Sole Proprietorships

SKIP AHEAD: Sole proprietorships are one-owner businesses. Any business with two or more owners cannot, by definition, be a sole proprietorship. If you know that there will be two or more owners of your business, you can skip ahead to "Partnerships," below.

A sole proprietorship is simply a business that is owned by one person and that hasn’t filed papers to become a corporation or an LLC. Sole proprietorships are easy to set up and to maintain—so easy that many people own sole proprietorships and don’t even know it. For instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions, or an independent contractor who isn’t on an employer’s regular payroll, you are automatically a sole proprietor. This is true whether or not you’ve registered your business with your city or obtained any licenses or permits. And it makes no difference whether you also have a regular day job. As long as you do for-profit work on your own (or sometimes with your spouse—see below) and have not filed papers to become a corporation or a limited liability company, you are a sole proprietor.

CAUTION: Don’t ignore local registration requirements. If you’ve started a business without quite realizing it—for example, you do a little freelance computer programming, which classifies you as a sole proprietor by default— don’t let the fact that you’re technically already a sole proprietor fool you into thinking that you’ve satisfied the governmental requirements for starting a business. Most cities and counties require businesses—even tiny home-based sole proprietorships—to register with them and pay at least a minimum tax. And if you do business under a name different from your own, such as Custom Coding, you must register that name—known as a fictitious business name—with your county. In practice, lots of businesses are small enough to get away with ignoring these requirements. But if you are caught, you may be subject to back taxes and other penalties. (See Chapter 6 for an explanation of how to make the necessary filings with the appropriate government offices.)

Pass-Through Taxation

In the eyes of the law, a sole proprietorship is not legally separate from the person who owns it. This is one of the fundamental differences between a sole proprietorship and a corporation or an LLC. And it has two major effects: one related to taxation (explained in this section), and the other to personal liability (explained in the next).

At income tax time, a sole proprietor simply reports all business income or losses on his or her individual income tax return. The business itself is not taxed. The IRS calls this "pass-through" taxation, because business profits pass through the business to be taxed on the business owner’s tax return.

You report income from a business just like wages from a job except that, along with Form 1040, you’ll also need to include Schedule C, on which you’ll provide your business’s profit and loss information. One helpful aspect of this arrangement is that if your business loses money—and, of course, many start-ups do in the first year or two—you can use the business losses to offset any taxable income you have earned from other sources.

Example:

Rob has a day job at a coffee shop, where he earns a modest salary. His hobby is collecting obscure records at thrift stores and rummage sales. Contemplating the sad fact that he has no extra money to spend at the flea market on Saturday morning, he decides to start selling some of the vinyl gems he’s found. Still working his day job, he starts a small business that he calls Rob’s Revolving Records.

During his first full year in business, he sees that a key to consistently selling his records is developing connections and trust among record collectors. Unfortunately, while he is concentrating on getting to know potential buyers and others in the business, sales are slow. At year-end he closes out his books and sees that his website, marketing items such as business cards, and other incidental supplies cost him nearly $9,000, while he made only $3,000 in sales. But there is some good news: Rob’s loss of $6,000 can be counted against his income from his day job, reducing his taxes and translating into a nice refund check, which he’ll put right back into his record business.

CAUTION: Your business can’t lose money forever. See the discussion of tax rules for money-losing businesses in Chapter 8.

Resource: Be ready for the day you’ll owe taxes. Once your business is under way and turning a profit, you’ll have to start paying taxes. (See Chapter 8 for an overview of the taxes small businesses face.) Taxes can get fairly complicated, however, and you may need more in-depth guidance. For detailed information on taxes for the various types of small businesses, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo). This book gives exhaustive information on deductions, record keeping, and audits— all of which will help you reduce your tax bill and stay out of trouble with the IRS.

Personal Liability for Business Debts

Another crucial thing to know about operating your business as a sole proprietor is that you, as the owner of the business, can be held personally liable for business-related obligations. This means that if your business doesn’t pay a supplier, defaults on a debt, loses a lawsuit, or otherwise finds itself in financial hot water, you, personally, can be forced to pay up. This can be a sobering possibility, especially if you own (or soon hope to own) a cool house, car, or other treasures. Personal liability for business obligations stems from the fundamental legal attribute of being a sole proprietor: you and your business are legally one and the same.

As explained in more detail in the sections that discuss corporations and LLCs, below, owners of these businesses enjoy what the law calls "limited personal liability" for business obligations. This means that, unlike sole proprietors and general partners, owners of corporations and LLCs can normally keep their houses, investments, and other personal property, even if the business fails. In short, if you are engaged in a risky business, you may want to consider forming a corporation or an LLC—although a thorough insurance policy can often protect you from lawsuits and claims against the business.

