Choosing a Business Structure

                

                                     By Jim Hingst

 Jim Hingst is a contributing writer for Sign Builder Illustrated magazine.

Choosing the right business structure is an important first step when starting a company. It affects your taxes, your exposure to liability and your relationship with partners. In the case of corporations, it also affects the amount of paperwork you are required to fill out.

 

Business structures fall into four basic categories: Sole Proprietorship; Partnership; Limited Liability Company (LLC); and Corporation. Both sole proprietorships and partnerships are designated as informal business structures. Both are “pass-through entities” which means that the profits pass through the business to the individuals. Rather than taxing the business for their profits and then taxing the individuals on their wages from the business, sole proprietors and partners only pay taxes once on their personal tax returns.

 

LLCs and corporations on the other hand are classified as formal business structures. That means that these structures exist legally separately from their owners. It also means that these businesses are subject to state and federal regulations in order to preserve their legal status.

 

Formal business structures, such as an LLC or Corporation, protect your personal assets in the event that you are sued or default on a loan. A formal structure also imbues your company with an aura of credibility.

 

Is a Lawyer Necessary?

 

You don’t need a lawyer to set up an LLC or a corporation. If you have all the time in the world, you can research the particulars involved in setting up your business and filing. Filing can easily be done on-line.

 

The reason that you should have a lawyer is that they are professionals. It’s what they do for a living. They have the experience to do things the right way and to do the job quickly. If you don’t do things the right way, you may need a lawyer at some time in the future if you mess things up. It’s your decision: pay the lawyer now or pay him later.

 

One important area where an attorney can help you is in deciding on LLC taxation. Do you want to be taxed as (1) sole proprietorship or partnership; (2) an S-Corporation; or (3) a C-Corporation?

 

Generally, taxation as a C-Corp for a small business is unrealistic. Large organizations may select this option if you intend to reinvest a significant portion of your profits in equipment or property or you have many investors. The disadvantage of a C-Corp is double taxation.  The corporation is taxed and then you as an owner and your employees are taxed.

 

If you are starting a new company, before you decide on your business structure (i.e., sole proprietorship, LLC, corporation) first consult your attorney and CPA. The legal structure that you select will impact your personal liability and affect how you will be taxed.  

 

In assisting you in choosing the right structure for your business, an attorney can help you avoid potential liability exposure. He can also help in obtaining any necessary business permits. What’s more, by reviewing and analyzing all of the different types of contracts you are involved in, such as leases and contracts with your business partners, he can protect your interests.

 

Sole Proprietorship.

 

As a sole proprietor, you are “the king of me.”  You and your business are one and the same. It is the easiest way to start a business. That can be a good thing, but at other times, not so good. You rake in all of the profits, but you are on the hook for all of the debts. What’s worse, you are personally liable if you default on a loan or are sued.

 

The good news is that if you open your shop as the only owner, you are a sole proprietor. You will, however, need to obtain any applicable state and local licenses and permits. You may also be required to file for a DBA with your County recorder if you operate your shop under any name other than yours.

 

Starting a sole proprietorship is easy and inexpensive. Compared to other business entities, taxes are lower.  What’s more, you are your own boss with no one to answer to. There are some downsides. You are personally responsible for all of your business liabilities. As a sole proprietor, you may also have more difficulty getting a commercial loan.

 

Running your shop as a sole proprietorship provides you with many advantages that other business structures do not have. You have fewer government regulations. Your tax obligations may also be lower because you are only taxed at the personal level. However, as a sole proprietorship you are self-employed and incur the self-employment tax of 15.3% along with applicable federal and state income taxes.

 

The catch is that you are personally liable for all of your shop’s debt. What’s more, if your business is sued and a judgement goes against your company, you are personally liable. That means that you could lose your home or other assets.

 

A general rule of thumb, if you are starting out in business or your shop is earning less than $40,000, you should operate your business as a sole proprietorship.

 

If you have significant personal assets, you should form an LLC before you start your business to protect these assets.

 

A single member LLC is taxed as a sole proprietorship and incurs the full 15.3% self-employment tax.

