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Reference Material
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NEW BUSINESS ENTITY CHOICES AND LIABILITY
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BUSINESS LIABILITY DIFFERENCES IN
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CORPORATE AND OTHER
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BUSINESS ENTITIES
DO YOU OWN A BUSINESS? IF YOU OPERATE AS A SOLE PROPRIETOR YOU ARE PERSONALLY RESPONSIBLE FOR ANY AND ALL LOSSES.
WHAT IS THE BEST WAY TO PROTECT YOURSELF? AND YOUR ASSETS?
WILL INCORPORATION OR SOME OTHER ALTERNATIVE MIGHT INSULATE YOU FROM LIABILITY?
DOES BEING IN A PARTNERSHIP PROVIDE ANY PROTECTION FROM LIABILITY?
Read below for the information which will help you decide the best solution to liability questions in your specific circumstances.
Contrary to what many people think, incorporation is not a requirement for doing business although it can provide substantial insulation and protection from business liability. By forming a corporation, business claims and suits would only reach corporate assets instead of the personal assets of the individuals operating or owning the business.
A partnership or even an individual can operate a business without the necessity of incorporation. However, if you are doing business as a sole proprietorship or a partnership, you are personally liable and your personal assets could be subject to claims and attachment for business related matters and lawsuits.
When you operate as a partnership there are liabilities of each partner and the partnership itself. They include:
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Partnership’s liabilities to partners
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Partnership’s liabilities to third parties
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Partner’s liabilities to third parties and to each other
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Partner’s liabilities on their separate obligations
There is no limited liability to protect a partner’s individual assets from claims arising out of business operation.
CORPORATIONS
1. TYPES OF CORPORATIONS
There is an important distinction between Type C corporations (for profit) and Type S corporations (also known as subchapter S). Both types of corporations provide limited liability protection to owners/shareholders. Both types of corporations require the filing of Articles of Organization and related documents and substantial filing fees.
A. TYPE C CORPORATIONS: NEGATIVE CONSIDERATIONS
1. Corporate income of a Type C corporation is taxed twice. It is taxed as corporate income and then again when received by an individual.
2. In Massachusetts, C corporations pay a minimum of $500.00 in corporate taxes each year.
3. High degree of administrative complexity required, requirements such as holding annual meetings and keeping detailed corporate records (minutes).
4. Unfavorable tax rate on long term capital gains.
5. Double taxation on liquidation.
6. Personal holding company tax applies
7. Accumulated earnings tax applies
8. No ability to make tax free contributions and distributions
9. No ability to make special tax allocations among owners
10. Taxed at corporate and individual level
11. Formal meetings and corporate minutes
12. Annual state reports
B. TYPE C CORPORATIONS: POSITIVE CONSIDERATIONS
1. High certainty of legal and tax outcomes
2. Ability to retain income at lower current tax cost
3. Good tax treatment of fringe benefits for owners
4. Deduction for corporate dividends received
5. Flexibility to select tax year
6. Limited liability for shareholders for corporation debts, claims and lawsuits
7. Increased opportunities for raising capital.
8. Personal liability protection for owners
9. No membership restrictions
C. POSITIVE CONSIDERATIONS OF S CORPORATIONS
1. An S corporation eliminates double taxation because the corporate portion of the tax is eliminated. Massachusetts is one state which gives S corporations favorable treatment by exempting them from corporate tax.
2. S Corporation status can eliminate accumulated earnings tax problems because all earnings, whether they are distributed or not are taxed to the stockholders each year. The stockholders pay personal income taxes on the corporate earnings passed through to them.
3. Another plus is that stockholders of S corporations can apply their deductible personal losses against their pro rata share of the company’s taxable income.
4. Stockholders can also deduct their pro rata share of an S corporation’s net operating loss from their personal Gross income.
5. Personal liability protection for owners
D. NEGATIVE CONSIDERATIONS OF S CORPORATIONS
1. High degree of administrative complexity, annual filings required. Formal meetings and corporate minutes
2. Qualification requirements for filing S corporation and election filing requirements.
3. Taxable income of S corporations is taxed to stockholders even if the income is not actually distributed to them. Where corporate cash flow is uneven or uncertain, S corporation status may not be the best choice.
4. Another disadvantage of S corporations is the classification of corporate losses. They are treated as losses from a passive activity to the extent a stockholder does not materially participate in the operation of the company.
