Introduction

When you start a business, you must decide on a legal structure for it. Usually you’ll choose either a sole proprietorship, a partnership, a limited liability company (LLC), or a corporation. There’s no right or wrong choice that fits everyone. Your job is to understand how each legal structure works and then pick the one that best meets your needs.

The best choice isn’t always obvious. After reading this chapter, you may decide to seek some guidance from a lawyer or an accountant.

For many small businesses, the best initial choice is either a sole proprietorship or—if more than one owner is involved—a partnership. Either of these structures makes especially good sense in a business where personal liability isn’t a big worry—for example, a small service business in which you are unlikely to be sued and for which you won’t be borrowing much money. Sole proprietorships and partnerships are relatively simple and inexpensive to establish and maintain.

Forming an LLC or a corporation is more complicated and costly, but it’s worth it for some small businesses. The main feature of LLCs and corporations that is attractive to small businesses is the limit they provide on their owners’ personal liability for business debts and court judgments against the business. Another factor might be income taxes: You can set up an LLC or a corporation in a way that lets you enjoy more favorable tax rates. In certain circumstances, your business may be able to stash away earnings at a relatively low tax rate. In addition, an LLC or corporation may be able to provide a range of fringe benefits to employees (including the owners) and deduct the cost as a business expense.

Given the choice between creating an LLC or a corporation, many small business owners will be better off going the LLC route. For one thing, if your business will have several owners, the LLC can be more flexible than a corporation in the way you can parcel out profits and management duties. Also, setting up and maintaining an LLC can be a bit less complicated and expensive than a corporation. But there may be times a corporation will be more beneficial. For example, because a corporation—unlike other types of business entities—issues stock certificates to its owners, a corporation can be an ideal vehicle if you want to bring in outside investors or reward loyal employees with stock options.

Keep in mind that your initial choice of a business form doesn’t have to be permanent. You can start out as sole proprietorship or partnership and, later, if your business grows or the risks of personal liability increase, you can convert your business to an LLC or a corporation.

Cross Reference: For some small business owners, a less common type of business structure may be appropriate. While most small businesses will find at least one good choice among the four basic business formats described above, a handful will have special situations in which a different format is required or at least is desirable. For example, a pair of dentists looking to limit their personal liability may need to set up a professional corporation or a professional limited liability company. A group of real estate investors may find that a limited partnership is the best vehicle for them. These and other special types of business organizations are summarized at the end of this chapter.

See An Expert: You may need professional advice in choosing the best entity for your business. This chapter gives you a great deal of information to assist you in deciding how to best organize your business. Obviously, however, it’s impossible to cover every relevant nuance of tax and business law—especially if your business has several owners with different and complex tax situations. And for businesses owned by several people who have different personal tax situations, sorting out the effects of “pass-through” taxation (where partners and most LLC members are taxed on their personal tax returns for their share of business profits and losses) is no picnic, even for seasoned tax pros. The bottom line is that unless your business will start small and have a very simple ownership structure, before you make your final decision on a business entity, check with a tax advisor after learning about the basic attributes of each type of business structure (from this chapter and Chapters 2, 3, and 4).

Sole Proprietorships

The simplest form of business entity is the sole proprietorship. If you choose this legal structure, then legally speaking you and the business are the same. You can continue operating as a sole proprietor as long as you’re the only owner of the business.

Establishing a sole proprietorship is cheap and relatively uncomplicated. While you do not have to file articles of incorporation or organization (as you would with a corporation or an LLC), you may have to obtain a business license to do business under state laws or local ordinances. States differ on the amount of licensing required. In California, for example, almost all businesses need a business license, which is available to anyone for a small fee. In other states, business licenses are the exception rather than the rule. But most states do require a sales tax license or permit for all retail businesses. Dealing with these routine licensing requirements generally involves little time or expense. However, many specialized businesses—such as an asbestos removal service or a restaurant that serves liquor—require additional licenses, which may be harder to qualify for. (See Chapter 7 for more on this subject.)

In addition, if you’re going to conduct your business under a trade name such as Smith Furniture Store rather than John Smith, you’ll have to file an assumed name or fictitious name certificate at a local or state public office. This is so people who deal with your business will know who the real owner is. (See Chapter 6 for more on business names.)

From an income tax standpoint, a sole proprietorship and its owner are treated as a single entity. Business income and business losses are reported on your own federal tax return (Form 1040, Schedule C). If you have a business loss, you may be able to use it to offset income that you receive from other sources. (For more tax basics, see Chapter 8.)

Form: Legal Forms for Starting & Running a Small Business by Fred S. Steingold (Nolo) contains a checklist for starting a sole proprietorship.

Personal Liability

A potential disadvantage of doing business as a sole proprietor is that you have unlimited personal liability on all business debts and court judgments related to your business.

EXAMPLE 1:

Lester is the sole proprietor of a small manufacturing business. Believing that his business’s prospects look good, he orders $50,000 worth of supplies and uses them up. Unfortunately, there’s a sudden drop in demand for his products, and Lester can’t sell the items he’s produced. When the company that sold Lester the supplies demands payment, he can’t pay the bill.

As sole proprietor, Lester is personally liable for this business obligation. This means that the creditor can sue him and go after not only Lester’s business assets, but his other property as well. This can include his house, his car, and his personal bank account.

EXAMPLE 2:

Shirley is the sole proprietor of a flower shop. One day Roger, one of Shirley’s employees, is delivering flowers using a truck owned by the business. Roger strikes and seriously injures a pedestrian. The injured pedestrian sues Roger, claiming that he drove carelessly and caused the accident. The lawsuit names Shirley as a codefendant. After a trial, the jury returns a large verdict against Roger—and Shirley as owner of the business. Shirley is personally liable to the injured pedestrian. This means the pedestrian can go after all of Shirley’s assets, business and personal.

One of the major reasons to form a corporation or a limited liability company (LLC) is that, in theory at least, you’ll avoid most personal liability. (But see Chapter 12 for a discussion of how a good liability insurance policy may be enough to protect a sole proprietor from personal liability if someone is accidentally injured.)

Income Taxes

As a sole proprietor, you and your business are one entity for income tax purposes. The profits of your business are taxed to you in the year that the business makes them, whether or not you remove the money from the business. This is called “flow-through” taxation, because the profits “flow through” to the owner’s income tax return. You report business profits on Schedule C of Form 1040.

By contrast, if you form an LLC or a corporation, you have a choice of two different types of tax treatment.

• Flow-Through Taxation. One choice is to have the IRS tax your LLC or corporation like a sole proprietorship or partnership (discussed above). The owners report their share of LLC or corporate profits on their own tax returns, whether or not the money has been distributed to them.
• Entity Taxation. The other choice is to make the business a separate entity for income tax purposes. If you form an LLC and make that choice, the LLC will pay its own taxes on the profits of the LLC. And as a member of the LLC, you won’t pay tax on the money earned by the LLC until you receive payments as compensation for services or as dividends. Similarly, if you form a corporation and choose this option, you as a shareholder won’t pay tax on the money earned by the corporation until you receive payments as compensation for services or as dividends. The corporation will pay its own taxes on the corporate profits.

Later in this chapter, I’ll explain the mechanics of choosing between these two methods. For now, just be aware that this tax flexibility of LLCs and corporations offers some tax advantages over a sole proprietorship if you’re able to leave some income in the business as “retained earnings.” For example, suppose you want to build up a reserve to buy new equipment or your small label-manufacturing company accumulates valuable inventory as it expands. In either case, you might want to leave $50,000 of profits or assets in the business at the end of the year. If you operated as a sole proprietor, those “retained” profits would be taxed on your personal income tax return at your marginal tax rate. But with an LLC or corporation that’s taxed as a separate entity, the tax rate will almost certainly be lower.