 

More than half of the businesses in the U.S. are sole proprietorships. You don’t need much more to get started than the tools of your trade. If you don’t employ anyone, you don’t need an Employer Identification Number (EIN). You don’t even need a separate business bank account. In fact, you will unlikely get a business account without an EIN. You simply file taxes using a Schedule C tax form.

 

The problem that sole proprietorships face is that because the line between personal expenses and business expenses is often blurred, the IRS is more likely to audit you versus operating as a more formal business structure. When you face an audit, there is a high probability that you will lose and end up paying more in taxes and penalties.

 

If that isn’t bad enough, as a sole proprietorship it is easy for someone to sue you. That puts all of your personal assets at risk. That may not bother you in the first place if you are dirt poor and have nothing to lose. However, a tenacious and vindictive litigant can pursue you to the ends of the earth to your dying day. Even after you lose everything you own, he can garnish your wages.

 

In the event that you pass away, as a sole proprietorship your business dies with you. That can be a problem for your family if they want to sell the business.

 

It is also more difficult for a sole proprietorship to obtain a business loan than operating your business using a more formal business structure, such as an LLC.

 

General Partnership.

 

At the very least, when forming a partnership, you should have a written partnership agreement. Never form a partnership on a handshake even when the partner is a friend or a family member. 

 

A partnership agreement is a contract between you and your business partners. The value of a partnership agreement is that it avoids possible disputes. When it comes to money, disputes are common. What’s more, as the saying goes, there is no such thing as friends when it comes to money.

 

Some areas that a detailed written agreement should include are:

 

• The nature of your business.

• Capital contributions of each partner.

• Distribution of profits and losses.

• How members withdraw from the partnership.

• Dissolution of the partnership.

 

A lawyer can help you structure an agreement and address all of the possible pitfalls that you can encounter when going into business with someone else. The fact is that partnerships rarely work for a variety of reasons.

 

A better alternative to a general partnership is a multi-member LLC. This business structure not only delivers all of the benefits of a formal general partnership agreement, but it also provides personal asset protection and flexibility in how your company is taxed.

 

Limited Liability Company (LLC).

 

Among small businesses, an LLC is the most popular business entity. Not only does it protect your personal assets, it also provides tax benefits, such as pass-through taxation. When profits pass directly through to the owners, the owners, not the business, are taxed. By comparison, businesses which are set up as C-corporations are taxed twice. First, the profits that the company makes are taxed. Then anything paid to the members is taxed again. Of course, an LLC can choose to be taxed as a C-corporation, which makes no sense for most businesses.

 

Tax Benefits of an LLC.

 

You can realize tax benefits as the sole member of an LLC, if you select to be taxed as an S-Corp. Here’s how. If your shop makes a profit of $100,000, you can pay yourself half as wages and half as dividends. If all of the profits are passed through to your personal tax statement, the normal self-employment tax is about $15,000. The self-employment tax of 15.3% covers 12.4% for Social Security and 2.9% for Medicare. You must also pay federal and state income tax.

 

On the other hand, as an S-Corp, if you pay yourself a reasonable salary of $50,000, you can reduce the self-employment tax by 50%. If this sounds like bookkeeping finagling, keep in mind that the IRS is more likely to audit you when filing as an S-Corp. For this reason, you should consult a lawyer or a CPA when selecting how your LLC should be taxed.  If the IRS deems that $50,000 is not a reasonable salary and some of what you paid yourself as dividends should be reclassified as wages, you could face tax penalties.

 

LLCs with multiple shareholders are not that different from a single owner LLC.  When an owner of an LLC filing as an S-Corp performs tasks within the business, he must be treated as an employee. He must receive reasonable compensation for his work. In addition to payroll deductions for Social Security and Medicare, federal and state taxes must also be withheld. With respect to other employees, the owner must contribute half of their employment taxes and all of his own. In part tax savings are realized from the money paid to shareholders, which is not subject to employment taxes. Another tax benefit is that unlike a C-Corp, LLCs and S-Corps do not incur corporate taxes, because they are pass-through entities.