5. Membership restricted to 100 shareholders
6. All incorporators of a Subchapter “S” Corporation must be US citizens or permanent residents.
Incorporation is not a requirement for doing business. A partnership or even an individual can operate a business without the necessity of incorporation, however, the liability exposure is quite different and much riskier.
Corporations and Limited Liability Companies (LLCs) are both excellent choices for business owners looking to minimize their personal liability and build greater credibility. But each entity also offers distinct tax and business advantages. Choosing the right one depends on the specific needs of your business.
The corporate business structure also saves you money in taxes, provides greater business flexibility and makes it easier to seek outside investment.
The primary advantage of a corporation is that its owners, known as stockholders or shareholders, are not personally liable for the debts and liabilities of the corporation. For example, if a corporation gets sued and is forced into bankruptcy, the owners will not be required to pay the debt with their own money. If the assets of the corporation are not enough to cover the debts, the creditors cannot go after the stockholders, directors or officers of the corporation to recover any shortfall.
LIMITED LIABILITY COMPANIES (LLC)
1. Personal liability protection for owners
2. Income/loss passed directly to members
3. Option to be taxed as corporation or LLC
4. Annual state reports
5. No membership restrictions
6. Flexible profit and loss allocations and elections
Limited Liability Companies (LLCs) offer the same personal liability protection as a corporation, but with fewer of the corporate formalities. They typically are not required to hold formal meetings or keep detailed corporate minutes. LLCs also offer great tax flexibility. Members can choose to be taxed as either a traditional corporation or as a "pass-through" entity.
An LLC is typically managed by its members/owners (referred to as member-managed). In that respect an LLC is unlike a corporation, which has a much more rigid and defined management structure, including directors and officers. All owners of the LLC are typically referred to as members, and they can have control and voting interest proportional to their ownership interest, or in proportions different from their ownership interest; however the members agree.
ADVANTAGES OF AN LLC (LIMITED LIABILITY COMPANY)
A Limited Liability Company (LLC) protects your assets like a corporation, but without the burden of corporate maintenance. That's why it's A VERY popular way to start a business.
At the basic level, when you form an LLC you are creating a type of business formed at the state level. There can be many benefits to forming an LLC with the state. LLC's can also offer tax advantages, limit your liability for business debts, and much more. However, with all the benefits of starting an LLC also come obligations such as more accounting, changes in tax issues, and some additional paperwork regarding your LLC filing.
Unlike partnerships and sole proprietorships, corporations and LLCs are legal business entities, separate from their individual owners and members. When you incorporate or form an LLC, you acquire personal protection from the debts and obligations of your business.
With a LLC, you can elect to be taxed as a corporation, or avoid "double taxation" by choosing to be a "pass-through" entity.
An LLC is often described as a combination of a partnership and a corporation. It combined the tax advantages and management flexibility of a partnership with the liability protection of a corporation.
Formation of an LLC is a popular alternative for sole proprietors and partnerships because of the protection of personal assets it provides. In addition by forming an LLC, “double taxation” is avoided because income from the LLC itself is not taxed at the company level. Taxes on profits and deductions of losses are computed at the individual level on the personal income tax return of each LLC member (or owner).
LLC members also have the option of electing taxation of the LLC as a sole proprietorship, partnership, C Corporation or S Corporation. Owners can make this election through the IRS by filing the appropriate forms after the company is formed with the state.
LIMITED LIABILITY SPECIFICS
An LLC is a hybrid between a corporation and a partnership. It is comparable to a corporation in which shareholders, or in the case of the LLC, owners (known as members) have limited liability for business designated debts and liabilities. If properly managed and structured, individual members’ personal assets are protected from business lawsuits and judgments. Each owner’s exposure to liability is limited to the amount of investment in the LLC.
Perhaps the most important advantage to LLCs is that it provides liability protection to the business owners, since owners are considered separate entities from the LLC.Owners or members of an LLC are not personally liable for business debts or liabilities in most situations. Personal legal liability protection is the same as that offered to shareholders of a corporation. In order to be afforded limited liability for your company, you should make sure to follow all state and federal requirements for keeping your corporation in good standing. There should also be a distinct separation between your personal and business assets.
PASS THROUGH TAXATION
When an LLC has only one member, the IRS automatically treats the LLC as a sole proprietorship. Where an LLC has multiple owners, it will be taxed as a partnership.
Owners report their share of profits and losses of the LLC on their personal income tax returns. No separate tax is assessed on the company itself.
If the LLC is to be taxed as a corporation, elections must be filed with IRS.
