Consider your options for structuring your business
You have several options on how your business is organized, and since it could take a couple of months to set some of them up you might as well accomplish this before you are paying rent, insurance, wages … Your customers or employees won’t really care about organization. Your creditors, landlord, CPA, the tax man, and possibly insurance carrier will care. This topic is beyond our expertise, so take the information below with a grain of salt. This page is meant to be a starting point, contact a CPA or experienced attorney.
There are two key points to keep in mind:
- Having a complex legal structure for your business does not negate your need for sufficient insurance coverage. If you have a corporation, LLC or other legal entity, you can still be sued as an individual for any negligence. As a start up or small business, most of the contracts you sign—loans, leases, or credit account, will most likely have a personal liability clause or personal guarantee clause even if your businesses name is on top of the contract. That means that even though it’s in your business name, if things go south you will be personally responsible. To sum up, “corporation” and “LLC” are not magic words that undo the reality of contact law.
- One good example of the Business Ego Trip that can get you in trouble are these Corporate Credit Cards. By getting one of these you feel good because your business’s name is on the card. Maybe even a title like “president.” Beyond impressing your server at Chili’s, corporate cards offer little additional value. Most have cardholder agreements a personal liability clause which most people don’t read and are based on your personal credit—that’s how you got on the mailing list. Also since it no longer a consumer card, the bank is not subject to those pesky consumer protection laws.
- Legal entities have been over-sold by seminar promoters. Some of the claims they made were only relevant with in the hotel ball room your seminar has been held in: you can use “corporate credit” instead of your own credit, “corporate credit” can be established instantaneously, or that you can use your new “corporate credit,” and nobody will care about your poor personal credit. No rational lender will give credit to an entity that was just formed or that has no assets. Sure if your company has been around for a while and has assets, you could get corporate credit or sell bonds. Unless you have been on the cover of Business Week, don’t think that you can get instant corporate credit.
We have listed a few pointers abut forms of organization in order of complexity.
Sole Proprietorship a.k.a. Doing Business as an Individual.
Basically, you are doing business as yourself; there is not a separate legal entity. This is the case even if you have a registered fictitious name. You do not have to file taxes separately for your business. They are filed as part of your 1040 on a separate worksheet called the Schedule C. Profits and losses from the Schedule C are then reported in a box on your Form 1040. The business does not pay any taxes itself; profits and losses are taxed at your personal rate. You are personally liable for business debts and liabilities even if they have your business name on them. There is no size limitation for your business to be considered a sole proprietorship. Under IRS rules a husband and wife can operate as a sole proprietorship even though this sounds like an oxymoron–hat way you don’t have to argue about who is the employee. (See Qualified Venture on page 2 of instructions for IRS Form 1065 http://www.irs.gov/pub/irs-pdf/i1065.pdf )
The government never forces you to make your business into something more complex like a corporation. You do not have to file any forms with California’s Secretary of State to start a sole proprietorship. You are free to use your own name for the business; but most businesses will have a business name. Unless you have a name that’s in use, you can use a variation of your personal name without a problem. Or you can use a fictitious business name. See our section on getting started in business.
Surf’s Up Business Tax Deductions When you file your Schedule C you will be subject to self-employment tax. This comes to about 16% of your net. This pays into Social Security and Medi-Care for you. But remember that there are a lot of opportunities to write off stuff on your Schedule C: all your business expenses, half the cost of business meals and entertaining, a vehicle cost and operating expense if its mainly used for business, and half of your health insurance cost. IRS Guide to the Schedule C http://www.irs.gov/pub/irs-pdf/i1040sc.pdf . Of coarse some people have discovered this and start a business just for the write offs. But the main purpose of your business must be to make a profit even if profit proves to be elusive. Suffice it to say that it would not be a good thing if the IRS determines you have a sham business. For any organization other than nonprofits, this is a good book to explain what may seem confusing in the aforementioned IRS publications
Organizing your business as a Partnership
There are two types of partnerships based on the partnership agreement. If no written partnership agreement is drafted, you are assumed to have adopted California’s standard agreement. (This is called the Reformed Uniform Partnership Act (RUPA) This is possibly a copy of California’s law available at the University of Pennsylvania’s website http://www.law.upenn.edu/bll/archives/ulc/uparta/1997act_final.htm )
An agreement is important because the easiest way to loose your best friend is to form a partnership with her. You may also want to file The basic problem with the standard agreement is that everything is equal even if one partner works harder or invests more. You may have an understanding of your partnership which is different based on what each partner brings to the venture. Thus it would be best to work out a written partnership agreement. You might also want to file this form with the California’s Secretary of State’s office to make it clear who is in the partnership and has authority to make decisions. This is especially important if you are working with a group of people who may all feel they are a “part of the business.”