 

Single Member LLC. If you are a one-man shop, set up as an LLC, you can segregate business finances from personal finances. This permits you to write off business-related expenses, such as office supplies and travel and entertainment costs.

 

For tax purposes, you may need to file any number of tax forms that were not required when filing as a sole proprietor. This can be complicated. For this reason, consult your CPA or tax professional.

 

What is a Reasonable Salary?

Taxed as an S-Corp, you must pay yourself a “reasonable salary” commensurate with the salary that you would pay someone to do your job.

 

If the IRS scrutinizes your tax return and deems that you are not paying yourself a reasonable salary, you can be subject to additional tax and penalties. What’s more, you could lose your S-Corp tax filing status.

 

Generally, if your excess earnings exceed $10,000 to $15,000 after paying yourself a reasonable salary, then electing S-Corp tax status probably makes sense. Keep in mind that you can always change your filing status on the future tax returns.

 

S-Corp status makes sense if you plan to take the excess earnings as a distribution. On the other hand, if you plan to reinvest these earnings at a later date, you might be better off selecting the C-Corp tax status.

 

Disadvantages of S-Corps.

 

To run payroll, you will need a bookkeeper. That cost may be significantly higher than any tax savings you may realize.

 

Choosing a Tax Classification. As an LLC you have the choice of tax classification. These choices are default, S-Corp and C-Corp. The default tax strategy is pass-through taxation.  If you are the sole member in an LLC, you are taxed as sole proprietor. When an LLC has multiple members, your business is taxed as a partnership. That means that profits are distributed among the members and subject to employment taxes.

 

An S-Corp is a little more complicated. Members can receive a salary and receive distribution of profits. If you choose this tax classification, your accounting will be more complicated and you will probably need professional assistance in accounting and tax preparation. As a word of caution, the IRS more thoroughly scrutinizes tax returns for S-Corps compared to tax classifications as sole proprietorships and partnerships.

 

Articles of Organization.

 

One of the usual requirements is submission of “articles of organization”, also known as the certificate of formation. The Articles of Organization provide a basic overview of the LLC that you are forming. This information includes the name and address of the business, the name and address of your registered agent, the purpose of your business and its management structure. This process also requires a filing fee, which may cost as much as $200.

 

Your Operating Agreement.

 

In registering your business, you should have an operating agreement, whether your state requires it or not, and whether the company is a single-member LLC or a partnership LLC. This agreement describes the rules under which your business will be run.

 

An operating agreement is a contract that governs the economic relationship among members. It describes the operation of the LLC, such as who makes decisions, the rights and responsibilities of members, resolution of disputes, distribution of profits and admission of new members. Without an operating agreement, the state’s default rules serve as a guideline for the LLC. The agreement prevents litigation in the event of disputes.

 

As a foundation, the operating agreement allows the members to indicate the initial investment each made and stipulate the percentage of ownership. It also specifies the tax classification for the LLC. Members can decide whether the LLC should be taxed as a sole proprietorship, partnership, S-Corporation or C-Corporation. The agreement also allows members to stipulate how to handle the community property interests of spouses, if you are in a community property state.

 

While your state may not require an operating agreement when filing for an LLC, you may need one when applying for a bank loan. An operating agreement also is helpful in court when investigating liability. In other words, the court may decide whether to assign liability to either the LLC liable or to the members.

 

If a single-member LLC decides that it is not to be treated as a corporation for tax purposes, it falls into the classification of a “disregarded entity.” In this classification, the business is considered to be separate from its owner for any liability. However, for tax purposes, profits pass through the business to the owner.  The owner pays income tax on the company profits on his or her personal income tax return.

 

In many cases, if your single-member LLC is classified as a disregarded entity, you can simply use your social security number on your federal tax return. However, if you have employees, you will need an Employer Identification Number (EIN). You are generally better off getting an EIN.

