BUSINESS LAW SERVICES

NEW BUSINESS ENTITY CHOICES

By Attorney Lynda L. Saracusa

• DO YOU OWN or ARE YOU STARTING A NEW 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 BUSINESS? AND YOUR ASSETS AND INVESTMENT? ?

•  WOULD INCORPORATION OR SOME OTHER ALTERNATIVE INSULATE YOU AND/OR YOUR BUSINESS FROM LIABILITY?

• WOULD A PARTNERSHIP PROVIDE ANY PROTECTION FROM BUSINESS LIABILITY?

GENERAL CONSIDERATIONS BEFORE SELECTING THE TYPE OF BUSINESS ENTITY:

  THREE VITAL ISSUES TO CONSIDER FIRST:

• What is the acceptable level of personal liability for business obligations/debts/losses?

• How and to whom is business income taxed?

• What are formalities or licensing requirements of creation ?

Business entities are not all the same. While some provide freedom to operate as you wish, you may be at risk for a great many types of liability that could be avoided with some careful consideration and planning.

Are you about to start a new business? Do you want the most protection available? What is the best legal answer to that question for your situation?

Read below for the information which will help you decide.

THE OPTIONS

• Should I consider being a SOLE PROPRIETOR?

• IS INCORPORATION THE ANSWER?

Contrary to what many people think, incorporation is not a requirement for doing business. Incorporation 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.

IS PARTNERSHIP FOR YOU?

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:

• Partnership liabilities to partners

• Partnership liabilities to third parties

• Partnership liabilities to third parties and to each other

• Partnership liabilities on their separate obligations

There is no limited liability to protect a partnership’s individual assets from claims arising out of business operation.

 Tax Reporting for a Partnership is done with form 1065 and Schedule K-1 issued to each individual partner showing their distributable share of the income.

What about a LIMITED PARTNERSHIP?

This is a different kind of formal partnership arrangement, also called an LP, where the General Partner has liability for the business operations and the Limited Partners have liability only up to the amount of their investment in the Limited Partnership.

Creating an LP requires the filing of a Limited Partnership Certificate with the Mass. Secretary of the Commonwealth as well as annual reports each with substantial filing fees.

The allocation of profits and losses is further spelled out in the Limited Partnership (LP) Agreement.

Could a LIMITED LIABILITY COMPANY (LLC) or PROFESSIONAL LIMITED LIABILITY COMPANY (PLLC) be the answer to your inquiry ?

Although creation of either type of LLC requires filing a Certificate of Organization with the Massachusetts Secretary of State, there is no member liability for LLC debt. Profits and losses are allocated according to the required operating agreement.

GENERAL CONSIDERATIONS

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.

DETAILED INFORMATION FOR EACH TYPE OF ENTITY

SOLE PROPRIETOR

Going solo! When operating as a sole proprietor, all the risks and rewards are yours.

You have personal liability for any and all business debts and claims but the income and benefits are all yours too.

Insurance can help ease the burden of liability but it will not cover every situation.

Financing and investment are usually limited to your personal assets.

Tax reporting for income from a sole proprietor business is done on the personal Form 1040 using a Schedule C and Schedule SE.

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.

TYPE C CORPORATIONS:

NEGATIVE CONSIDERATIONS

• Corporate income of a Type C corporation is taxed twice. It is taxed as corporate income and then again when received by an individual.

• In Massachusetts, C corporations pay a minimum of $500.00 in corporate taxes each year.

• High degree of administrative complexity required, requirements such as holding annual meetings and keeping detailed corporate records (minutes).

•  Unfavorable tax rate on long term capital gains.

•  Double taxation on liquidation.

•  Personal holding company tax applies

•  Accumulated earnings tax applies

•  No ability to make tax free contributions and distributions

•  No ability to make special tax allocations among owners

•  Taxed at corporate and individual level

•  Formal meetings and corporate minutes

•  Annual state reports
  

TYPE C CORPORATIONS

POSITIVE CONSIDERATIONS

• High certainty of legal and tax outcomes

•  Ability to retain income at lower current tax cost

•  Good tax treatment of fringe benefits for owners

•  Deduction for corporate dividends received

•  Flexibility to select tax year

•  Limited liability for shareholders for corporation debts, claims and lawsuits

•  Increased opportunities for raising capital.

•  Personal liability protection for owners

•  No membership restrictions

S CORPORATIONS

POSITIVE CONSIDERATIONS

• 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.

• 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.

•  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.

•  Stockholders can also deduct their pro rata share of an S corporationïon’s net operating loss from their personal Gross income.

•  Personal liability protection for owners

S CORPORATIONS

NEGATIVE CONSIDERATIONS

• High degree of administrative complexity, annual filings required. Formal meetings and corporate minutes

• Qualification requirements for filing S corporation and election filing requirements.

• 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.

• 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.

• Membership restricted to 100 shareholders

• 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)

OVERVIEW

• Personal liability protection for owners

• Income/loss passed directly to members

• Option to be taxed as corporation or LLC

• Annual state reports

• No membership restrictions

• 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.

LIMITED LIABILITY COMPANIES (llc)

ADVANTAGES

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 COMPANIES (llc)

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 & 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.

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 & 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.

GENERAL BUSINESS ADVISORS/HELP YOU WILL NEED

Attorney: Choose an attorney with some business, commercial or corporate experience to set up the business the way you choose and to draft documents that will avoid disputes and issues. If you don’t know an attorney with those qualifications call the State Bar Association. They can refer you to someone qualified to advise and help you.

An Accountant can provide valuable advice and structure for your business. Periodic reviews can be invaluable for records and tax filings.

An Insurance Agent can supply information and coverage for business liability, personal liability, umbrella coverage, casualty and liability insurance, even professional liability insurance if applicable.

A Computer Technical advisor can be a life line for your business. More and more business is being conducted via the internet. Having the right computers and programs can give you a true advantage over the competition. Get the best hardware you can afford and have this advisor on call to help in emergencies and for upgrades and general maintenance.

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.

BUSINESS LEASES/BUILDING PURCHASES

The right location can guarantee the success of your business. The wrong one can be disastrous! A professional real estate broker can assist you in your search for the best building to lease or buy for your business.

If you decide to buy, make sure to have a building inspection so you can get some expert advice about the condition and defects of the property. Well worth the expense.

A local broker can provide you with resources, listings, contacts, information, referrals to inspectors and other professionals, assistance with negotiations, connections, and show you prospective properties to lease or own.

The terms are negotiable, not set in stone. You may be able to negotiate changes to some of all of the following:

• Lease Rental period

• Terms and conditions

• Renewals

• Net lease inclusions-exclusions

• Real estate tax liability

• Insurance requirements

• Repair responsibilities

• Uses

• Condition

• Security Deposit

• Assignment /Subletting

• Breach details/correction

As with everything in business in general, I highly recommend that all dealings with the Landlord and everyone else for that matter, are in writing. This avoids future problems and disputes and there is a paper trail that shows that the understanding of the parties at the time of signing.

BUSINESS LAW SERVICES