Tip: You can share ownership of your business with your spouse and still maintain its status as a sole proprietorship. If you choose to do this, in the eyes of the IRS you’ll be co-sole proprietors. You can either split the profits from your business if you and your spouse file separate returns (and separate Schedule Cs), or you can put them on your joint Schedule C if you file a joint return. Only a spouse can be a co-sole proprietor. If any other family member shares ownership with you, the business must be organized as a partnership, corporation, or limited liability company.

Fringe Benefits

If you operate your business as a sole proprietorship, tax-sheltered retirement programs are available. A Keogh plan, for example, allows a sole proprietor to salt away a substantial amount of income free of current taxes. So does a one-person 401(k). You can’t really do any better by setting up an LLC or a corporation.

A "C corporation" or an LLC that chooses to be taxed as a separate entity does have an advantage when it comes to medical expenses for the owner and his or her spouse and dependents. As a sole proprietor, you are limited as to how much you can deduct for medical expenses on your personal tax return: You can deduct only the amount that exceeds 7.5% of your adjusted gross income for the year. If you form an LLC or a corporation, however, and choose to have it taxed as a separate entity, you can have your business pay all of your family’s medical expenses (so long as they’re not covered by insurance) and then take these amounts as a business deduction. You won’t be personally taxed for the value of this employment benefit.

In the past, sole proprietors could deduct only a portion of health insurance premiums for themselves and family members, while LLCs and corporations (if separate taxable entities) could deduct 100%. That sometimes provided a reason to form an LLC or corporation, but no longer. A self-employed person can now deduct 100% of those premiums.

Still, if you form an LLC or a corporation and choose to have it taxed as a separate entity, you can acquire an additional benefit that may be helpful. The first step is for the business to hire you as an employee. Then, the business can pay not only 100% of your family’s health insurance premiums, but can also pay for any medical expenses not covered by insurance. It can take all of these payments as a business deduction; you won’t be personally taxed for the value of this employment benefit.

Resource: To learn about how a person qualifies for Social Security benefits, see Social Security, Medicare & Government Pensions, by Joseph Matthews with Dorothy Matthews Berman (Nolo).

Routine Business Expenses

As a sole proprietor, you can deduct day-to-day business expenses the same way an LLC, corporation, or partnership can. Whether it’s car expenses, meals, travel, or entertainment, the same rules apply to all of these types of business entities.

You’ll need to keep accurate books for your business that are clearly separate from your records of personal expenditures. The IRS has strict rules for tax-deductible business expenses (covered in Chapter 8), and you need to be able to document those expenses if challenged. One good approach is to keep separate checkbooks for your business and personal expenses—and pay for all of your business expenses out of the business checking account.

But whatever your system, please pay attention to this basic advice: It’s simple to keep track of business income and expenses if you keep them separate from the start—and murder if you don’t.

Partnerships

If two or more people are going to own and operate your business, you must choose between establishing a partnership, a corporation, or a limited liability company (LLC). This section looks at the general partnership, which is the type of partnership that most small businesses will be considering. The limited partnership is described toward the end of this chapter.

The best way to form a partnership is to draw up and sign a partnership agreement (discussed fully in Chapter 2). Legally, you can have a partnership without a written agreement, in which case you’d be governed entirely by either the Uniform Partnership Act or the Revised Uniform Partnership Act (explained in Chapter 2).

Beyond a written agreement, the paperwork for setting up a partnership is minimal—about on a par with a sole proprietorship. You may have to file a partnership certificate with a public office to register your partnership name, and you may have to obtain a business license or two. The income tax paperwork for a partnership is marginally more complex than that for a sole proprietorship.

Personal Liability

As a partner in a general partnership, you face personal liability similar to that of the owner of a sole proprietorship. Your personal assets are at risk in addition to all assets of the partnership. In other words, you have unlimited personal liability on all business debts and court judgments related to your business.

In a partnership, any partner can take actions that legally bind the partnership entity. That means, for example, that if one partner signs a contract on behalf of the partnership, it will be fully enforceable against the partnership and each individual partner, even if the other partners weren’t consulted in advance and didn’t approve the contract. Also, the partnership is liable, as is each individual partner, for injuries caused by any partner while on partnership business.

EXAMPLE 1:

Ted, a partner in Argon Associates, signs a contract on behalf of the partnership that obligates the partnership to pay $50,000 for certain goods and services. Esther and Helen, the other partners, think Ted made a terrible deal. Nevertheless, Argon Associates is bound by Ted’s contract even though Esther and Helen didn’t sign it.

EXAMPLE 2:

Juan is a partner in Universal Contractors. Elroy, one of his partners, causes an accident while using a partnership vehicle. Juan and all the other partners will be financially liable to people injured in the accident if the car isn’t covered by adequate insurance. The same would be true if Elroy used his own car while on partnership business.

In both of these situations, the personal assets (home, car, and bank accounts) of each partner will be at stake, in addition to partnership assets. But remember that a partnership can protect against many risks by carrying adequate liability insurance.

Partners’ Rights and Responsibilities

Each partner is entitled to full information—financial and otherwise—about the affairs of the partnership. Also, the partners have a "fiduciary" relationship to one another. This means that each partner owes the others the highest legal duty of good faith, loyalty, and fairness in everything having to do with the partnership.

EXAMPLE:

Wheels & Deals, a partnership, is in the business of selling used cars. No partner is free to open a competing used-car business without the consent of the other partners. This would be an obvious conflict of interest and, as such, would violate the fiduciary duty the partners legally owe to one another.

Unless agreed otherwise, a person can’t become a new partner without the consent of all the other partners. However, in larger partnerships, it’s common for partners to provide in the partnership agreement that new partners can be admitted with the consent of a certain percentage of the existing partners—75%, for example.

State laws regulating partnerships dictate what occurs if one partner leaves your partnership and you don’t have a partnership agreement that provides for what happens. In about half the states, the partnership is automatically dissolved when a partner withdraws or dies; the business is then liquidated. In such a state, it’s an excellent idea to put a provision in your partnership agreement that allows the business to continue without interruption, despite the technical dissolution of the partnership. A partnership agreement, for instance, may contain a provision that calls for a buyout if one of the partners dies or wants to leave the partnership, avoiding a forced liquidation of the business. (Traditionally, these are known as "buy-sell" agreements, but now we generally refer to them as "buyout agreements.")

EXAMPLE:

Tom, Dick, and Mary are equal partners. They agree in writing that if one of them dies, the other two will buy the deceased partner’s interest in the partnership for $50,000 so that the business will continue. (Be aware that often a partnership agreement doesn’t fix a precise amount as the buyout price but uses a more complicated formula based on such data as yearly sales, profits, or book value.) To fund this arrangement, the partnership buys life insurance covering each partner in an amount large enough to cover the buyout. If Tom dies first, under the terms of the agreement, his wife and children will receive $50,000 from the partnership to compensate them for the value of Tom’s ownership interest in the business. Technically, the remaining partners would operate as a new partnership, but the important point is that the business would keep functioning.

Other states—generally those that have adopted the revised version of the Uniform Partnership Act—follow a slightly different rule. In those states, if your partnership was created to last for a fixed length of time or was created for a specific project, and a partner leaves before the fixed time expires or the project is done, the partnership isn’t automatically dissolved. Instead, the remaining partners have the opportunity to continue the existing partnership rather than having to form a new one. But even if your state follows this more flexible approach, you’ll still want to use buyout provisions to specify how the departing partner—or the family of a partner who’s died—gets compensated for his partnership interest.

Cross Reference: Chapter 5 discusses buyout provisions in greater detail.

