You have a business idea. It may be that you have discovered a unique product or idea (invented or just came upon an opportunity to market some else’s product or idea). Perhaps it is filling a discerned need in your community, say an Italian restaurant or book store, fitness club or any number of other perceived needed facilities in your community. Perhaps it is a real estate opportunity at a unique “ideal” location which you have discovered/controlled.
In most cases, it is definitely advisable to establish a business identity and generally advisable to establish a separate (from you personally) business entity. In many cases, it will cost money (sometimes lots of it) to actually launch your enterprise. Also, as with most business ventures, you plan to earn money and, generally, a profit from your enterprise. Many enterprises will also require more than one person to effectively operate the enterprise. This might be simply employees but it may require the actual “investment” of more than just you. In some cases, you actually came up with your idea with one or more other people who all desire to pursue the enterprise. We often loosely refer to such people as your “partners.” This article is intended to assist you in charting a course for your enterprise which will be appropriately suited for your expectations.
Of utmost importance is the type of entity that you create. In this regard, let us look at your choices:
1. Sole Proprietorship;
2. Partnership – “General” or “Limited;”
3. Corporation (“C Corporation”);
4. S Corporation;
5. Limited Liability Company (LLC); and
6. Nonprofit Corporation or LLC.
Although it is very difficult in any article to thoroughly review each of the foregoing entities, we provide the following simple definitions of each of the above-listed entities:
1. Sole Proprietorship
Although you may select a name other than your own such as “ABC Enterprises” which will require you to register with your state a “fictitious name,” a sole proprietorship has no separate legal existence from you, the owner. Income and losses are taxed on your personal income tax return.
There are two types of partnerships which are described as:
a. General Partnership – This is a combination of at least two separate people or entities for the joint conduct of a business enterprise in which each partner has unlimited liability for the obligations of the enterprise. While votes on decisions can be allocated to the percentage of ownership of each partner, often decisions are made by the concept of “one man, one vote.” In any event, each individual partner (whether a 50% owner or a 1% owner) can be held personally liable for all of the debt or obligations of the partnership; and
b. Limited Partnership – In this type of partnership, not every partner will be liable for the obligations or debts of the entity. The partnership will have one or more general partners and one or more limited partners. The most notable item here is that a limited partnership also has “limited liability” which generally means that the limited partner cannot be held liable for the debts of the partnership beyond the amount of funds that the limited partner has invested in the partnership. The general partner, however, is liable for all of the debts of the entity. However, we often make a corporation or LLC the general partner which enables the parties to essentially limit their liability.
“C Corporation” – We are going to describe corporations in both 3 and 4 of this article because there is a very different tax treatment of corporations depending upon the type of corporation the organizers select.
a. Corporation (generally) – A corporation is a separate legal entity which is owned by shareholders and the governance of the company is generally ruled by a Board of Directors who are elected by the shareholders.
b. In some cases, there are more than one “class” of shareholders, and not every class has the same rights, including share of profits and voting privileges, among other things.
c. The “C” designation comes from the U.S. Internal Revenue Code and basically means that the corporation is taxed separately from its owners (shareholders). This is different from a sole proprietorship or partnership where the income taxation is at the owner’s level and on the owner’s income tax return.
d. One of the downsides of this tax structure is that when the corporation is sold, there is usually income tax to be paid, first by the corporation and second by the owner shareholders.
4. S Corporation
This is a corporation which has elected a special tax status from the federal and state government to allow all of the taxable income of the corporation to be passed down to the corporation’s shareholders, i.e. to be taxed as a partnership or sole proprietorship. However, most all corporate governance issues are typical of all corporations.
5. Limited Liability Company (LLC)
An LLC is a flexible form of enterprise which blends elements of partnership and corporate structures. Although not a partnership or corporation, it does provide limited liability to its owners similar to the shareholders of a corporation. But, it can be taxed like a partnership for both federal and state purposes. This has become the entity of choice for many new enterprises. Please note that an LLC can select to be taxed like a “C” Corporation or as a partnership.
6. Nonprofit Corporations or LLCs
Most entrepreneurs do not intend to not make a profit; however, there are times and circumstances where a nonprofit corporation or LLC may be desirable when the organizer is mostly interested in accomplishing a unique goal and will be satisfied with receiving just a salary and having the entity not be subject to federal and state taxes in many cases. Please note, however, that not all nonprofit entities are tax exempt. There are additional standards at both the state and federal level to allow a nonprofit entity to be tax exempt. An example of a nonprofit corporation which is typically not tax exempt would be an entity owned by a group of hunters to own a hunting cabin property.
Each of the foregoing entities will not be appropriate for all business enterprises. For instance, it is generally foolish to have a real estate enterprise as a C Corporation. This can cause enormous problems from a taxation perspective. First, you will want the ability to pass through to the investor all of the tax deductions available to an entity holding an improved piece of real estate. Moreover, a sale of the real estate asset would result in tax at the C Corporation level and again at the individual investor level, commonly called “double taxation.” Consequently, partnerships or LLCs, which are taxed as partnerships, are the typical choice for real estate entities.
Restaurants are generally considered high risk and, consequently, we would generally recommend a corporate form or at least an LLC which has limited liability. This is typical advice for most business enterprises which may have any significant risk of liability.
It is also very important to be conscious of the roles of the various investors, such as who will be the CEO, whether as a President of a corporation or Manager of an LLC. But, the most important issue is “control.” Who is/are in control of the entity? There are many different ways to assure that a particular investor or group of investors are in control of the entity and safe from unwanted takeovers. This topic is too complex to be a part of this article, as very careful planning and strategizing is typically advisable to address the “control” issue.
It is most important to determine at the beginning of the venture when everyone is of one mind and relatively optimistic about the future to address and agree upon the issue of how easily transferable will be the ownership interests. In some respects, each investor most likely wants the ability to acquire the interest of any investor who unexpectedly dies or elects to withdraw from the entity. In order to accomplish this, an owner’s agreement must be a fundamental part of the initial organizational documents. But, the investors also need to be flexible enough to enable the infusion of additional equity investments.
Many people do not realize that not every legal entity can last forever. Both federal tax law and many state partnership laws require the “termination” of the entity in certain circumstances, including the death of a partner or the passing of time. LLCs and corporations do not have comparable provisions. This issue should not be forgotten.
The remaining issues for this article relate to the ability of the enterprise to raise additional capital and bring in additional investors to help raise that capital. In this regard, it is fundamental that the entity has enough flexibility built into its organizational and investor documents to enable the issuance of more stock or membership or partnership interests and that applicable securities laws be appropriately considered by the enterprise. This does not mean that upon creation the entity file a securities registration with the United States Securities Exchange Commission or relevant state regulatory bodies. Rather, it does mean that creating a corporation with only ten or one hundred authorized shares of stock may be ill-advised.
While this article raises almost as many questions as it answers, hopefully it has helped the reader to appreciate the importance of the initial legal decisions to commence a business enterprise. Most of the above issues can be readily addressed with some brief but sound legal and accounting advice which should not cost thousands of dollars or long delays.