 

Other than California, Delaware, Maine, Missouri, Nebraska and New York, you are not required to adopt an operating agreement. What’s more, no state requires that you file one with the Secretary of State, where the LLC was formed. Nevertheless, you should create an operating agreement for your business, even if your company is a single-member LLC. Here’s why you need one:

 

• An operating agreement establishes guidelines for resolving any legal disputes that may arise. Without one, the LLC must follow your state’s default rules.

 

• Banks and other lenders may request an operating agreement when you open a business bank account or apply for a loan. The operating agreement ensures the lender that the person acting on behalf of your company has that authority.

 

• If your business is a single-member LLC, an operating agreement helps safeguard your company’s limited liability standing.

 

What an Operating Agreement Entails. In structuring an operating agreement, include the following components:

 

• Basic company information: Business name, location, purpose, duration of the LLC;

 

• Names of the members (owners);

 

• Explanation of how members are compensated (salaries and distribution of profits);

 

• Voting rights of the members;

 

• Contact information for your registered agent. When you start an LLC or corporation, you must designate a registered agent (also known as a resident agent or statuary agent). The registered agent is authorized to represent your company. He or she is your point person, who receives government notices, documents and other correspondence.  Your operating agreement must list the agent’s physical street address and other contact information. The registered agent must also be available during normal business hours; 

 

• Designate whether your LLC is member-managed or manager-managed. The difference is that in a member-managed LLC, the members or owners run the day-to-day operations. In manager-managed LLCs, the members hire managers to run the company.

 

• Define the responsibilities of the members and managers;

 

• Indicate how the LLC elects to be taxed;

 

• Procedure for adding and removing members; and

 

• Explain the process for dissolving the LLC.

 

The members should sign the operating agreement and stored it with your other business documents. Each member should receive a copy.

 

Employer Identification Number.

 

If you have employees or your business is organized as a partnership, LLC or corporation, you will need an Employer Identification Number (EIN), also known as a federal tax ID number.

 

Every formal business structure must apply for an EIN from the IRS, after (not before) your business is legally formed. You also must apply for an EIN if you hire an employee even as a sole propitiator or partnership or private individual. The application process is simple. While you can apply by mail using the IRS Form SS-4, it is much simpler to apply on-line.

 

The EIN is the equivalent of a social security number for your company. You will need an EIN to file your state and federal tax returns, apply for business licenses, open a business bank account, hire employees or withhold employment taxes.

 

Employment Taxes. As an employer you must withhold federal and state income taxes from the wages of your employees. You must also withhold Social Security and Medicare taxes. Employees pay half of the FICA taxes and as an employer you must contribute half of their taxes. That amount to 6.2% for Social Security and 1.45% for Medicare of your employees’ wages. What’s more, you must also pay for Federal Unemployment tax out of your company funds, not from your employees’ wages.

 

Choosing a Registered Agent.

 

When you file for an LLC or form a corporation, you will generally be required to designate one person as a “Registered Agent” also known as a statutory agent. This is the person assigned to receive time-sensitive legal documents, such as subpoenas, lawsuits or tax notices, for your business. The registered agent then forwards the documents to the appropriate person within your company. The person assigned must have a physical address. The registered agent can be a member of the LLC or you can hire a service.

 

Not having a registered agent can result in serious legal problems. If a process server cannot contact your registered agent, the court can continue with the case and rule against your company without you even being aware. Failure to maintain a registered agent can result in the state fining your company and even in dissolution of your LLC or corporation. When this happens, you could lose the liability protection that your LLC or corporation provides and you put your personal assets at risk.  

 

Do You Need a DBA?

 

The DBA (doing business as) permits a company to operate using a name or brand which is different from the legal name of the business. You should contact the business services division of your Secretary of State’s office to learn what is required in your state. How and where you file can vary depending on your company’s business structure. Generally, the DBA requirement is satisfied as part of an LLC application.

 

A DBA does not provide you with any legal protection for your business names or brands as a trademark would. A DBA is also no substitute for an LLC and does not protect your personal assets. It is simply a state legal requirement.

 

The Corporate Veil.