Income Taxes

In terms of income and losses, the tax picture for a partnership is basically the same as that of a sole proprietorship. A partnership doesn’t pay income taxes. It must, however, file an informational return that tells the government how much money the partnership earned or lost during the tax year and how much profit (or loss) belongs to each partner. Each partner uses Schedule E of Form 1040 to report the business profits (or losses) allocated to him or her and then pays income tax on this share, whether or not this income was actually distributed during the tax year. If the partnership loses money, each partner can deduct his or her share of losses for that year from income earned from other sources (subject to some fairly complicated tax basis rules—see "Investment Partnerships," below).

Fringe Benefits and Business Expenses

When it comes to retained earnings, tax-sheltered retirement plans, and fringe benefits, a partnership is like a sole proprietorship, and the discussion about fringe benefits, above, applies to partnerships as well.

Likewise, business expenses can be deducted in the same way for a partnership as for a sole proprietorship; the discussion about business expenses, above, applies here as well.

Caution: Put it in writing. If you go the partnership route, I strongly recommend that the partners sign a written partnership agreement, even though an oral partnership agreement is legal. The human memory is far too fallible to rely on for the details of important business decisions. Chapter 2 contains basic information on how to write a partnership agreement

Corporations

If you’re concerned about limiting your personal liability for business debts, you’ll want to consider organizing your business as either a limited liability company (LLC) or a corporation. (Of course, you may have other reasons in addition to limited liability for considering these two business structures.) Because the corporation has a longer legal history, I’ll deal with it first, but the LLC—covered next—may well be preferable for your particular business, despite its relative newness.

This book deals primarily with the small, privately owned corporation. I’ll assume that all of the corporate stock is owned by one person or a few people, and that all shareholders are actively involved in the management of the business—with the possible exception of friends and relatives who have provided seed money in exchange for stock. Because there are many complexities involved in selling stock to the public, I don’t discuss public corporations.

The most important feature of a corporation is that, legally, it’s a separate entity from the individuals who own or operate it. You may own all the stock of your corporation, and you may be its only employee, but—if you follow sensible organizational and operating procedures—you and your corporation are separate legal entities.

All states have adopted legislation that permits a corporation to be formed by a single incorporator. All states permit a corporate board that has a single director, although the ability to set up a one-person board may depend on the number of shareholders. (See Chapter 3 for more details.) In addition, many states have streamlined the procedures for operating a small corporation, to permit decisions to be made quickly and without needless formalities. For example, in most states, shareholders and directors can take action by unanimous written consent rather than by holding formal meetings, and directors’ meetings can be held by telephone.

Limited Personal Liability

One of the main advantages of incorporating is that, in most circumstances, it limits your personal liability. If a court judgment is entered against the corporation, you stand to lose only the money that you’ve invested. Generally, as long as you’ve acted in your corporate capacity (as an employee, officer, or director) and without the intent to defraud creditors, your home and personal bank accounts and other valuable property can’t be touched by a creditor who has won a lawsuit against the corporation.

EXAMPLE:

Andrea is the sole shareholder, director, and officer of Market Basket Corporation, which runs a food store. Ronald, a Market Basket employee, drops a case of canned food on a customer’s foot. The customer sues and wins a judgment against the business. Only corporate assets are available to pay the damages. Andrea is not personally liable.

Caution: Liability for your own acts. If Andrea herself had dropped the case of cans, the fact that she is a shareholder, officer, and director of the corporation wouldn’t protect her from personal liability. She would still be personally liable for the wrongs (called torts, in legal lingo) that she commits. So much for theory. In practice, incorporating may not actually give you broad legal protection.

In the real world, banks and some major corporate creditors often require the personal guarantee of individuals within the corporation. So the limited liability gained from incorporating isn’t always as valuable a legal shield as it first seems.

EXAMPLE:

Market Basket Corporation borrows $75,000 from a bank. Andrea signs the promissory note as president of the corporation, but the bank also requires her to guarantee the note personally. The corporation runs into financial difficulties and can’t repay the debt. The bank sues and wins a judgment against the business for the unpaid principal plus interest. In collecting on the judgment, the bank can go after Andrea’s assets as well as the corporation’s property. Incorporation offers no advantage over a sole proprietorship when an owner personally guarantees a loan.

As mentioned above, liability insurance can protect against many of the risks of doing business. Because of this, many businesses can structure themselves as sole proprietorships or partnerships without worrying about unlimited personal liability. But if you operate a high-risk business—child care center, chemical supply house, asbestos removal service, or college town bar—and you can’t get (or can’t afford) liability insurance for some risks that you’re concerned about, incorporation may be the wisest choice.

EXAMPLE:

Loren is afraid that a clerk at his After Hours beverage store might inadvertently sell liquor to an underaged customer or one who has had too much to drink. If that customer got drunk and hurt someone in a car accident, there might be a lawsuit against the business.

Loren contacts his insurance agent to arrange for coverage, but learns that his liquor store can afford only $50,000 worth of liability insurance. Loren buys the $50,000 worth of insurance, but also forms a corporation—After Hours, Inc.—to run the business. Now if an injured person wins a large verdict, at least Loren won’t be personally liable for the portion not covered by his insurance.

The lesson of these examples is clear: Before you decide to incorporate your business primarily to limit your personal liability, analyze what your exposure will be if you simply do business as a sole proprietor (or a partner in a partnership).

The limited liability feature of corporations can be valuable, protecting you from personal liability for:

• Debts that you haven’t personally guaranteed, including most routine bills for supplies and small items of equipment.
• Injuries suffered by people who are injured by business activities not covered adequately by insurance.

Also, for a business with more than one owner, incorporating can offer a great deal of protection from the misdeeds or bad judgment of your co-owners. In contrast, in a partnership, as noted above, each partner is personally liable for the business-related activities of the other partners.

EXAMPLE:

Ted, Mona, and Maureen are partners in Mercury Enterprises. Mona writes a nasty letter about Harold, a former employee, which causes Harold to lose the chance of a good new job. Harold sues for defamation and wins a $60,000 judgment against the partnership. Ted and Maureen are each personally liable to pay the judgment even though Mona wrote the letter.

If Mercury Enterprises had been a corporation, Mona and the corporation would have been liable for the judgment, but Ted and Maureen would not. Ted and Maureen would lose money if the assets of the corporation were seized to pay the judgment, but their own personal assets would be safe.

Caution: Payroll taxes. Limited liability doesn’t protect you if you fail to deposit taxes withheld from employees’ wages—especially if you have anything to do with making decisions about what bills the corporation pays first. Also, because unpaid withheld taxes aren’t dischargeable in bankruptcy, you want to pay these before you pay other debts (most of which can be wiped out in bankruptcy) in case your business goes downhill.

Income Taxes

Federal taxation of corporations is a very complicated topic. Here I deal only with basic concepts.

The federal tax laws distinguish between two types of corporations. A “C corporation” is treated as a tax-paying entity separate from its investors and it must pay corporate federal income tax. By contrast, a corporation that chooses “S corporation” status doesn’t pay federal income tax; instead, income taxes are paid by the corporation’s owners.

S Corporations

Electing to do business as an S corporation lets you have the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partner. Among other things, this means that as long as you actively participate in the business of the S corporation, business losses can be used as an offset against your other income—reducing, maybe even eliminating, your tax burden. The corporation itself doesn’t pay taxes, but files an informational tax return telling what each share-holder’s portion of the corporate income is.

EXAMPLE:

Paul decides to start an environmental cleanup business. Because insurance isn’t available to cover all of the risks of this business, he forms a corporation called Ecology Action, Inc. This limits Paul’s personal liability if there’s a lawsuit against the corporation for an act not covered by insurance.

