Carts of Cash Book 2 – Chapter 1 – Business Legal Structures

Chapter 1
Business Legal Structures

There are four main ways that you can structure your business from a legal standpoint.  Each offers advantages and disadvantages.  They are sole proprietorship, partnership, corporation, and LLC (Limited Liability Company).

Sole Proprietorship
Let’s say you finish this training program today, set up your cart, and along comes your first hungry customer.  If you sell him a hot dog, you are automatically a sole proprietorship.  This is the simplest and least regulated form of business, and the cheapest to set up, which makes it the most popular legal structure for new businesses.  I was a sole proprietor for a while, and eventually became an LLC after my business grew.

There is one point that you should be crystal clear about.  As a sole proprietorship, you and the business are one and the same in the eyes of the law.  You are personally responsible for any debts incurred by your business.  If your business is sued, any damages can be taken from your personal assets.  In other words, the financial and legal practices of your business need to be sound, otherwise you put everything you own at risk.  Also, in the event of your death, the business dies too.  It is not automatically transferable to a spouse or child.  The only way to avoid this is to incorporate or form an LLC (which will be discussed below).  My purpose isn’t to scare you away from the sole proprietorship legal structure.  I think it is an acceptable way to start out.  I just want to make you aware of your personal exposure so that you’ll pay close attention to how you run your business.

Let’s assume that you are in business as a sole proprietorship, you’re selling dogs and making some money.  Now you want to get paid.  How does that work?  I’ll give you the short version here, and explain it in more detail in the bookkeeping section.  You can’t hire yourself as an employee unless you are incorporated, so you can’t deduct your wages as a business expense.  You simply take a “draw”.  In other words, withdraw as much money as you need from the business bank account.  You can draw as much or as little as you want and it doesn’t need to be at regular intervals.  If you are used to getting a fixed weekly paycheck, this may take some getting used to.  Because a draw is not a wage, you don’t have to pay payroll taxes on it.  For tax purposes, your “wage” is equal to the profit shown by your business at the end of the year and is independent of your draws.  You file a Schedule C “Profit or Loss From Business” along with your personal Form 1040 Income Tax return.  Your personal income tax is based on the profit generated by your business.  You are also responsible for paying “Self Employment Tax” which covers your Social Security and Medicare obligations.  As long as you don’t have any employees, all you need is your Social Security number to identify your business when filing federal tax forms and documents.  If you don’t want to use your Social Security number, or if you have employees, you need a Federal Employer Identification Number (often referred to as simply EIN).  This is covered later, in Chapter 2.

Partnerships
Partnerships offer some advantages over going it alone.  You have more initial capital to get the business off the ground, more people to do the work, more flexibility to take time off, and moral support when the going gets tough.  Drawbacks include more paperwork, greater legal exposure, and the potential for major disagreements concerning business practices and strategy, which can damage personal relationships.  In some instances, forming a partnership may be a permanent solution to a temporary problem.  This book will deal with General Partnerships, one of three types of legally recognized partnerships (Limited Partnerships are a type of financing arrangement – not a business legal structure, and Limited Liability Partnerships (LLPs) are mostly used by legal and accounting firms).

The most important thing to be aware of when forming a partnership is the legal liability that you expose yourself to.  Any individual in the partnership can be held personally responsible for the legal and financial liabilities of the business.  Also, all partners can be held individually liable for the actions of any partner taken on behalf of the partnership.  If one partner gets into legal trouble while conducting partnership business, each individual partner may be in hot water as well.  You may be held responsible for payment of a line of credit applied for by your partner, even if you knew nothing about it.  Again, the only way to insulate your self from personal exposure is to incorporate or form an LLC.

State laws govern the actions of partnerships based on the Uniform Partnership Act (UPA).  In recent years, some states have adopted the New Universal Partnership Act (NUPA).  There are two areas where these acts differ.  Under the UPA, the partners (owners) are the partnership.  They are one and the same in the eyes of the law.  This means that the death or withdrawal of any partner or the addition of a new partner terminates the partnership.  In order for the business to continue, a new partnership agreement must be drawn up, and therefore a new business created.  Also, because the partners are the partnership, partners cannot sue each other (just as you can’t sue yourself).  Under the NUPA, partners can sue each other.  Also, under NUPA, the business is a separate entity from the partners themselves and can continue regardless of individual partners joining or leaving the partnership. This eliminates a mountain of paperwork.  Be sure to check with your Secretary of State’s Office to determine which partnership act applies to you.