 

A key reason to form an LLC or corporation is to provide yourself a “corporate veil” which protects your personal assets, such as your home, cars and savings. The corporate veil, however, is not bulletproof if creditors or plaintiffs have sufficient grounds to pierce the veil. These grounds include fraud, insufficient funding, inadequate insurance coverage or failure to follow corporate formalities. Plaintiffs can also appeal to the court’s sense of fairness in lieu of other grounds. The protection of the corporate veil varies from state to state.

 

Preserving the Corporate Veil Protection. Just as C-Corps and S-Corps have corporate veil protection so do LLCs if you follow the necessary procedures. This veil must be maintained or you lose its protection. To prevent this from happening you should take the following steps:

 

• Create and maintain an operating agreement, resolutions, bylaws and annual owner’s meeting minutes and membership certificates.

 

• Make sure that the company owns all of the equipment, tools, vehicles and supplies used at your business.

 

• Keep all funds for the LLC separate from the personal funds of the members. In addition, open a bank account for the LLC and apply for a business credit card. In setting these up, you should use your EIN number not your social security number.

 

• When you buy anything, sign contracts or write company documents make sure that you do it in the company’s name not your name. Make sure you establish your LLC before you purchase any business assets. This can help avoid any issues when transferring title of property under your name to the LLC. As a condition of your mortgage, you may be required to pay off the mortgage before title transfer.

 

• Publicize the existence of your LLC on your website, social media, news releases and marketing literature. 

 

Business Insurance.

 

An LLC helps protect your personal assets. It does not, however, protect the assets that the business owns. In most cases, liability insurance is the most important coverage that your business needs. It covers your company for any claims against your company. You should also consider investing in commercial property insurance, a policy for company vehicles and business interruption insurance. Of course, you will also need worker’s compensation insurance to comply with your state’s requirements.

 

A commercial umbrella insurance policy protects your business for any claims that are beyond the coverage of your other policies. It is not a substitute for your regular insurance policies.

Melissa Cox of Snyder Insurance Agency Inc. in Michigan City, Indiana advises that you should sit down with an insurance professional ensuring that the policy is written correctly based on the business entity type you choose. With a sole proprietorship operating with a DBA, the insurance policy should name both you as the owner and the business name.  Consider your liability limit carefully. If your business is sued for more than your insurance limit, it will be paid out of business assets. In the case of a sole-proprietorship or partnership, it will come out of the owners' pockets.

 

Cox also says that if you will have employees, it's also a good idea to talk to an agent about how worker's compensation will be handled. Worker’s Comp is different for an LLC and Corporation than it is for a sole proprietorship. The Owners may or may not be covered and could be subject to a minimum payroll rating, directly affecting the premium.

 

Selecting S-Corp Tax Classification.

 

An S-Corp is a tax classification you can select if your business structure is an LLC. It is not a formal business entity like LLCs and C-Corporations. If you decide to classify your business as an S-Corp, be prepared to do more paperwork.

 

When you elect the S-Corp tax classification, you can realize significant savings on your taxes. As a member of an LLC you are not an employee of your company. You are an owner. As an owner you can pay yourself a salary as an employee and receive a distribution of profits. Each type of payment is taxed differently.

 

By comparison, if you elect to be taxed as either a sole proprietorship or as a partnership, all earnings pass through to the members. All of these earnings are subject to employment tax and federal and state income taxes.

 

Certain restrictions apply to S-Corps. These include:

• Having fewer than 100 employees.

• Owners must be U.S. citizens or legal residents.

• Individual members must not include LLCs or Corporations.

• S-Corps can only issue one class of stock.

 

Protecting LLC Assets in a Revocable Living Trust.

 

Putting all of the assets of your LLC into a revocable trust has many benefits. To protect your company’s assets for your beneficiaries, a revocable living trust can have either sole or partial ownership of your LLC. A revocable trust is a living trust which allows the person who formed it to change or revoke it at any time. 

 

One advantage of having a revocable living trust own all of the LLC membership assets is to name a successor trustee to administer the affairs of your company in event you become incapacitated.

 

In the event that you would pass away, the company assets would be held in trust, which would avoid probate. The assets can be either distributed at the time of death of the owner or the administrator can continue to manage the business.