Paul is also concerned about taxes. He expects his company to lose money during its first few years; he’d like to claim those losses on his personal tax return to offset income he’ll be receiving from consulting and teaching work. He registers with the IRS as an S corporation. Unless he changes that tax status later, his corporation won’t pay any federal income tax. Paul will report the corporation’s income loss on his own Form 1040 and will be able to use it as an offset against income from other sources.

For many years, if you wanted to limit the personal liability of all owners of your business and have the income and losses reported only on the owners’ income tax returns, you would have no choice but to create an S corporation. Today, you can accomplish the same goal by creating an LLC. Because an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, it’s generally better to structure your business as an LLC than as an S corporation. (But see “Choosing Between a Corporation and an LLC,” below, for a discussion of when it might be better to create an S corporation.)

See An Expert: Limits on deductions. You can deduct S corporation losses on your personal return only to the extent of the money you put into the corporation (to buy stock) and any money you personally loaned to the corporation. Also, if you don’t work actively in the S corporation, there are potential problems with claiming losses, because they might be considered losses from passive activities. For the most part, you can use losses from passive activities only to offset income from passive activities. See your tax adviser for technical details.

Shareholders pay income tax on their share of the corporation’s profits regardless of whether they actually received the money or not. If the corporation suffered a loss, shareholders can claim their share of that loss.

EXAMPLE:

Assume the same facts as above except that there are two other shareholders in Ecology Action, Inc. Paul owns 50% of the stock, and Ellen and Ted each own 25%. Paul would report 50% of the corporation’s profit or loss on his personal tax return, and Ellen and Ted would each report 25% on theirs.

Most states follow the federal pattern in taxing S corporations: They don’t impose a corporate tax, choosing instead to tax the shareholders for corporate profits. About half a dozen states, however, do tax an S corporation the same as a C corporation. The tax division of your state treasury department can tell you how S corporations are taxed in your state.

Cross Reference: To be treated as an S corporation, all share-holders must sign and file IRS Form 2553. For more information on this and other requirements for electing S corporation status, see Chapter 8.

C Corporations

Under federal income tax laws, a C corporation is a separate entity from its shareholders. This means that the corporation pays taxes on any income that’s left after business expenses have been paid.

As you saw earlier in this chapter, a sole proprietorship doesn’t pay federal income tax as a separate entity; the owner simply reports the business’s income or loss on Schedule C of Form 1040 and adds it to (or, in the case of a loss, subtracts it from) the owner’s other income. Similarly, a partnership doesn’t pay federal income tax; rather, the partnership annually files a form with the IRS to report each partner’s share of yearly profit or loss from the partnership business. Each partner then adds his or her share of partnership income to other income reported on his or her personal tax return (the familiar Form 1040) or deducts his or her share of loss. And an S corporation is treated as a sole proprietorship or partner-ship for federal income tax purposes, depending on the number of owners.

A C corporation is different. It reports its profits on Form 1120 and pays corporate tax on that income. In addition, if the profits are distributed to shareholders in the form of dividends, the shareholders pay tax on the dividends they receive (creating the much-feared "double taxation" scenario).

In practice, however, a C corporation may not have to pay any corporate income tax even though it is a separate taxable entity. Here’s how: In most incorporated small businesses, the owners are also employees. They receive salaries and bonuses as compensation for the services they perform for the corporation. The corporation then deducts this "reasonable" compensation as a business expense. In many small corporations, compensation to owner-employees eats up all the potential corporate profits, so there’s no taxable income left for the corporation to pay taxes on.

EXAMPLE:

Jody forms a one-person catering corporation, Jody Enterprises Ltd. She owns all the stock and is the main person running the business. The corporation hires her as an employee with the title of president. The corporation pays her a salary plus bonuses that consume all of the corporation’s profits. Jody’s salary and bonuses are tax-deductible to the corporation as a corporate business expense. There are no corporate profits to tax. Jody simply pays tax on the income that she receives from the corporation, the same as any other corporate employee.

Tax Savings Through Income Splitting

As an alternative to paying out all the corporate profits in the form of salaries and bonuses, you may want to leave some corporate income in the corporation to finance the growth of your business. You can often save tax dollars this way because, for the first $50,000 of taxable corporate income, the tax rate and actual taxes paid will generally be lower than what you’d pay as an individual.

You can see how the federal government taxes corporate income in the chart below. Note that the corporate tax rate reaches a high of 39% for taxable income between $100,000 and $335,000 and then drops down once taxable income exceeds $335,000.

Here’s an example of how, with proper planning, a small incorporated business can split income between the corporation and its owners, retaining money in the corporation for expenses and lowering the corporation’s tax liability to an amount that’s actually less than what would have to be paid by the principals of the same business if it were not incorporated.

EXAMPLE 1:

Sally and Randolph run their own incorporated lumber supply company, S & R Wood, Inc. One year their sales increase to $1.2 million. After the close of the third quarter, Sally and Randolph learn that S & R Wood is likely to make $110,000 net profit (net taxable corporate income) for the year. They decide to reward themselves and other key employees with moderate raises in pay, give a small year-end bonus to other workers, and buy some needed equipment.

This reduces the company’s net taxable income to $40,000—an amount that Sally and Randolph feel is prudent to retain in the corporation for expansion or in case next year’s operations are less profitable. Taxes on these retained earnings are paid at the lowest corporate rate, 15%. If Sally and Randy had wanted to take home more money instead of leaving it in the business, they could have increased their salaries and paid individual income taxes at a rate of at least 10% but more probably 25% or 28% or higher, depending on their tax brackets.

Caution: Watch out for a double tax trap. C corporation shareholders (like Sally and Randy) can also consider taking some income in the form of dividends rather than salary. Doing so, however, will often increase the tax burden because both the corporation and the shareholder will have to pay income tax on the distributed funds. Still, in some situations, taking some dividends in place of salary may make sense—for example, if the corporation is in the 15% bracket and the shareholder is in the 28% (or higher) bracket. In that case, the money saved on income and Social Security taxes will more than offset the fact that the corporation can’t deduct the dividend payment for tax purposes. But this gets complicated. Let a tax pro help you figure it out. Also, be aware that paying dividends won’t make sense if you have a personal service corporation. Such corporations pay a flat 35%.

EXAMPLE 2:

Now assume S & R Wood is not incorporated but instead is operated as a partnership. Now the entire net profits of the business ($110,000 minus the bonuses to workers and deductible expenditures for equipment) are taxed to Sally and Randolph. The result is that the $40,000 (which was retained by the corporation in the above example) is taxed at their individual rate of 25% or 28% or higher rather than the 15% corporate rate.

For a more detailed explanation of how income-splitting can be an advantage to owners of small corporations, see How to Form Your Own California Corporation, or Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State, both by Anthony Mancuso (Nolo).

The main point to remember is that once your business becomes profitable, doing business as a C corporation allows a degree of flexibility in planning and controlling your federal income taxes that is unavailable to partnerships and sole proprietorships. To determine whether or not favorable corporate tax rates are a compelling reason for your business to incorporate, you’ll need to study IRS regulations or go through an analysis with your accountant or other tax adviser.

Tax savings may be a largely theoretical advantage for the person just starting out. If your business is like many startups, your main concern will be generating enough income from the business to pay yourself a reasonable wage. Retaining profits in the business will come later. In this situation, the tax advantages of incorporating are illusory.

EXAMPLE:

In its first year of operation, Maria’s store, The Bookworm, has a profit of $25,000. As the sole proprietor, Maria withdraws the entire $25,000 as her personal salary, which places her in the 15% tax bracket after she subtracts her deductions and personal exemption. It doesn’t make sense for Maria to incorporate to take advantage of income-splitting techniques—even if she could get by on say, $20,000 a year, if she left the remaining $5,000 in the corporation, it would be taxed at the 15% corporate tax rate, so her total tax bill would be the same.