Making someone your partner is not an elegant way to side step those pesky employment laws. You may be able to avoid employment tax, share the risk if there is not profit made, and motivate your partner to work hard. On the other hand there some other consequences of becoming a general partner. Before you go into a tacit or explicit general partnership, these are some things to think about: If the business accumulates debt or liabilities, your creditors can go after the partners. They will not be fair and demand an equal share from each partner in court. The partner who can pay will pay. If your other partners are asset poor or disappear, you end up holding the bag. A second issue is that any partner could sign binding contracts for the partnership.
[Not 100% sure about this, general partnership pro-rata profits/losses are reported on Form 1065 and individual income tax Schedule E. The general partnership does not necessarily pay separate taxes itself. Net income ends up on the partner’s Schedule E and is taxed at their personal rate.]
Many well known companies are formed as limited partnerships. The most well known in Orange County is Cedar Fair—the current owners of Knots Barry Farm. The Blackstone group is another famous Limited Partnership. This kind form of organization has often been used to buy businesses with high operating cash flow such as real estate and oil wells. In some sense they are a highbred organizational form having the ease of management associated with a corporation—i.e. no group decisions—and the pass through tax advantages of a sole proprietorship.
The advantage is that you have a general partner (you could have more than one but typically there is one general) who makes the decisions. That eliminates most of the fighting over operations and major decisions. Limited partners contribute assets to the partnership—typically cash—and do not have a say in management. The limited partners are shielded from liability. They can only loose what they put in.
Limited Partnerships have what the IRS calls pass through income. Income from the partnership is reported on an informational return and then each partner receives a K-1 Statement that indicates profits and losses. This is reported on your individual tax form via the Schedule E. It should be noted that profits do not necessarily equal distributions. The partnership can make money and retain it. You would still owe taxes on the profit because it passes through to your Schedule E. You can also write off losses on your Schedule E generated by the Limited Partnership even though you did not have to compensate the business out-of-pocket for these losses. Hence their popularity as a tax shelter.
LLC Limited Liability Company
This is an actual corporation, not a prestigious name. You can be the only one in the corporation, but it still has to follow all the rules. You have to file with California’s (or Nevada’s) Secretary of State, maintain records, and have board meetings. If you are just using LLC as a title for your personal business, it will not have served its main purpose—limiting your liability form business losses.
As with partnerships, income from the LLC passes through to your individual income tax return, and your LLC does not have to pay corporate taxes. If you are what the IRS calls a Single Member LLC (i.e. the only person in your LLC) you file your income on your Schedule C and get to take all those groovy Schedule C business deductions just as a sole proprietor would; but you would have additional protection of your personal assets. See http://www.irs.gov/pub/irs-pdf/i1040sc.pdf for more explanation. If there is more than one owner of a LLC, your LLC will file an informational return and issue K-1’s. This income is reported on your Schedule E.
As with a partnership, the LLC may not be as good as it seems when it comes to liability protection. If you are a new LLC, most credit agreements, lease, and supplier funding agreements will have a personal guarantee clause. A LLC does not completely protect you against being sued for personal actions because your business will be sued along with you “as an individual.” The so called corporate liability vale can be pierced if it can be shown that the LLC’s business in not separate from your personal life or other business interests.
Barring any inappropriate individual behavior and latent personal guarantees, the LLC should do what it is intended to do. You can only loose what you put in. But be careful of who you choose to be co-owners of your LLC. Another owner could potentially enter into a binding contract on behalf of the LLC.
These are some recommended books on the subject that you should read before you see a lawyer so you understand what LLCs are all about. (You might be noticing a trend here. Nolo books are great for subjects like this.)
Form your LLC
Your LLC operating manual
Do Business as a Corporation
There are several types of corporations each have their advantages.
