Which Format
Is Right For Your Business?
Business Options | Simple Explanation of the Corporation
Limited Liability | Assets to Always Put Into the Corporation
Other Corporation Benefits | Multiple Corporations
First, What are the Options?
When you go into business, you will realize
that each business form has its advantages and disadvantages. Your goal
is to operate in a business format that provides maximum tax advantages,
profit and protection! Each has its own section of the Internal Revenue
Code and applicable case law. The state laws in which it is organized
affect each. Let's examine some of the common possibilities.
Sole Proprietorship: This is the
least complicated form of business organization from the standpoint
of operations and taxes. One person can form it without any documentation
at all. A basic business license is all that is required to operate
in any state in the union. What is the downside?
- A sole proprietorship's owner is personally
liable for all business liabilities and debts!
- All income is reported on Schedule C of the Form
1040, and taxed on the owner's personal income tax bracket which can
be as high as 39.6% plus state taxes!
- For a small business, Schedule C of Form 1040 is
one of the most audited forms.
- A profitable sole proprietorship is subject to intense
scrutiny by the IRS!
- The success or failure of the sole proprietorship
is determined by the success of the effort of the owner and family.
- It is very difficult for a sole proprietorship to
raise money for growth and expansion.
- Sole proprietorships are fragile entities that live
and die with their owners!
General Partnership: This is formed
by two or more people under an agreement which may be oral or written,
depending upon state law. All partners are the General Partners. The
General Partnership is usually subject to state law and requires registration
with the state. A General Partnership may have other partners called
silent partners, secret partners or nominal partners. A General Partnership
files a Partnership return, Form 1065. It is a flow-through entity,
meaning that all of the profits and losses flow through to the partners.
What is the downside?
- A General Partnership usually terminates when one
of the partners dies.
- All partners are personally liable for all
of the partnership's debts!
- The partner with the most money may end up paying
for all of the other partners!
Limited Partnership: This is
similar to the General Partnership, but only the General Partner is
personally liable for the debts of the partnership. Limited partners
do not have a say in management. They simply invest money in the partnership.
They can only lose the amount of their investment. Assets are protected
inside the Limited Partnership via a charging order. What is the
downside?
- Unlimited liability for the General Partner.
- The limited partnership may terminate upon the death
of one of the partners.
- A limited partnership may inadvertently take on liability
if he gets involved in decision making.
Each of these entities falls short when
it comes to overall tax and limited liability advantages. Although the
limited partnership offers very good asset protection, the LLC is stronger!
First, Let's Consider the Corporation
No business can become a fortress unless
it operates with the correct business organization. Why gamble your
personal wealth on the success of your enterprise? The odds are that
80% of businesses fail in this country, making this is a poor gamble.
When you engage in any business activities, those activities must be
kept separate from the assets held by you or other businesses. Since
business activities carry a high potential for lawsuits, you will want
to isolate and remove those activities from the entity where the other
assets are kept (all assets should be held by an LLC, not a corporation).*
The corporation is one of several vehicles that are a part of the asset
protection plan.
*This is certainly better than holding
them in your own name. Assets are at risk when they are placed
in a corporation. Don't be fooled by what other companies may
tell you. What could go wrong? In Nevada it is very difficult to locate
the shareholder. Let's consider the worst case scenario. Unfortunately,
you just injured or even killed someone in a car accident. The judge
determines that you are the major shareholder of the corporation.
Your insurance will only cover a portion of the claim. Now the creditor
is looking for more money from you and wants all your assets. If
he finds out that you own the stock (at least 51%), the creditor will
seize the stock, then proceed to liquidate the corporation and
get all of the assets held in the corporation!
What if the corporation itself gets sued,
and the insurance doesn't cover the lawsuit? The same result occurs
in that the corporation will lose all of its assets! The only difference
here is the fact that in this situation your personal assets are
protected. As you will learn, corporations have tremendous tax benefits
and provide some liability protection. Actually, corporations and limited
liability companies work very well together.
Corporations, like Limited Liability Companies,
are created by the state. First, you must realize that a corporation
consists of four groups of individuals: officers, employees, and a board
of directors and shareholders. Of course, it is possible for a person
to wear all four hats, as in a one-person corporation. It is
imperative for the corporation to maintain a separate and distinct identity
from the individuals operating the corporation. And of course, it should
be formed for business reasons.
The shareholders own the corporation. This
gives them the right to elect the directors and to approve or reject
corporate actions. These actions might include a merger or liquidation.
Essentially the directors are the elected representatives of the shareholders.
It is their job to watch over the corporation between meetings of shareholders.
The directors report to the shareholders
about what the company has done since the last meeting. The corporate
officers who are appointed by the board of directors conduct the day
to day business of the corporation.
