*************DISCLAIMER: The materials on this web site have been prepared for informational purposes only and should in no way be considered legal advice. You should not act on the information provided in these materials without consulting an attorney. By providing these materials, Verner, Liipfert, Bernhard, McPherson and Hand is not entering into an attorney-client relationship with the user of this web site. This is not a solicitation for business. If you choose to contact us through e-mail, please do not provide us with any confidential material. *************CONTENTS:
- Part I: Establish Your Business as a Legal Entity
- Part II: Establishing a Legal Business Form
Part I: Establish Your Business as a Legal Entity
One of the first steps every small business owner must take is establishing an appropriate business form. Whether you choose a sole proprietorship, corporation, partnership or limited liability company, there are several legal issues that every small business owner should analyze thoroughly before proceeding. This paper is meant to alert you to legal issues you should be aware of before making any decisions regarding the form of your business, and is not intended as legal advice. You should consult an attorney before taking any actions based on the information given in this paper.Choose the Right Form for Your Business
The first and most important decision a new businessperson can make is to choose an appropriate business form. The form of business you decide on will be based on the number and type of owners, your exposure to liability, simplicity and tax planning.
Most small business owners choose one of four different types of business forms (see the SBA Website for more information):
- sole proprietorship
- limited liability company
The following are some issues that every small business owner should address before selecting a business form:
- Are You Likely to be Sued?
- Is Pass-through Taxation Right for Your Company?
- Are You Likely to Have Outside Investment in Your Company?
- Corporate Governance Issues.Who.s Running This Thing?
Many small businesses do not generate significant revenue or engage in business transactions that are likely to subject them to liability. If your company is one of these businesses, you may opt for the simple and inexpensive option of a sole proprietorship.
However, you should think carefully about liability arising from unexpected places. Do you have a contractual relationship with a marketing partner, an Internet Service Provider (ISP), a web designer or an investor? If so, there is a chance that you may be sued under one of these agreements. A sole proprietorship or general partnership will not protect you from personal liability for the debts or other liabilities of your business. If you believe that your company may have even a remote chance of being sued, a more formal business form such as a limited liability company may provide you with the protection you may need.
Is Pass-through Taxation Right for your Company?
Pass-through taxation allows owners, partners or members of certain business forms to report profits and losses on their personal tax return. What.s so great about that?
First, pass-through taxation may eliminate "double taxation" on your entities. profits. For instance, if you form a corporation, the profits of your entity may be taxed at the corporate tax rate and then your salary or dividend would then also be subject to personal income tax. A simple example is helpful.
Lets say XYZ Corporation has $100,000 in net taxable profit one year. For purposes of this example, assume a combined federal and state corporate tax rate of 40 percent and a personal rate of 30 percent. First, the IRS would take 40 percent or $40,000 of the corporation.s income. Second, any income derived from the corporation on your personal tax return would also be subject to personal income tax. Assuming the rest of the $60,000 could be considered income, the IRS would then take 30 percent, or $18,000,bringing your total tax liability on the $100,000 of net taxable income to $58,000.
By contrast, if XYZ were a pass-through entity, your tax liability would correspond to your personal income tax bracket, in this case 30% or $30,000. Thus, even if you were in the highest personal tax bracket, your total tax liability would be less as a pass-through entity, because you would not be paying twice on the same income.
Another useful feature of pass-through entities is that, in certain cases, you can deduct business losses. If you expect, as many start-ups do, to incur losses during the first years of operations you may consider a pass-through entity.
Assume, for example that XY Partnership is a partnership of two individuals who share profits and losses equally. Both X and Y contributed $10,000 to XY in its first year. If the partnership has $20,000 in losses, both partners would be able to deduct $10,000 on their personal income tax returns as business losses. This deduction would offset the payment of tax on other taxable income. If you believe pass-through tax treatment is right for your business, you should carefully consider whether an LLC or a partnership is the right business form for you.
The question you may be asking yourself is why would anyone not want pass-through taxation? The answer has little to do with tax benefits, and more to do with the investor-friendly structure of corporations. The benefits of setting up a corporation will be discussed in the next section.
Are You Likely to Have Outside Investment in Your Company?
Many companies start small and plan to stay small. With the advent of the Internet, however, there are innumerable possibilities for small business owners to dramatically expand their business and increase their consumer base.
If your company plans to aggressively market its product(s) on the Internet and lacks the additional resources to do so, some type of outside investment may be necessary. venture capitalists and angel investors have provided many small companies with the cash flow necessary to grow. However, not all business forms are suitable for such outside investment. If you are contemplating outside investment, you should consider a more flexible entity, such as a corporation.
You can finance the cash needs of your corporation through either debt or equity. Generally, equity means shareholders contribute cash or property to the company in exchange for stock. Be aware that this and many other types of sales of stock to outside investors requires compliance with federal and state securities laws. You should consult an attorney before engaging in these types of transactions.
Financing through debt usually means your company is borrowing money. This type of financing rarely requires compliance with federal or state securities laws. However, many financial institutions will not loan money to businesses that are not well-established without securing personal guarantees from a borrower(s). (for more information on financing, see SBA.s webpage on financing at http://www.sba.gov/financing/).