Type S Corporation a.k.a. A Private Corporation and A Closely Held Corporation
Under some circumstances a Type S Corporation may have a tax advantage over a LLC. This occurs when the owner(s) of the business are in high tax brackets and the corporation elects to pay corporate taxes. This is discussion is a bit above our pay grade, but if you are in an uber-high tax bracket contact your CPA about this possibility. With tax rates changing all the time, there is no good rule of thumb. But LLC’s have become more popular in recent years because of lower administration costs and there are fewer restrictions.
S-Type corporations have two advantages over C-Type corporations: income is not double taxed, and financial disclosure requirements while more daunting than LLCs are significantly less daunting than Type C corporations. The number of investors you can have is limited to 500. If you go beyond that, you may be forced to become a Type C corporation. Note that the limitation is on the number of investors not shares, so if you investors sell off fractions of the shares they own, that could be a problem.
S-Corps are taxed like partnerships with the exception that these types of corporations pay an additional State income tax of 1.5% to the Golden State. Share holders also face the problem of phantom income which results from being taxed on their share of the profits even if it is not distributed.
More info see http://en.wikipedia.org/wiki/S_corporation
Surf’s Up It would be a good idea to read up on corporations before setting one up, even if you will get legal help. At least you will not be paying an attorney $xyz/hour to explain basic stuff. Check out this Nolo book which will provide a great background.
Type C Corporation A.K.A. A Public Corporation
This is how most of our favorite large corporations are organized. Small businesses tend to avoid this because of a double taxation problem. Profits are taxed on the corporate level. (Although it should be pointed out that some of our corporate citizens are very good at tax planning. For 2010 General Electric didn’t owe any taxes.) Then as that income is distributed as dividends to share holders, it is reported on Schedule B of your 1040 tax form; and you pay personal taxes on this income. Currently the rate paid on dividends is low, but some members of congress—from districts outside Orange County—want to increase the dividend rate to the same as your persona income rate.
This form of incorporation does have advantages. There is no limitation on the number of shareholders (S Corporations cannot have more than 100 shareholders.) so it is possible to raise capital by selling shares. You can get listed on an exchange. (The issue with the S Corporations is that if Shareholder Bob sells his shares of to a bunch of other people, the corporation is deemed a public Type C and must comply with all the Securities and Exchange Commission’s disclosure laws, and face double taxation.). Also, as opposed to Type S Corps, there are not US citizenship restrictions on shareholders.
Type B Corporations — Benefit Corporation
This is a new type of California Corporation (AB361-2011). [video] Think if it as a hybrid between a Not-For-Profit organization (see below) and a for profit corporation. It’s goal is to benefit society, make profits for its owners, and take advantage of the a corporations ability to raise money to invest in a business. In a regular type of corporation or partnership, management has the legal responsibility to maximize the shareholder’s or partner’s value. If your goals are not exclusively to build personal wealth, this might be a good option. Additionally, it has the benefit of conveying the fact that your business endeavors are not driven by greed to potential customers. (Another way to accomplish the same goal is to have a form profit corporation and donate shares to a charitable trust. The best known example of this is the Hershey Trust which was set up by Milton Hershey and owns a significant portion of Hershey Company stock.) In addition to maximizing shareholder value, management haves a fiduciary responsibility to also consider:
1) Purpose: have a corporate purpose to create a material positive impact on society and the environment;
2) Accountability: expand fiduciary duty to require consideration of the interests of workers, community and the environment; and
3) Transparency: publicly report annually on overall social and environmental performance against a comprehensive, credible, independent, and transparent third party standard. (From B-Labs)
In other words, a shareholder cannot object if management makes decisions that reduce profits for the sake of the criteria stated above. video This video is by Donald Simon who helped write AB361. You will need to get third party verification that you are meeting the criteria above. B-Labs is the most well known third party and if you meet their standards you are permitted to use their Certified B Corporation (B) trademark.
Note that there is an assumption that you need to have a California Corporation if you live in or are doing business in the Golden State. This is false. You can incorporate in any one of the other 49 states. Low tax and regulation states such as Nevada and Delaware have been popular homes for California businesses. You only need to meet a minimum requirement for a physical location in the state which may be an attorney’s office. There are companies that specialize in setting up your corporation out-of –California to avoid our state’s taxation and regulation and the state’s relatively harder incorporation setup procedure. And Nevada is making it as advantagous as possible to set up your official business residence in their state.