Limiting Personal Liability
If a corporation is formed and operated
properly, the creditors of the corporation can only look to the assets
of the corporation for recovery. This is known as "limited liability".
The owner's liability is limited to the capital contributed to
the corporation. There are conditions to limited liability. It is not
absolute. Creditors may attempt to seek recovery from the shareholders
or officers (if they can locate them). The creditor may attempt to pierce
the corporate veil by trying to prove the corporation was merely the "alter ego" of its operators. There are simple steps you can
take to guard against this. Namely, it is very important to maintain
accurate corporate records. These should include, but are not limited
to, holding regular shareholder and director meetings, holding annual
meetings, keeping an up-to-date minutes book and issuing stock. It is
also important to use the corporate name, not your name, in all business
contracts and business dealings. In fact, many attorneys won't even
allow their clients to operate as a sole proprietorship or partnership!
Corporate funds are for the business only! Do not commingle funds! Corporate
money is separate from personal money.
What Asset Should You NEVER
Own Personally, Not Even for One Day!
Property! Why? Because of the EPA (Environmental
Protection Agency). If you have ever been in the legal chain of title
of a piece of property, even if you owned the property 20 years ago,
the EPA can go after everyone personally for any violations! They make
the IRS look like the Boy Scouts. Can you see how it would make sense
to have a "fall guy" like an entity take the hit for any unforeseen
EPA problems that might develop in the future when you are long out
of the picture?
What about having high levels of insurance
to protect your assets from a lawsuit? Is it enough to have a $10
million umbrella policy and other insurance's to protect you in case
of a lawsuit? Absolutely not! Is insurance valuable? Yes, but only to
a certain extent. By no means should anyone rely on it as his or her
main asset protection plan. Why not? Because there are law suits today
that no one's insurance will cover. Does your insurance policy cover
you in case of discrimination in the work place? What about sexual harassment?
What about punitive damages? This can be devastating and in many cases
is not covered by any insurance plan! Unfortunately, your assets can
be lost by the false sense of security that insurance provides!
Here's the bottom line; if you operate
a sole proprietorship and your business is sued, you stand to lose both
your business AND personal assets! With a corporation, only the business
assets are at risk (that's why it's called limited liability). You may
want to take things a step further and form an LLC to protect the assets
inside the business. If you operate a business that has more than
one component (i.e., boat rentals and Jet Ski rentals), it would
make sense to form two separate corporations to limit the exposure
of each individually.
If both divisions were under one corporation
and one division was sued, that could contaminate the other division.
In other words, Don't put all your eggs in one basket!
Unlimited Life
A corporation can theoretically live forever
because it is a separate entity from the owners. A corporation only
goes out of business when the shareholders deem that action is appropriate.
Centralized Management
The corporation is a separate entity from
its shareholders. The shareholders do not operate the corporation. Responsibility
for operation rests with the board of directors (who are elected by
the shareholders). They appoint officers to carry out the day-to-day
business of the corporation. The operation of the corporation is
centralized in the hands of the officers, who are the managers of
the corporation.
Free Transferability
of Interests
Corporate ownership of shares are technically
freely transferable. The operation of the corporation is not disrupted
by the transfer of shares. The shareholders must act only through the
power to vote to affect the operation of the corporation. In some cases,
transferability may be limited by federal or state security laws.
Protection Against
Tort Claims
The corporation is a great tool for protection
against claims of negligence arising out of an employer-employee
relationship. If one of your employees injures someone in a car
accident while picking up supplies for you, you are likely to be responsible
for the damages. However, if that employee is an employee of a corporation,
the corporation, not the officers or directors, will be liable
for the injury!
Protection from Customers
When a corporation buys goods and
the customer gets injured the corporation is liable not the principals.
If the corporation sells goods or services, liability will usually
be limited to the corporation. For example, if the corporation is providing
contracting services to fix a home, only the corporation would be liable
for faulty service! For these reasons, the corporation provides a very
useful shield against personal liability in connection with the sale
of products and services.
Does More Than One Corporation Make Sense?
Absolutely, if you have more than one business
or business parts! Especially if you have a profit-making part of your
business and another part makes no profit. Why put the problem part
of your business in the same basket as the profit part of your business?
If the problem part of your business gets
sued, the profit-making part will not be affected. For example, suppose
you had two successful gas stations in your hometown, and you now open
a third.
If they are all in one corporation and
that corporation is sued, you could lose your entire business because
all your eggs were in one basket! There is typically no tax advantage
when owning multiple corporations if you own more than 80% of two corporations.
Keep in mind that a corporation must be operated as a separate legal
entity from you or you may lose the corporate protection.
Now let's enter the world of Limited Liability
Companies and see how they compare with corporations.
Which State to Incorporate In?