While LLCs file tax returns, the company does not pay federal income tax. Consequently, administrative paperwork and accounting are simpler for an LLC. Personal assets are not connected to the company if the LLC is in litigation. Taxes “pass-through” the company, and the individual members are taxed at an individual levels and not the company level according to their profits or losses.
For federal income tax purposes the profits of an LLC (Limited Liability Company) “pass through” to the personal income of the members/owners. In the case of a single member LLC it is taxed the same as a sole proprietorship (i.e. typically filed on the schedule C of the owner’s personal income tax filing). In the case of a multi member member it is taxed the same as a partnership (i.e. a 1065 partnership return is filed with the IRS, with a schedule K-1 being supplied to each partner/member showing the proportional profit/loss allocated to them, with this being filed on the schedule C or E).
CITIZENSHIP/ENTITIES
All members of a Subchapter “S” Corporation must be US citizens or permanent residents. There is no similar requirement for an LLC. Members may be individuals, other partnerships; they may be non-resident aliens or a trust as well. This allows for more flexibility for the company formation.
MANAGEMENT FLEXIBILITY
An LLC has much more flexibility than a corporation. An LLC may be managed directly by its owners (members) or by a manager who may be but is not necessarily a member. A Subchapter S corporation is limited to a maximum of 100 owners, an LLC has no such limitation. An LLC may have an unlimited number of owners (members).
The operating agreement is akin to a partnership agreement for a General Partnership or Limited Liability Partnership (LLP). It is an internal contract among the members/owners of the LLC, and it lays out such things as ownership interest, member responsibilities, accounting method, adding or removing members, terms for concluding the LLC, etc. Even if it is not required by a given state for forming an LLC it is certainly recommended for avoiding confusion and disputes. When dealing with private companies for financing issues (loans, mortgages, etc.) it may be required by that company.
SIMPLIFIED RECORDS REQUIREMENTS
An LLC is not required to hold an annual meeting and keep meeting minutes as required for corporation. An LLC does require an operating agreement which spells out how and by whom the LLC will be managed, each owner’s (member’s) name, the percentage ownership held by each member and many other specifics about the operation of the LLC. Annual LLC reports are also required for compliance with state obligations. Some states permit online or e-filings to meet this obligation.
DEDUCTIBLE BUSINESS EXPENSES
Normal business expenses such as an owner’s (member’s) salary may be deducted from the LLC profits before income is allocated to its owners for tax purposes.
FLEXIBLE PROFIT AND LOSS ALLOCATIONS AND ELECTIONS
Unlike a corporation, an LLC is not required to allocate profits and losses in proportion to ownership interest ("member interest'). This means that the owners of an LLC can agree to allocate the company's profits and losses among themselves however they see fit and not necessarily based on the percentage of the company each owner controls.
Distributions need not be equal. If one member invests more or contributes more to the business, that member may reap more of the profits. The agreements of disbursement are stipulated in the LLC operating agreement.
NATIONAL RECOGNITION
The LLC is now a recognized business structure in all 50 states and the District of Columbia.
ANOTHER IMPORTANT OPTION TO INCORPORATION OR FORMING AN LLC
Although doing business as a sole proprietorship or a partnership can expose the business owners to increased risk of loss, commercial liability insurance is available to protect assets from liability related to the operation of business. Coverage is available at very reasonable rates for substantial coverage. This is sometimes required as a condition of your lease if the space where you operate your business is not your own.
Other considerations and requirements for doing business:
In advance of setting up business, the employment contracts/agreements for the people working for or with you must specify and it is crucial that the appropriate decisions be made to designate whether these will be partners, employees or independent contractors. It is vital that the appropriate decisions and designations are made to designate which they are and how they are paid. There is a substantial difference and distinction between employees and independent contractors for Federal and state tax purposes, employment tax purposes and filing requirements. Failure to address these issues can be disastrous. Resolution after the fact, can be expensive and drain critical capital from your business.
However, if you are doing business under a name other than your own you are required to file a DBA (doing business as) certificate in the city or town in which the business is located.
FEDERAL AND STATE TAX LIABILITY
If you have employees other than yourself or the principle partners, you will be required to apply for employer tax numbers with the IRS and Massachusetts Department of Revenue. You will also be required to withhold and pay quarterly taxes and file quarterly tax returns.
If you will be selling products or goods, you must apply for a resale tax number with the Massachusetts Department of Revenue and pay sales tax on the goods sold.