Fringe Benefits

The tax rules governing fringe benefits are complicated. Generally, however, if your business will be offering fringe benefits to employees, you can enjoy a tax advantage if you organize as a C corporation. The business can pay for employee benefits and then take these amounts as business expense deductions. You and the other shareholders who work as employees of your corporation can have the corporation pay for employee benefits such as:

• deferred compensation plans
• group term life insurance
• reimbursement of employee medical expenses that are not covered by insurance, and
• health and disability insurance.

But the real advantage is how these fringe benefits are treated on your personal tax return. As a shareholder, you won’t be personally taxed for the value of these employment benefits. That’s because employees of a C corporation—even if they’re owners—do not have to pay income tax on the value of the fringe benefits they receive. So, for example, your corporation may decide to provide medical insurance for employees and to reimburse employees for uninsured medical payments. The corporation can deduct these payments as a business expense—including the portion paid for the corporation’s owner-employees—and you and the other owner-employees are not taxed on these benefits.

Other types of business entities can also deduct the cost of many fringe benefits as business expenses, but owners who receive these benefits will ordinarily be taxed on their value. That’s because the tax laws distinguish between an employee and a self-employed person. The tax laws say that you’re a self-employed person—and therefore are taxed on your fringe benefits—if you’re a sole proprietor, a partner in a partnership, a member of an LLC that’s taxed as a partnership, or an owner of more than 2% of the shares of an S corporation. An owner-employee of a C corporation, however, isn’t classified as a self-employed person. So when it comes to the taxation of fringe benefits, owner-employees of a corporation enjoy a unique advantage.

This favorable tax treatment may seem like a powerful reason to organize your business as a C corporation. Not so fast. Obviously, there’s no benefit unless your business provides these benefits to employees in the first place. And that may be too expensive for some new businesses—especially because many types of employee benefits must be provided on a nondiscriminatory basis to a wide range of employees or to none, and must not be designed to primarily aid the business owner. If you put together a fringe benefit package that favors you and other owner-employees, the IRS will require owners to pay tax on their portion. Few new businesses can afford to carry expensive benefit programs—a cost that typically more than offsets any tax advantage to you as owner of a C corporation.

Here are some of the IRS ground rules for fringe benefit plans:

• Medical Reimbursement Plans. If your business promises to pay those portions of your employees’ medical expenses that are not covered by health insurance, your plan can also include the spouse and dependents of each employee. Usually you’ll set a limit on the total amount that can be reimbursed during the year; this limit must be the same for all eligible employees. In the typical small business, if you include owner-employees in the plan, your plan must benefit 70% of all employees or at least 80% of all employees who are eligible to participate. You can exclude employees who work less than 35 hours per week or have been employed less than three years or are nonresident aliens. As long as you meet these rules, employees—even owner-employees—won’t be taxed on reimbursements they receive. If you violate these rules, however, an owner may have to pay tax on all or part of the reimbursements that he or she receives under the plan. (These technical rules apply only to reimbursement of medical expenses—not to employer payment of medical insurance premiums.)
• Group Life Insurance. Your business can provide up to $50,000 of group term life insurance tax-free to employees (including yourself) if you meet certain conditions. As an owner-employee of a small corporation, you’ll probably be a "key employee" under the tax laws. A key employee is an officer who is paid more than $145,000 a year (this figure is revised periodically), an owner of at least 5% of the company, or an owner of at least 1% of the company who is paid more than $150,000 a year. If you are a key employee and want to deduct the cost of the insurance from your gross income, your plan must meet special rules: It must benefit at least 70% of all employees, limit the aggregate value of the plan accounts of key employees to 60% of the aggregate value of the plan accounts of all plan employees, or meet other IRS guidelines for "nondiscrimination." All benefits available to participating key employees must be available to all other participating members as well. You can provide different dollar amounts of life insurance to different employees without being "discriminatory" if the amount of coverage is uniformly related to compensation. Also, you can exclude employees who’ve worked for your company for less than three years.

Clearly, this is technical stuff. Let’s say you open a video store and hire a bunch of students to work part time during peak periods, and contract out for bookkeeping services. In such a case, you can set up a medical reimbursement plan without having to worry about covering a whole slew of employees. You could exclude the students because they work less than 35 hours a week. Your bookkeeper, being an independent contractor, wouldn’t be an employee and wouldn’t have to be covered. So perhaps your plan would cover only yourself and a few full-time employees, plus the families of all covered employees.

Retirement Plans

It used to be that by incorporating you could set up a better tax-sheltered retirement plan than you could get as a sole proprietor, a partner, or a shareholder-employee of an S corporation. There are no longer any significant differences.

Attracting Investors

To start and successfully run a small business, you may need more money than you can muster from your own savings or the cash generated by the enterprise. As explained in greater depth in Chapter 9, you have two basic options in raising money from outside sources: borrowing it or getting it from investors. If you expect to seek money from investors—even if they’re family members, friends, or business associates—there’s a substantial advantage in forming a corporation.

Unlike a lender who, in return for providing money, receives a promise that you’ll repay it with interest, an investor becomes a part-owner of the business. Although it’s possible to form a partnership and make an investor a partner or to form an LLC and make an investor a member, it’s often more practical to form a corporation and make the investor a shareholder. That little piece of paper that the corporation issues—the stock certificate—is tangible proof of the shareholder’s ownership interest in the business and it’s something that most investors have come to expect. Put another way, if you offer an investor a partnership interest or an LLC interest, you’re more likely to run into resistance than if you offer him or her stock in a corporation.

Keep in mind that shareholders don’t necessarily have to have equal rights to elect the board of directors or to receive dividends. To distinguish between various types of shareholders, you can issue different classes of stock with different rights, for example:

• common, voting shares to the initial owners who will be working in the business
• nonvoting shares for key employees to keep them loyal to the business, or
• nonvoting preferred shares to outside investors, giving them a preference if the corporation declares dividends or is sold.

To repeat this key point, the fact that the corporate structure makes it relatively easy to distinguish between different investors by issuing different classes of stock is a real advantage.

Tip: Stock options can motivate employees. Issuing stock options to employees at a favorable price can be a great way to motivate them, especially for a business that sells stock to the public or plans to do so. That’s because employees who hold options know that if the business is profitable and its stock price goes up, they’ll be able to cash in their options at a substantial profit. This can motivate them to help make the business successful. Also, employees who get stock options are often willing to work for a slightly lower salary, making investment capital go farther in the early days of business life.

Structuring your business as a corporation is not only advantageous but actually essential if—like many small business owners—you dream of someday attracting investors through a public offering. And, fortunately, it’s become far easier than it used to be for a small business to do just that without turning to a conventional stock underwriting company. Congress and state legislatures have liberalized laws that enable a small corporation to raise from $1 million to $10 million annually through a relatively easy-to-use procedure called a “limited public offering.”

Tip: Consider using the Internet to sell shares. You may decide to market your shares by placing your company’s small offering prospectus on the Internet—something now allowed by the Securities and Exchange Commission (SEC), the federal agency that watches over securities laws. If your company creates a website to inform the public about your products and services, you can also use that site to distribute your prospectus and market your shares. Of course, you’ll first need to take care of the paperwork required by federal and state securities laws.

Cross Reference: Forming and running a corporation is discussed in more detail in Chapter 3.

Limited Liability Companies

The LLC is the newest form of business entity. It has enjoyed a meteoric rise in popularity among both entrepreneurs and lawyers—and for good reason. It’s often a very attractive alternative to the traditional ways of doing business, which are described above.