Top Reasons to Incorporate in Nevada
- No Corporate Income Tax
- No Taxes on Corporate Shares
- No Franchise Tax
- No Personal Income Tax
- Nominal Annual Fees
- Nevada corporations may purchase, hold, sell or transfer shares of its own stock. Nevada corporations may issue stock for capital, services, personal property, or real estate, including leases and options. The directors may determine the value of any of these transactions, and their decision is final.
- No Franchise Tax on Income
- No Inheritance or Gift Tax
- No Unitary Tax
- No Estate Tax Competitive Sales and Property Tax Rates Minimal Employer Payroll Tax – 0.7% of gross wages with deductions for employer paid health insurance
Nevada’s Business Court Developed on the Delaware model, the Business Court in Nevada minimizes the time, cost and risks of commercial litigation by: Early, comprehensive case management Active judicial participation in settlement Priority for hearing settings to avoid business disruption Predictability of legal decisions in commercial matters
WOW talk about business friendly. of coarse California will get you on some of these tax issues if you are employing people in the state, selling in the state … Determining what triggers California’s tax/regulatory authority for business that operate in the state is beyond our expertise. We found one interesting book on the subject:
The author points out that California charges a much higher filing fee and a tax on world wide profits.
Some businesses, such as cash-advance or quickie lending companies, have even found a way to avoid federal regulations. They have incorporated in one of our Native American Nations (trying to avoid the term Indian Reservation).
Many California companies are incorporated across state line in Nevada. The advantages are that Nevada has on corporate tax, no franchise tax. Also people believe that it is harder for creditors and litigants to pierce the corporate veil – i.e. sue the owners as individuals and go after their personal assets—in Nevada. According to the legal experts on Wikipedia, the question of are you personally libel decided on in California Courts based more investor friendly on Nevada Law. Corporate issues, however, are decided in Nevada’s court system. Apparently a LLC or Type S or Type C corporation can also be more easily set up in Nevada with lower fees.
Often people talk about organizing their business as a company. Unfortunately, this has no specific meaning. It could refer any of the above forms of organization except for one person business operating as a sole proprietorship.
Congress has finally gotten the message that it’s too much hassle to set up a corporation. If the Politicos are correct, you will soon be legally be allowed to get small investments from people who do not have a large net worth. You will be able to have more than 500 investors. Currently people producing film projects and the like have found a work around by giving investors promotional items. But soon everyone will be able to get into the act.
Crowd funding has been stressful for non-profit projects and entertainment/art projects.
Check out the website www.indiegogo.com and KickStarter. They help producers raise money, and take a 4% cut if you reach your goal and a 9% cut if you do not. There is also a 3% cut taken out for credit card processing. If you put your money into one of these ventures, you are a contributor rather than an investor. You get prizes or rewarded with product. They do not seem to be able to call it an investment or indicate that you will be entitled to a financial return. If they did, that would constitute a “security” and be under the jurisdiction of the SEC (federal Securities and Exchange Commission) along with state departments of corporations. In one of the pitches we watched, you got a “founding member’s card” and the presenter said something like “if we are successful, we don’t know what the card will be worth.” Some small businesses have been popping up on their website in addition to the film/art projects such as an anti-hangover drink, environmentally friendly coffee supplier in South America, video game and app development, and a Donut shop in Virginia. They were all seeking relatively small sums of money. Under current law, this seems like it would work best for non-profit projects.
Non Profit or Not-for Profit Organization aka 501c
Nolo Press book on how to form a non profit corporation
This book goes into detail about how to form a non-profit corporation under California law. The actual forms are included, and there is a disk with documents and other forms on it. This book is targeted to people who want to form non-profit corporation with 501 c (3) status.
This book is a more general book. It discusses what nonprofit organizations are all about and discusses a lot of aspects involved in running a nonprofit organization.
It is possible that the business activity you want to engage in could be done with the benefits of a nonprofit corporation. Why would any one do a business except in the hopes of making a profit? Well, a non-profit organization has its advantages.