 

To avoid any confusion, your trust document should include all of the details covering the management of the business. In the case of dissolution of the business, an estate distribution plan will ensure that the assets of the trust are divided among your beneficiaries in the way you want. This also protects the estate against claims of creditors and ex-wives.

 

Putting your LLC into a revocable living trust is a conversation that you should have with your attorney at the time you discuss the topic of business structures. 

 

Forming a Corporation.

 

The requirements for forming a corporation are governed by the rules in the state where the business is formed. Generally, you should incorporate in the state where your company operates. You may have heard that some businesses incorporate in Delaware and Nevada because their laws are more business-friendly. While this is true, you must also register your company as a foreign corporation and pay taxes in the state where it is physically located and operating. In addition, you also must pay taxes in Delaware or Nevada. 

 

Forming a corporation makes sense if your company has more than 100 employees and generates significant sales and profits.  The C-Corporation establishes a business as a separate legal entity. In other words, the company exists independently or separately from its owners or shareholders.

 

For a larger corporation, this business structure has advantages. The biggest advantage is limited liability. Another advantage is stability. Because a corporation is a separate legal entity, if one of the owners dies, the business continues. A sole proprietorship or partnership frequently dies when an owner dies.

 

For a smaller company, forming a corporation requires time-consuming paperwork and more expense. Double taxation is another disadvantage. Because a corporation is not a viable business structure for most small companies, this article will not devote much time to it.

 

Articles of Incorporation.

 

One of the first tasks required in forming a corporation is to write Articles of Incorporation. These are similar to Articles of Organization required for LLCs. The requirements will vary from state to state. You will need to inquire about these requirements at the Secretary of State’s office for your state. Generally, they will have forms and guidelines covering the preparation of these articles.

 

The Articles of Incorporation provide the basic information and outline for the business including company name and location; names of the members on the board of directors and the numbers of shares which can be issued.

 

Corporate Bylaws.

 

While the Articles of Incorporation provide a basic outline of the business, the Corporate Bylaws get into the specific rules governing the organization. These specifics might outline the company mission and objectives; responsibilities of each of the board members; how meetings are conducted; how the board of directors are elected and how they in-turn select corporate officers.

 

While you can write your own Articles of Incorporation and Corporate Bylaws the easiest way to prepare these is to consult with your attorney.

 

Conclusion.

 

For most companies, forming your company as an LLC is your best option. Whatever choice you make, make sure to take the following steps:

 

• Do your homework. Read as much as you can about the advantages and disadvantages of the various business structures.

 

• As part of your research, contact your Secretary of State’s office. Find out the regulations, forms and procedures necessary to form a business in your state.

 

 

• Discuss the different business structure options with your attorney and  CPA or tax professional.

 

• Do all of your planning before you open for business. Remember that proper prior planning prevents poor performance.

 

 

About Jim Hingst: Sign business authority on vehicle wraps, vinyl graphics, screen printing, marketing, sales, gold leaf, woodcarving and painting. 

After fourteen years as Business Development Manager at RTape, Jim Hingst retired. He was involved in many facets of the company’s business, including marketing, sales, product development and technical service.

Hingst began his career 42 years ago in the graphic arts field creating and producing advertising and promotional materials for a large test equipment manufacturer.  Working for offset printers, large format screen printers, vinyl film manufacturers, and application tape companies, his experience included estimating, production planning, purchasing and production art, as well as sales and marketing. In his capacity as a salesman, Hingst was recognized with numerous sales achievement awards.

Drawing on his experience in production and as graphics installation subcontractor, Hingst provided the industry with practical advice, publishing more than 190 articles for  publications, such as  Signs Canada, SignCraft,  Signs of the Times, Screen Printing, Sign and Digital Graphics and  Sign Builder Illustrated. He also posted more than 500 stories on his blog (hingstssignpost.blogspot.com). In 2007 Hingst’s book, Vinyl Sign Techniques, was published.  Vinyl Sign Techniques is available at sign supply distributors and at Amazon. 

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