The state laws controlling how an LLC is created and the federal tax regulations controlling how an LLC is taxed are still evolving. Fortunately, the evolutionary trends are extremely favorable to small businesses. On the formation side, it’s becoming simpler and simpler to set up an LLC. On the tax side, LLCs are benefiting from increased flexibility.

Resource: For an in-depth discussion of LLCs and step-by-step guidance on creating one, see Form Your Own Limited Liability Company by Anthony Mancuso (Nolo).

Once you’ve decided that your business should be organized as an entity that limits your personal liability for business debts, you’ll have to weigh the pros and cons of forming an LLC against the pros and cons of forming a corporation. Sometimes one or the other will clearly emerge as the better choice. Other times the differences are more subtle—which often means that either will suit your needs equally well. After you’ve absorbed the information on both legal formats, see "Choosing Between a Corporation and an LLC," below, for help in choosing between the two.

Limited Personal Liability

As with a corporation, all owners of an LLC enjoy limited personal liability. This means that being a member of an LLC doesn’t normally expose you personally to legal liability for business debts and court judgments against the business. Generally, if you become an LLC member, you risk only your share of capital paid into the business. You will, however, be responsible for any business debts that you personally guarantee (of course, you can reduce your risk to zero by not doing this) and for any wrongs (torts) that you personally commit (a good insurance policy should help here—see Chapter 12).

By contrast, as discussed above, owners of a sole proprietorship or general partnership have unlimited liability for business debts, as do the general partners in a limited partnership (and limited partners who take part in managing the business—discussed below).

Number of Owners

Every state allows an LLC to be formed by just one person. This means that if you plan to be the sole owner of a business and you wish to limit your personal liability, you have a choice of forming a corporation or an LLC.

Tax Flexibility

If you create a single-member LLC, it will not be taxed as a separate entity, like a C corporation, unless you elect to have it taxed in this manner. Normally, you won’t choose corporate-style taxation, preferring to have your single-member LLC report its profits (or losses) on Schedule C of your personal return, just as a sole proprietorship would.

Similarly, if you have an LLC with two or more members, it will be treated as a partnership for tax purposes, with each partner reporting and paying income tax on his or her share of LLC profits unless you elect to have the LLC taxed as a corporation. Again, you normally won’t elect to do this, preferring to have your multimember LLC follow the partnership tax route. This means that the LLC will report its income (or loss) on Form 1065, an informational return that notifies the IRS of how much each member earned (or lost). Each member will then report his or her share of profits or losses on that member’s personal Form 1040.

Occasionally, the members of an LLC will conclude that there’s an advantage to being taxed like a C corporation, with two levels of tax—one at the business entity level (for company profits) and another at the owners’ personal income tax level (for salaries and dividends). LLCs that are taxed like C corporations are able to split monies between business owners and the business itself, which may result in a significant overall tax saving. (See “Tax Savings Through Income Splitting,” above, for a discussion of income splitting in the corporate context.)

If, after reviewing all the financial implications—and after perhaps seeking the advice of a tax pro—you elect corporation-style taxation, you’ll do this by filing IRS Form 8832, Entity Classification Election. Where the LLC has two or more members, those members can all sign the form or authorize one member or manager to sign.

Tip: Electing to have your LLC taxed as a C corporation can be advantageous if you want to receive tax-free fringe benefits from the business. If you follow the usual practice of having pass-through taxation for your LLC—meaning that the business isn’t taxed as a separate entity—then as a business owner you’ll be taxed on the value of the fringe benefits you receive from the LLC (unlike other employees). A different rule applies if you elect to have your LLC taxed as a C corporation. In that situation, as long as you meet the IRS guidelines, you can receive fringe benefits as an owner-employee of the LLC and not have to pay tax on the value of those benefits. (For more on the tax treatment of fringe benefits, see "Fringe Benefits," above.)

Flexible Management Structure

An LLC member may be an individual or a separate legal entity such as a partnership or corporation that has invested in the LLC. You and the other members jointly run the LLC unless you choose to have it run by a single member, an out-side manager, or a management group—which may consist of some members, some nonmembers, or both. If you decide to form an LLC, I recommend that all the members sign an operating agreement that spells out how the business will be managed. Again, the details of how to do this are covered well in Form Your Own Limited Liability Company by Anthony Mancuso (Nolo).

Flexible Distribution of Profits and Losses

The members of an LLC can divide the LLC profits and losses any way they want. Although it’s common to divide LLC profits and losses according to the percentage of the business’s assets each member contributed, this isn’t legally required.

EXAMPLE:

Jim, Janna, Jill, and Jerry—certified personal trainers—form Fit for Life, LLC to operate a family fitness center. Each contributes $25,000 to the enterprise. Because Jim, who has a strong business background, has put together the LLC, set up a bookkeeping system, arranged for a bank loan to purchase necessary equipment, and negotiated a very favorable lease at a good location, the owners state in their operating agreement that for the first two years, Jim will receive 40% of the LLC’s profits and that Janna, Jill, and Jerry will each receive 20%. After that, they’ll share profits equally.

By contrast, rules governing corporate profits and losses are considerably more restrictive. A C corporation can’t allocate profits and losses to shareholders; instead, shareholders must receive dividends according to the number of shares they own—if they receive dividends at all. (But it is possible, although more cumbersome, to establish two or more classes of stock, each with different dividend rights.) Similarly, in an S corporation, profits and losses are attributed to the shareholders based on their shares: a shareholder who owns 25% of the shares in an S corporation ordinarily must be allocated 25% of profits and losses—no more and no less. Sometimes, however, corporations can get away from this strict formula by adjusting the salaries of shareholders who work in the business.

The easy flexibility allowed to LLCs in distributing profits and losses permits businesses to be creative and even make distributions to members who have contributed no cash.

EXAMPLE:

Howard and Saul run a home repair business organized as an LLC. Howard puts up all the money needed to buy a van, tools, and supplies and to pay for advertising brochures and radio commercials. Saul, who has little cash but loads of experience in doing home repairs, will contribute future services to the LLC. Although the owners could agree to split profits and losses equally, they decide that Howard will get 60% for the first three years as a way of paying him back for taking the risk of putting up cash.

Cross Reference: Starting and operating an LLC is discussed in more detail in Chapter 4.

Resource: For forms to use in setting up an LLC: See Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo), and Nolo’s LLC Maker, an easy-to-use software program that simplifies and automates much of the work of forming an LLC.

Choosing Between a Corporation and an LLC

Let’s assume that you’ve read all the earlier material in this chapter and that you now understand the chief legal, tax, and financial characteristics of the main types of business entities. Let’s also assume that you’ve concluded it would be best to operate your small business through an entity that limits the personal liability of all the owners—even if following this strategy involves a bit more paperwork, complexity, and possible expense.

For the reasons explained earlier in this chapter, you’ve probably narrowed your choice of entity to either the tried and true corporation or the new and streamlined LLC. Which is better? There’s no answer to this question that applies to every business. Nevertheless, some general principles may be helpful.

For the majority of small businesses, the relative simplicity and flexibility of the LLC makes it the better choice. This is especially true if your business will hold property, such as real estate, that’s likely to increase in value. That’s because C corporations and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, LLC member-owners avoid this double taxation because the business’s tax liabilities are passed through to them; the LLC itself does not pay a tax on its income.

