Business Entity Considerations - The Corporation
For the past few weeks, I have been discussing various business entities for individuals who are either in business for themselves or thinking about becoming business owners in the future. This week, we will continue this series by highlighting another common entity; the Corporation.
In a Corporation, the shareholders are its owners. Shareholders elect a board of directors which sets the overall direction of the organization. The board then elects officers who carry out the day-to-day operations of the business. This structure sounds like only very large companies can be corporations but in fact, most corporations are small and tightly owned.
In the eyes of the law, a Corporation is considered a separate legal entity distinct from its owners and management. The first thing most people think of is the issue of liability. As a general rule, a Corporation protects its shareholders, directors, and officers from personal liability. This level of protection is known as the “corporate veil”.
It is very important to follow the formalities of being incorporated. Some of these formalities include shareholder and directors meetings, keeping minutes of these meetings, and keeping records that are completely separate from your personal records. For example, unlike a sole proprietorship, it would not be acceptable for a corporation to have one checking account for personal and business purposes. Even when signing documents, it is important to include the Corporation's name, your name, and your title within the Corporation.
Failing to adhere to formalities can result in individual shareholder(s) becoming personally liable for corporation debts. This is also true in the corporation is set up to defraud. If the corporation is sued, the courts can remove shareholders personal liability protection by “piercing the corporate veil”.
There are also certain registrations/filings that have to be made to satisfy State requirements. Some are one time occurrences and some are yearly. The cost to maintain proper corporation status is also a consideration, especially for smaller businesses.
Taxation: This depends on whether the corporation is a “C” Corp or an “S” Corp. A “C” Corporation pays taxes on its profits. If the corporation distributes profits to its shareholders in the form of a dividend, this is also taxable income to the shareholder. In essence, the same money can be taxed twice (at the company level and at the shareholder level). Many smaller, tightly held corporations avoid this by distributing what would otherwise be profits, as bonuses to its shareholder/employees. “C” Corporation losses however can only be used to offset gains from other years (either by going back in more profitable years or carrying the loss forward to future years).
In an “S” Corporation, the corporation files an information return and business profits or losses are passed on to its shareholders. The shareholders account for this income or loss on their personal tax returns.
In summary, a corporation can be an effective way to protect your business from personal liability. Since a corporation is seen as an entity completely distinct and separate from its owners, it's crucial for shareholders to run the business that way and follow corporate formalities. Another advantage is that corporate shares are easily transferable. One drawback to a Corporation is that its organization and operation is more formalized and costly.
In future articles, I will discuss the LLC (Limited Liability Company) and the LLP (limited liability partnership).
The General Partnership Business Entity back to top
Last week we discussed the Sole Proprietorship business entity including its major advantages and disadvantages. This week, we will discuss the General Partnership.
As its name implies, this form of business entity is a partnership between 2 or more individuals or entities that join together to engage in business operations for a profit.
Like a sole proprietorship, a General Partnership is easy to form. Usually the only paperwork required is a business name certificate, filed at the County office building for a nominal fee.
Although oral partnership agreements are completely legal and enforceable, it is more prudent, to have a written agreement should any disputes occur between partners. Such disputes are usually a result of simple misunderstandings or failure to anticipate changing circumstances.
As with a sole proprietorship, the main disadvantage of a general partnership is the issue of liability. Each general partner is liable for all debts, obligation, and expenses of the partnership. Creditors can tap into your personal assets and you are responsible for partnership debts and obligations incurred by you AND your partner(s).
Regarding taxation, partnerships are treated as flow through entities by the Internal Revenue Code. Partners are only required to report their proportionate share of revenue and expenses on their personal tax returns. The IRS also allows for ownership allocation to be based on factors other than amount of capital contributed. For example, a general partnership may have two individuals where one puts more money into the business but the other partner plays more of an active role in the day to day operations. The partners may decide that a 50%/50% ownership is appropriate even though the other partner did not contribute as much capital. The IRS will respect this as long as the arrangement has “substantial economic effect”. Most States, including New York, follow the federal income tax pattern and treat the partnership as a flow through entity.
Another thought that should be taken into consideration is a contingent plan in the event of a disability, death, or retirement of an existing partner. This involves a plan to buy out the retiring, disabled, or deceased partner if the remaining partner wishes to continue on with the business. This issue will be addressed in the future articles!
Overall a general partnership is similar to a sole proprietorship in regards to liability, ease of creation, and taxation. It can be an appropriate business entity between two or more individuals with proper planning, forethought, and a partnership agreement in place.
Business Entity Structures - Which one is right for your business? back to top
At some point, business owners (both small and large alike) must decide on which structure to operate under. Typical structures include the sole proprietorship, general partnership, and Corporations (both “C” and “S”). There are advantages and disadvantages to all entities. This week we will discuss the sole proprietorship.
The Sole proprietorship is the most common form of business ownership. This is often by default since many business owners start off with a “side” business while they are employed elsewhere. The sole proprietorship is owned by a single individual and is the least complicated of all business organizations. From a legal standpoint, both the individual and the business are viewed as one entity. Usually there is no paperwork involved unless the business involves certain permits or licenses. For example, a beautician would need to obtain the needed professional certification to legally operate.
Advantages: The owner generally has total control over the business because the proprietorship is owned by one person. Profits and losses generated by the business are personal to the owner. As mentioned above, ease of ownership is another advantage.
The largest disadvantage of sole proprietorships is unlimited liability. Owners are liable both financially and legally for all actions of the business. In a nutshell, personal assets are NOT protected.
Tax Treatment: From a taxation standpoint, the owner does NOT have to obtain a separate employer identification number from the IRS. Business revenues and expenses are reported on “Schedule C”. Record keeping is often done on a “cash basis” as opposed to the more complicated “accrual” basis of accounting. It's also important to remember that self-employment taxes (FICA) are imposed on income generated by the business. As a self-employed individual, this represents a total of 15.3% of net income and represents both the employer and employee share of social security and medicare taxes. In order to keep sole proprietors from being double taxed on the employer portion of FICA taxes, the IRS allows an “above the line” deduction for one-half of the self-employment tax. There are other deductions as well (retirement plan, mileage, etc.) that can be taken.
In future articles, I will discuss some other common types of ownership along with their advantages, disadvantages, and tax treatment.
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