Large institutional investors (such as a venture capital group) often require that the business they are investing in be a corporation. These types of investors like the corporate form because corporations allow different classes of stock to be issued.
These investors usually will require "preferred" stock in exchange for their investment. Preferred stock owners have certain advantages over common stockholders in terms of dividends and profits disbursed by the company. A recent trend among Internet companies is to have small or limited offerings of stock online through your web site. Again, stock transactions are usually subject to federal and state securities laws and you should consult an attorney before engaging in the sale of stock.
However, if your initial investors are friends and family (who care more about your company.s success rather than being first in line for profits) then there may not be a need for a corporation. These investors may be content with being a limited partner in your partnership or a member of your LLC. Many of these transactions are not subject to federal securities laws. If you believe that a corporate form may be necessary in the future, you can change the business form of your company at such time.
Corporate Governance Issues - Who.s Running This Thing?
The last issue you should consider before deciding on a business form is the managerial and structural organization of your company. While virtually every business form can be structured to accomplish your goals, some provide initial flexibility.
For instance, LLCs allow members to allocate profits and losses differently from ownership interests. Thus, member X of a two-member LLC may really be a passive investor who is not interested in the day-to-day operations of the company. Member Y, on the other hand, has invested a significant amount of time starting and running the business. As such, the operating agreement of the LLC could provide that member X is only entitled to 20 percent of the profits.
If, on the other hand, a corporation were to declare a dividend, the dividends generally must be given to shareholders based on the number of shares held. This may vary if, as discussed above, there are differing classes of stock. Corporations also usually require the appointment of certain officers and a board of directors. Indeed, many venture capital investors require a seat on the board of directors to ensure that their money is being well spent. This multi-layered approach to corporate governance can prove difficult in making certain decisions, but can also be helpful in maintaining a clear chain of command and attracting investors
Other Factors in Business Formation
Certainly, there are many other factors to keep in mind when choosing a business form. One possible issue is continuity of existence. Corporations can have an indefinite period of existence, and can survive until dissolved or bankrupt. Some partnerships (and, of course, sole proprietorships), on the other hand, will terminate upon the death or withdrawal of a partner.
Some business forms, such as corporations, are usually more expensive to form and require the observance of certain formalities. Further, depending on the initial form selected, it can occasionally be difficult for a business to switch to a new form.
Part II: Establishing a Legal Business Form
Once you have chosen the appropriate business form for your small business, there are several additional steps that you need to take to ensure that your business is legally established and remains in good standing.
Regardless of what type of business form you decide on, you have to file certain papers with the state government (usually with the commissioner of corporations or secretary of state) and then pay a fee. Generally, formalizing your business form with the state requires that you provide the appropriate government entity with at least the following information:
- The name of the corporation;
- The names and addresses of the incorporators, members or partners;
- The name of agent for formal service of legal documents;
- Purpose of the entity, if applicable; and
- Duration of the entity, if applicable.
Additionally, formalizing your business form often requires that you take the following actions:
- Issue stock and determine shareholders, if applicable;
- Appoint directors and officers, if applicable;
- Make initial capital investment, if applicable;
- Make the necessary tax filings, if applicable;
- Set up the corporate record book, if applicable; and
- Adopt board resolutions regarding corporate organization, if applicable.
Keeping your Ducks in a Row - The Importance of Observing Formalities
Sometimes there seem to be so many formalities for different corporate forms that you may be tempted to forego learning all of the rules or to simply ignore some of them. Don.t give in to this temptation!
Small companies are especially vulnerable to legal actions where plaintiffs attempt to demonstrate that the company in question was not really a company but merely the "alter ego" of its owners or members. Under this theory, the owners established the company solely to protect themselves from liability. If plaintiffs succeed in demonstrating the "alter ego" theory, a business owner can be held personally liable for the actions of his or her business. Therefore, even if you are a one or two person operation or a family business, you should observe all the formalities of your business form.
First and foremost, do not commingle any of your personal assets and corporate assets. Make sure you establish separate bank accounts and credit cards for your small business. Also, maintain healthy business procedures like keeping specific accounting records, filing necessary government documents, holding regular shareholder and directors meetings and preparing and maintaining the minutes or records of those meetings.Permits and Licenses Are Required
Even very small or part-time businesses may have certain permit and/or licensing requirements. It is your responsibility to adhere to any and all permit and licensing regulations that apply to your business.
What do you need? The answer is different for every business and in every city, county and state. Many states allow you to apply for certain permits online. Some common permits include:
- Business Licenses.
- Police Permits.
- Seller's Permits.
- Liquor Licenses.
- Building Permits, Fire Certificates, Zoning Permits.
- Federal Export Licenses.
If you think your business might need a permit, check with an attorney before you start conducting business.
Choosing the right business form for your company can be a time consuming and labor intensive process. Despite the inclination to just "get going," you should carefully weigh all your options before starting a business.
If your budget permits, we strongly suggest hiring an attorney, tax professional or small business advisor to help you make the right choice. Don't get discouraged with all this paperwork and red tape. With a little time and effort spent at the outset, you will ensure that the business form you establish is ideal for your needs and that you are well positioned to strengthen and grow.