But an LLC isn’t always the best choice. Occasionally, other factors may tip the balance toward a corporation. Such factors include the following:

• You’d like to provide extensive fringe benefits to owner-employees. Often, when you form a corporation, you expect to be both a shareholder (owner) and an employee. The corporation can, for example, hire you to serve as its chief executive officer and pay you a tax-deductible salary, which, from a tax standpoint, is far better than paying you dividends, which can’t be deducted by the corporation as a business expense and therefore wind up being taxed twice (once at the corporate level and once at the personal level). But corporate employees (including employees of a C corporation who are also owners) don’t just receive pay—most also receive fringe benefits. These benefits can include the payment of health insurance premiums and direct reimbursement of medical expenses. The corporation can deduct the cost of these benefits and they are not treated as taxable income to the employees. Having your own corporation pay for these fringe benefits and then deduct the cost as a business expense can be an attractive feature of doing business through a C corporation. These opportunities for you to receive tax-favored fringe benefits are somewhat reduced if you do business as an LLC.
• You want to entice or keep key employees by offering stock options and stock bonus incentives. Simply put, LLCs don’t have stock; corporations do. While it’s possible to reward an employee by offering a membership interest in an LLC, the process is awkward and likely to be less attractive to employees. Therefore, if you plan to offer ownership in your business as an employee incentive, it makes sense to incorporate rather than form an LLC.
• You plan to sell ownership interests to the public. The securities industry and securities laws are geared to the selling of corporate shares—not LLC membership interests. So a corporation is the better choice if you’ll be going public. If you’re not planning to go public immediately but may do so someday, you can start out as an LLC and then convert to a corporation later on.
• You’re concerned about self-employment taxes. As an S corporation shareholder, you may wind up paying less self-employment tax than you would as an LLC member. This is explained below.

Resource: For more on this subject, see LLC or Corporation: How to Choose the Right Form for Your Business by Anthony Mancuso (Nolo).

Special Structures for Special Situations

It’s very likely that the best organizational structure for your small business is either a sole proprietorship, partnership, corporation, or LLC. There are, however, some situations in which other, less common entities will either offer some tax or other advantage or will be legally required. For instance, you and your tax adviser may decide that selecting a less common structure may be desirable for your business. Your real estate investment group, for example, may find some benefit in creating a limited partnership (described below). Or, you may find that the law in your state requires you to select a less common structure for your business; for example, if you’re a doctor or an accountant and you want to limit your personal liability, state law may require you to form a professional corporation, a professional LLC, or a limited liability partnership.

Limited Partnerships

The kind of partnership covered in "Partnerships," above, is a general partnership. It’s very different from another form of partnership known as a limited partnership, which, in certain circumstances, can combine the best attributes of a partnership and a corporation.

Most limited partnerships are formed to invest in real estate because of tax advantages for those who are passive investors; the passive investor is often able to personally write off depreciation and other real estate deductions. For the majority of other types of small businesses with more than one owner, chances are that forming either a general partnership, a corporation, or an LLC will be the best way to go.

A limited partnership works like this. There must be one or more "general partners" with the same basic rights and responsibilities as in any general partnership, and one or more "limited partners," who are usually passive investors. The big difference between a general partner and a limited partner is that the general partner is personally liable for the obligations of the partnership and the limited partner is not personally liable for them. The most a limited partner can lose by investing in a limited partnership is the amount that he or she:

• paid or agreed to pay into the partnership as a capital contribution; or
• received from the partnership after it became insolvent.

To maintain this limited liability, a limited partner may not participate in the management of the business, with a very few exceptions. A limited partner who does get actively involved in the management of the business risks losing immunity from personal liability, meaning he or she would have the same legal exposure as a general partner.

The advantage of a limited partnership as a business structure is that it provides a way for business owners to raise money from passive investors (the limited partners) without having either to take in new partners who will be active in the business or to engage in the intricacies of creating a corporation and issuing stock.

EXAMPLE:

Anthony and Janice’s plan is to buy rundown houses, renovate them, and then sell them at a good profit. All they lack is the cash to make the initial purchases. To solve this problem, they first create a partnership consisting of the two of them. Then they establish a limited partnership, with their own partnership as the general partner, and seek others who are willing to invest for a defined interest in the venture. Anthony and Janice figure that they need $100,000 to get started. They sell ten limited partnership interests at $10,000 each. The limited partners are given the right to a percentage of the profits for a specified number of years, but they are not liable for any obligations of the partnership.

A general partnership that’s been operating for years can also create a limited partnership to finance expansion.

EXAMPLE:

Judith and Aretha have been partners in a small picture frame shop for two years. They want to expand into a bigger store in a much better location, where they can stock a large selection of fine art prints as well as frames. To raise money, they create a limited partnership, offering each investor an 8% interest in the total net profits of the store for the next three years as well as the return of the invested capital at the end of that period in exchange for a $20,000 investment. They sell four limited partnership interests, raising $80,000.

There is a downside to limited partnerships: Doing business as a limited partnership can be at least as costly and complicated as doing business as a corporation. Although limited partnerships don’t have to issue stock, state laws typically require that a limited partnership file registration information about the general and limited partners.

Caution: Watch out for confusing labels. Despite the similarity in names, there are major differences between a limited partnership (discussed above) and a limited liability partnership (discussed below).

The differences between a limited partnership and a limited liability partnership are:

• A limited partnership consists of at least one general partner and one or more limited partners. A general partner in a limited partnership is personally liable for all debts of and judgments against the business—regardless of who incurred the debt or other liability. A limited partner is generally not personally liable for any debts or judgments unless he or she actively participates in the business.
• A limited liability partnership (LLP) is a special form of general partnership and is usually reserved for professionals such as doctors, lawyers, and accountants. Normally, a partner in an LLP isn’t personally liable for the negligent acts of other partners but is liable for his or her own negligence and for other partnership debts.

Choices for Professionals

If you are a professional, such as a doctor, lawyer, or accountant, your choice of business structure may have to take into account certain additional factors. These include your need to avoid group liability and state laws or rules of professional ethics governing your choices of business structure.

Professional Corporations

Laws in every state permit certain professionals to form corporations known as "professional corporations" or "professional service corporations." In many states, people in certain occupations (for example, doctors, lawyers, or accountants) who want to incorporate their practice can do so only through a professional corporation. In some states, some professionals have a choice of incorporating as either a professional corporation or a C corporation (which can elect to be an S corporation).

The list of professionals eligible to incorporate is different in each state. Usually, though, professionals that must create a professional corporation include:

• accountants
• engineers
• health care professionals such as audiologists, dentists, nurses, opticians, optometrists, pharmacists, physical therapists, physicians, and speech pathologists
• lawyers
• psychologists
• social workers, and
• veterinarians.

Call your state’s corporate filing office (usually the secretary of state or corporation commissioner) to see who is covered in your state.

Typically, a professional corporation must be organized for the sole purpose of rendering professional services, and all shareholders must be licensed to render that service. For example, in a medical corporation, all of the shareholders must be licensed physicians.

Professional corporations aren’t as popular as they used to be. The main reason for professionals to incorporate—favorable corporate taxation rules—has disappeared. Before 1986, professionals who incorporated could shelter more money from taxes than sole proprietors or partners could. This has all changed. Most professional corporations are now classified as "personal service corporations" by the IRS (see "Personal Service Corporations," below). Because the corporate income of personal service corporations is taxed at a flat rate of 35%, there’s no longer any advantage to be gained by the two-tiered tax structure that allows C corporations to save taxes on some retained earnings. Tax laws, however, still give favorable treatment to fringe benefits for corporate employees in professional corporations.

The other reason for professionals to consider incorporating is the limitation on personal liability. It’s no secret that malpractice verdicts against professionals continue to climb. Although incorporating can’t protect a professional against liability for his or her negligence, it can protect against liability for an associate’s negligence.

EXAMPLE 1:

Dr. Anton and Dr. Bartolo are surgeons who practice as partners. Dr. Bartolo leaves a medical instrument inside a patient, who bleeds to death. The jury returns a $2 million verdict against Dr. Bartolo and the partnership. There is only $1 million in malpractice insurance to cover the judgment. Dr. Anton (along with Dr. Bartolo) would be personally liable for the $1 million not covered by insurance.

