liability protection for its owners (referred to as members) that a corporation does and all the efficiency and tax advantages of a partnership. Like a corporation, an LLC is established by filing Articles of Organization with the Secretary of State. A federal tax identification number or FEIN is also obtained for the company.

However, instead of the cumbersome and rigid corporate book, an LLC sets forth its rules, organizational structure, and agreement of the member(s) in an operating agreement. This flexible arrangement is similar to a partnership agreement than a corporate book. The obvious advantage with an LLC is ease or organization. Although an LLC files a tax return, all tax liability flows through to the individual members. Unlike a corporation, an LLC may disburse compensation to its members more easily pursuant to the operating agreement and without regard to the rigid corporate capital structure. All members in an LLC may participate in management, or the operating agreement may set forth voting rights between managing and non-managing members.

An LLC is particularly well suited for real estate ventures as there are usually varying degrees of management and capital contributions made by the members and the desire to avoid the corporate tax structure. Now, however, the LLC is gaining greater acceptance and use in all areas of business organization. The main disadvantage of an LLC if cost. The filing costs and attorney’s fees are usually higher than those of the other entities discussed above. In addition, annual reporting and franchise tax burdens of the corporation also exist with an LLC.

In choosing from among these options, you should consider the tax advantages of the organization, liability exposure of your operation, expenses of setup, control of the entity, transfer of ownership and estate planning opportunities, and ease of sale of the business. There are myriad other issues to consider, but these are the key points to take into account as you choose you operational structure.

Regardless of the size of your business, the latter two structures (Corporations and Limited Liability Company) should be seriously considered as they are the only forms of business organization that provide liability protection for you and your family if you are sued. In addition, there are significant tax advantages to operating as a Corporation or Limited Liability Company (LLC). In today’s litigious society, one should never underestimate the benefits of full liability protection in choosing the corporate form. Likewise, the tax savings manifest in the corporate form of operation can often mean the difference between success and failure when cash flow is an issue in your new venture.