There seems to be some misconceptions about what a nonprofit organization is all about. The first misconception is that you can not make money and that the people running the nonprofit organization must take an oath of poverty. This is wrong. The word nonprofit or not-for-profit is misleading. You can make a profit so long as it is dedicated to the organizations non-profit core mission and is not given out directly to its members or leaders. In other words, no dividend checks can be given out. But this is similar to many start-up companies where the profits are plowed back into the business for years. And just as the CEO of a corporation can draw a nice salary from the business, the executive director of a nonprofit corporation can be compensated very well at a rate commensurate with your responsibility and leadership. There are no explicit salary limitations in the law. You and your staff also have pretty much the same rights to be compensated as your corporate brethren. For instance, your organization can have a health care plan as part of your compensation. And you can sock money away in something that’s just like a 401K called a 403B.
The second misconception about nonprofits is that they can only be for direct charity to the needy. The most blatant counterfactual to this is the New York Stock Exchange. Some people perceive their trading floor as the most iconic symbol of American Greed. In 1971, no doubt motivated by greed, they changed their form of organization to a nonprofit corporation. But don’t rush out and send a tax-deductable donation to our friends at the exchange. Not all nonprofit organizations have a special type of status, called 501 c (3) status, which allows you to deduct your contributions.
Well this topic is becoming very interesting and very complex. So some not-necessary legally correct or complete definitions might clear things up:
Nonprofit Organizations These are simply organizations of more than two people that is focused on a public purpose goal. These can be organized as what are usually called unincorporated nonprofits. They have disadvantages similar to partnerships. A “member(s)” can bind all the other partners to a contract. If things go south members can be personally liable, and creditors can go after those who are most able to pay. Officers can be held liable for actions of the association. That is because these organizations are not a separate legal entity, and may not be able to own property directly, borrow money …
Nonprofit Corporation Unless small or in existence for a shout period of time, this is the most advantageous type of nonprofit organization. It must be chartered and approved by a state government. Like corporations, it offers asset protection to those involved. There are more rules in setting up how the corporation is run than with a for profit corporation.
Tax –Exempt Organization aka E.O. This means that the organization is exempt from paying taxes on it’s earnings. But people mistakenly use this term to mean that the organization has 501 c (3) status. To see a list of all forms of organizations that can have tax exempt status see IRS Publication 557. http://www.irs.gov/pub/irs-pdf/p557.pdf See page 65 for a list of all the types of tax exempt organizations. You, or your attorney will submit a form to the IRS, and if approved you will receive a Letter of Determination that states your tax exempt status. (In the interest of being complete, it is also possible to have a nonprofit organization that is not exempt form taxes.) Examples of businesses that have memberships for a common goal, even social, and child care operators could have EO status.
501c (3) status is granted to certain organizations The advantage of this is that if you raise funds, the contributors can generally take a deduction on Schedule A of their From 1040. The primary purpose of the organization must be religious, charitable, scientific, testing for public safety, literacy, educational, armature sports, and prevention of cruelty to children or animals. As you can see some of these categories are broad, so it’s best to check with a CPA or attorney before applying for EO status.
So, if you have looked at the IRS publication, it is clear that nonprofit organizations can get very complex. Unless you are very good at dealing with IRS regulation, you will need an attorney to set up your corporation and an accountant to fill out your tax forms. There are other drawbacks. The company does not typically have stockholder ownership in the conventional sense. So it may be harder to raise money for capital improvements. Also, there is no easy exit strategy. You will not be able to contact a business broker to sell your business, and allowing someone to pay you to take over the organization and become executive director may not be legal. [This is going beyond our pay grade.] So why would you want to incur this expense?
First income generated from your primary mission is tax free. This gives you a huge advantage over for profit organizations. And it avoids the phantom income problems of Type S corporations and Limited Partnerships. Even if you do not have 501 c (3) status, money collected for general membership (usually called dues) is not taxable. And if you do achieve the coveted 501 c (3) status, you can solicit donations from members of the community, and get grants from the government and private foundations.
Non-profit organizations are regulated by the IRS. Because the tax code gets really fuzzy in terms of what activity could be valid, you need to contact an attorney validate have a public purpose and the advantages of forming a nonprofit corporation. For instance, consider two health clubs. They both do about the same thing. But one is for profit and has to pay taxes on income generated from its membership fees. The other charges dues and is a non-profit company and doesn’t have to pay corporate taxes. The executive director can be well compensated and all of the profits can be plowed back into operations without taking a tax hit. You have probably have guessed the name of the latter—the YMCA.
Photo:Photo of Files. We picked this photo because when you organize your business you will have stuff to file away for years. Photo Cred Jessica Mullen (cc) http://www.flickr.com/photos/jessicamullen
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