EXAMPLE 2:

Drs. Anton and Bartolo create a professional corporation. Dr. Bartolo commits the malpractice described in Example 1. Dr. Anton, a corporate employee, would not be personally liable for the portion of the verdict not covered by insurance. Dr. Bartolo, however, would still be personally responsible for the $1 million excess, because he was the one guilty of malpractice. (In some states, Dr. Anton would be free from personal liability only if the professional corporation carried at least the minimum amount of insurance mandated by state law.)

Insurance is a better alternative for most professionals than is the limited liability offered by incorporation. But with malpractice rates soaring for many professionals, it’s often hard to afford all the insurance you could possibly need, so forming a professional corporation can be a useful backup.

As an alternative to incorporating, professionals wishing to limit their personal liability should consider forming a professional limited liability company or limited liability partnership, as described below.

Professional Limited Liability Companies

As explained above, licensed professionals are permitted to incorporate but, in most states, they can do so only by forming a special type of corporation—a professional corporation (PC). Similarly, in many states, licensed professionals who wish to form an LLC are required to use a special type of LLC known as a "professional limited liability company" (PLLC).

Lawyers or doctors in a group practice, for example, may choose to form a PC or PLLC so that each member of the group is legally liable for only his or her malpractice—not the malpractice of other members of the group, as would be the case in a partnership. Members of a PLLC also won’t be personally liable for other business debts such as obligations owed to business creditors, lenders, and the landlord.

Typically, state laws require that all PLLC members be licensed to practice the same profession—accounting, for example, or engineering.

Especially if the PLLC consists of lawyers, accountants, engineers, doctors, or other health care professionals, state law may require that each member at least carry a specified amount of malpractice insurance or be bonded.

See An Expert: Check the law in your state before setting up a PLLC. If you’re a professional and considering forming a PLLC, you need to check your state’s statute to learn which professionals can and can’t form such an entity. There’s wide variation from state to state. (For example, in California, many professionals, such as doctors, therapists, engineers, architects, lawyers, and pharmacists, cannot form any type of LLC.) If you’re a member of a state professional society, its administrator may know the answer, or you can check the statute book at a nearby public library. (See Chapter 24 for information on doing legal research.)

Limited Liability Partnerships

In a few states, laws or professional ethics rulings prevent accounting or law firms from doing business as corporations or LLCs. If you’re an accountant or lawyer in such a state and would like some limitation on your personal liability for business obligations, look into forming an LLP. Unfortunately, the protection it offers is usually less than you’d get by forming a corporation or LLC—but it’s better than nothing.

Available in some but not all states, an LLP is simply a general partnership whose partners enjoy some protection from personal liability. LLPs are authorized under state statutes and there’s a bit of variation from state to state.

Typically a partner in an LLP is personally liable only for his or her own negligence (malpractice) or that of an employee working directly under the partner’s supervision; the partner isn’t personally liable for the negligence of anyone else in the firm. That’s helpful but, as a partner in an LLP, you’re still personally liable for a large variety of partnership debts not involving your own negligent acts, for example, obligations owed to business creditors, lenders, and the landlord—regardless of which partner incurred the obligation for the partnership.

EXAMPLE:

Hillary, Edgar, and Paula—all certified public accountants—want to form a new firm, but determine that ethics rules in their state prevent them from forming a professional corporation or PLLC. Instead, they form an LLP. Hillary, during a period of disarray in her personal life, messes up big time on a tax return for a major client, who has to pay huge penalties to the IRS. The client sues for malpractice and is awarded a $25,000 judgment. The LLP and Hillary are liable for paying the judgment. Edgar and Paula are not.

During the same period, Hillary also orders $15,000 worth of fancy office furniture, which the LLP can’t afford. All three partners are personally liable for the furniture debt. (By contrast, if local ethics rules had allowed the three accountants to organize their accounting firm as a PC or PLLC and they had done so, none of them would be personally liable for the cost of the furniture unless they personally guaranteed payment.)

Caution: Check the law in your state before setting up an LLP. If you’re a professional and considering forming an LLP, you need to check your state’s statute to learn which professionals can and can’t form an LLP, because of the wide variation from state to state. (For example, only architects, accountants, and lawyers can form LLPs in California, where LLPs are referred to as "registered limited liability partnerships," or RLLPs.) If you’re a member of a state professional society, its administrator may know the answer, or you can check the statute book at a nearby public library. (See Chapter 24 for information on doing legal research.)

Nonprofit Corporations

Each state permits people to form nonprofit corporations, also known as not-for-profit corporations. The main reason people form these corporations is to get tax-exempt status under the Internal Revenue Code (Section 501(c)(3)). To get tax-exempt status, the corporation must have been formed for religious, charitable, literary, scientific, or educational purposes.

If a corporation is tax-exempt under Section 501(c)(3), not only is it free from paying taxes on its income, but people and organizations who contribute to the nonprofit corporation can take a tax deduction for their contributions. Because many nonprofit organizations rely heavily on grants from public agencies and private foundations to fund their operations, attaining 501(c)(3) status is critical to success.

Tax-exempt status isn’t the only benefit available to a nonprofit corporation. The nonprofit label seems to create an altruistic aura around the organization and the people running it. The message is, "We’re not in this for the money—we really do love kids (or music or animals)." Also, an organization that plans to do some heavy mailing may be attracted by the cheaper postal rates that nonprofits are charged.

What kinds of groups should consider becoming nonprofit corporations? Here’s a partial list:

• child care centers
• shelters for the homeless
• community health care clinics
• museums
• hospitals
• churches, synagogues, mosques, and other places of worship
• schools
• performing arts groups, and
• conservation groups.

Most nonprofit corporations are run by a board of directors or trustees who are actively involved in the corporation’s work. Officers and employees (some of whom may also serve on the board) usually carry out the corporations’s day-to-day business and often receive salaries.

Keep in mind that if you put assets into a nonprofit corporation, you give up any ownership or proprietary interest in those assets. They must be irrevocably dedicated to the specified nonprofit purposes. If you want to get out of the business, you can’t sell it and pocket the cash. If the nonprofit corporation does end, any remaining assets must go to another nonprofit.

Resource: This book is addressed primarily to people starting and running a business for profit, so you’ll find little here on the peculiarities of nonprofit corporations. If you want to learn about such corporations in greater depth, see How to Form Your Own Nonprofit Corporation by Anthony Mancuso (Nolo). That book provides step-by-step instructions for forming a nonprofit corporation in all states.

Cooperatives and Cooperative-Type Organizations

Some people dream of forming a business of true equals—an organization owned and controlled democratically by its members.

These grassroots business organizers often refer to their businesses as a group, collective, or co-op—but these are usually informal rather than legal labels. Everyone who starts a business with others needs to select a legal structure. Generally, this means picking one of the traditional formats described in this chapter: a nonprofit corporation, a partnership, a C corporation, or an LLC. However, some states do have specific laws allowing the formation of a “cooperative corporation.” For example, in some states, a consumer “co-op” could be created to manufacture and sell arts and crafts.

If a co-op law exists in your state, it can help make the process of democratic ownership go more smoothly. Otherwise, you’ll need to make sure your partnership agreement, corporate bylaws, or LLC operating agreement contains the cooperative features that you and the other members feel are appropriate.

Resource: To learn more about cooperative-type organizations and how to start one, visit the website of the National Cooperative Business Association at www.ncba.org. You can order many helpful publications there. Another fine resource is Legal Sourcebook for California Cooperatives: Start-up and Administration, by Van P. Baldwin (University of California at Davis.) It covers incorporating and operating under the California Consumer Cooperative Corporation Law, and can be downloaded for free at http://cooperatives.ucdavis.edu/CFC_pubs/.