Partnerships are not required to have a formal agreement as to how business will be conducted, but it is a good idea.  In the absence of an agreement, state law determines how the business will be run which may not be to your liking.  Even if you do have a formal partnership agreement, outside parties are not subject to the contents of such agreements and can bring legal action against any or all of the partners.  A written partnership agreement should be signed by all partners and should address such things as how profits or losses will be distributed, who will perform each function of the business, how much time each partner is expected to put in, how much capital each partner will invest, who owns the rights to the business name if the partnership is dissolved, who will be the official “signer” for routine banking, etc.  If these responsibilities are not formally declared, they are certain to become a source of confusion and conflict at some point.

Whether or not your state sees a partnership as a separate business entity (as under the NUPA), all partnerships need a Federal Employer Identification Number (FEIN or EIN) as discussed earlier.  Like a sole proprietorship, a partnership pays no income taxes itself.  It must, however, file an informational income tax return (Form 1065).  Each partner pays personal income tax based on their share of the profits (whether they are distributed or not) by filing Schedule E along with their personal income tax return.

Corporations
Most people think of corporations as giant businesses like Coca-Cola or General Motors.  Although many corporations are huge, many more are small or even one person companies.  Some have earnings in the billions, while others earn a few thousand dollars a year.  Contrary to popular misconceptions, incorporating probably won’t save you any money at tax time, and many states charge corporations a franchise tax or flat fee each year.  The paperwork involved in corporations is easily double that of a sole proprietorship.  So why incorporate?

Two words: Limited Liability.  A corporation is a separate legal entity in the eyes of the law.  It is responsible for it’s debts, enters into contracts, and can be sued just like a person.  The owner (or owners) of a corporation are protected from creditors and some forms of legal action because, unlike a sole proprietorship, they are separate from the company, merely shareholders who own stock in the corporation.  The concept of limited liability protects the shareholder (you) from suppliers and others that your business (corporation) owes money to.  If the business fails, the creditors can’t go after your personal assets.  Limited liability does not automatically shield you from lawsuits.  In the event that your company is sued by an injured employee, fails to pay its taxes, or acts with gross negligence, you will probably be named in the lawsuit along with the corporation because you are an officer.

A secondary benefit of the corporate legal structure is the continuity of the business.  If the owner dies, the corporation continues on.  This is a great benefit to the owner’s dependants who may assume ownership through acquisition of the stock.

A unique aspect of the corporation is that it is the only business structure in which the owner can hire himself as an employee.  If you work in the business, you must be on the payroll as an employee with payroll deductions.  This has some advantages as far as taxes and benefits go, as we will see.

Corporations come in two types, the C Corporation and the S Corp.  A C corporation pays income tax on it’s profits, and then the owner pays income tax on those same profits when they are distributed, in essence double taxing the owner.  There are advantages to the C corp such as the ability to retain up to a quarter of a million dollars in the corporation each year.  These “retained earnings” may be reinvested in the business, or paid out to shareholders at a later time.  The advantage is that the retained earnings are taxed only at the corporate level – the owners pay no taxes on these earnings, thereby avoiding the double taxation.  If your corporate tax rate is lower than your personal tax rate, then the retained earnings that you don’t take out of the business are taxed at the lower rate.  Your accountant will be able to tell if you are able to take advantage of this.  Just be aware that if you take those retained earnings in the future then they are considered taxable dividends and you’re back to double taxation.  In a C corp, your wages (remember – you are an owner/employee) are a deductible business expense, therefore not subject to taxation at the corporate level.  If your wages and year-end bonus eat up all of the corporation’s profit, then corporate income tax would be zero.  This is another way to avoid double taxation.  Medical expenses are not taxable to employees of a C corp and are 100% tax deductible to the corporation itself.  These savings on health care costs may make incorporation worthwhile if your medical expenses are high

The S corp, sometimes referred to as a subchapter S corp, is a cross between a C corp and a sole proprietorship, having some of the advantages of both.  It is intended to provide the advantages of incorporation to smaller businesses and can have no more than 75 shareholders.  The main difference is that the S corp is considered by the IRS to be a “pass through entity”.  In other words, the profits of an S corp pass through to the owner-shareholders who pay income tax on this profit at their personal tax rate.  The S corp itself pays no federal income tax (but must file an informational tax return Form 1120-S).  Therefore S corps are not subject to double taxation.  This is their biggest advantage.  If your corporate tax rate is higher than your personal rate, then an S corp allows you to take advantage of the lower rate while enjoying the limited liability that comes with the corporate structure.  However, S corp owners fall under the same rules as sole proprietors as far as benefits like health insurance go, which is a drawback compared to C corps.

A final benefit of incorporation is the image projected by those three little letters, INC.  Potential customers perceive you differently than your non-incorporated competitors.  Your business immediately appears larger, better organized, and more capable.  The marketing value of INC is something to consider.

Incorporating a business is not particularly difficult but there is a lot to know and it is beyond the scope of this book.  If you want to do it yourself, here is how to get started.  A good first step is to go online to your secretary of state’s web site.  There you can find information regarding incorporation in your state, including fees and downloadable forms.  You can usually perform a search to see if your business name is taken.  There are books available on how to incorporate your business, but be sure to get one that details the process in your particular state, since the laws, fees, and procedures vary widely.  If you don’t have the time to do it yourself, or think you need help, don’t hesitate to contact a local attorney.  You don’t need to decide today.  You can incorporate an existing business at any time.  I suggest starting out as a sole proprietorship or partnership, get the business off the ground, and then think about incorporation if you feel it would be advantageous.

A final note on the corporate legal structure.  If you want to enjoy the benefits of limited liability, you must play by the rules.  In other words, a corporation must act like a corporation.  It must have one or more stockholders, directors, officers and employees (you may be all four).  You must hold an annual meeting with written minutes.  This may take place by yourself in your kitchen but you must write down what you meet with yourself about – funny but necessary.  Also, everyone you deal with must know that you are incorporated.  The easiest way to do this is to always use “Inc” after your business name.  Always file your tax returns on time, keep the business capitalized so that you don’t constantly pay bills late, and be fiscally responsible.  If you fail at any of these tasks, a court may hold that you are not really a corporation and allow creditors to go after your personal assets.  The legal term for this is “piercing the corporate veil”.  The common term is “deep doo doo”.

Limited Liability Company
This legal structure combines many of the features of corporations and partnerships.  LLCs get the limited liability of an S corp and also the “pass through” tax status, thereby avoiding tax at the corporate level.  But, unlike S corps, an LLC can choose to be taxed as a corporation if it is to their advantage.

LLCs have a looser structure, more flexibility in how profits are distributed, and can have more than 75 shareholders (called “members” in an LLC).  Members do not have to be U.S. citizens.  They don’t have to hold meetings, issue stock certificates, or keep written minutes.  Many states do not require LLCs to pay the franchise taxes applicable to corporations.

Unlike a partnership, members are protected by limited liability, and each member of an LLC is only liable for their own negligence, not that of other members.  One person can set up an LLC in most states (check first).

An LLC can remove a member – corporations cannot remove a shareholder.  If your LLC has investor members who don’t actively participate in the business, you may be subject to certain securities laws so be sure to check this out if it applies to you.  LLCs are treated as partnerships for tax purposes, which means no federal income tax but they must file Form 1065 (informational return).  Members pay taxes on their share of profits, whether distributed or not.

Make everyone you transact business with aware that you are an LLC or you may lose your limited liability status.  LLCs do not enjoy the health care deductions given to C corps.  Finally, an existing sole proprietorship or partnership may be converted to an LLC at any time, so don’t worry about it now if you’re not sure.

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