CAUTION: Commercial insurance doesn’t cover business debts. Commercial insurance can protect a business and its owners from some types of liability (for instance, slip-and-fall lawsuits), but insurance never covers business debts. The only way to limit your personal liability for business debts is to use a limited liability business structure such as an LLC or a corporation (or a limited partnership or limited liability partnership).

Creating a Sole Proprietorship

Setting up a sole proprietorship is incredibly easy. Unlike starting an LLC or a corporation, you generally don’t have to file any special forms or pay any special fees to start working as a sole proprietor. You simply declare your business to be a sole proprietorship when completing the general registration requirements that apply to all new businesses, such as getting a business license from your county or city, or a seller’s permit from the California Board of Equalization.

For example, when filing for a business tax registration certificate with your city, you’ll often be asked to declare what kind of business you’re starting. Some cities require only that you check a "sole proprietorship" box on a form, while others have separate tax registration forms for sole proprietorships. Similarly, other forms you’ll file, such as those to register a fictitious business name and to obtain a seller’s permit, will also ask for this information. (These and other start-up requirements are discussed in detail in Chapter 6.)

Partnerships

Bring two or more entrepreneurs together into a business venture, stir gently and—poof!—you’ve got a partnership. By definition, a partnership is a business that has more than one owner and that has not filed papers with the state to become a corporation or an LLC (or a limited partnership or limited liability partnership).

CAUTION: Beware of local registration requirements. If you’re going into business with others, don’t let the fact that you’re automatically a partnership fool you into thinking that you’ve satisfied the governmental requirements for starting a business. Most cities and counties in California require all businesses to register with them and pay at least a minimum tax. And if you do business under a name other than the partners’ names, you must register that name—known as a fictitious business name—with your county. (See Chapter 6 for an explanation of how to make the necessary filings with the appropriate government offices.)

General vs. Limited Partnerships

Usually, when you hear the term "partnership," it means a general partnership. As we discuss in more detail below, general partners are personally liable for all business debts, including court judgments. In addition, each individual partner can be sued for the full amount of any business debt (though that partner can turn around and sue the other partners for their shares of the debt).

Another very important aspect of general partnerships is that any individual partner can bind the whole business to a contract or business deal—in other words, each partner has "agency authority" for the partnership. And remember, each of the partners is fully personally liable for a business deal gone sour, no matter which partner signed the contract. So choose your partners carefully.

There are also a couple of special kinds of partnerships, called limited partnerships and limited liability partnerships. They operate under very different rules and are relatively uncommon, so are only briefly described here.

A limited partnership requires at least one general partner and at least one limited partner. The general partner has the same role as in a general partnership: he or she controls the company’s day-today operations and is personally liable for business debts. The limited partner contributes financially to the business (for example, invests $100,000 in a real estate partnership) but has minimal control over business decisions or operations, and normally cannot bind the partnership to business deals. In return for giving up management power, a limited partner gets the benefit of protection from personal liability. This means that a limited partner can’t be forced to pay off business debts or claims with personal assets, but can lose the entire investment in the business. But beware: A limited partner who tires of being passive and starts tinkering under the hood of the business should understand that personal liability can quickly become unlimited that way. If a creditor can prove that the limited partner acted in a way that led the creditor to believe that he or she was a general partner, that limited partner can be held fully and personally liable for the creditor’s claims.

Resource: More on limited partnerships. See Form a Partnership: The Complete Legal Guide, by Ralph Warner and Denis Clifford (Nolo).

Another kind of partnership in California, called a limited liability partnership (LLP ), provides all of its owners with limited personal liability. These partnerships are only available to professionals— licensed lawyers, accountants, and architects— and are particularly well suited to them. Most professionals aren’t keen on general partnerships because they don’t want to be personally liable for another partner’s problems—particularly those involving malpractice claims. Forming a corporation to protect personal assets may be too much trouble, and California won’t allow these professionals to form an LLC. The solution is often a limited liability partnership. This business structure protects each partner from debts against the partnership arising from professional malpractice lawsuits against another partner. (A partner who loses a malpractice suit for his or her own mistakes, however, doesn’t escape liability.)

As attractive as they are, limited partnerships and limited liability partnerships (and limited liability companies, discussed below) are not cheap to create. The filing fee is just $70, but California also charges a minimum annual tax of $800 for both types of limited partnerships. The tax is due in the first quarter of operations, whether or not you’re making a profit.

Pass-Through Taxation

Similar to a sole proprietorship, a partnership (general or limited) is not a separate tax entity from its owners; instead it’s what the IRS calls a "pass-through entity." This means the partnership itself does not pay any income taxes; rather, income passes through the business to each partner, who pays taxes on an individual share of profit (or deducts a share of losses) on an individual income tax return (Form 1040, with Schedule E attached). However, the partnership must also file what the IRS calls an "informational return"—Form 1065—to let the government know how much the business earned or lost that year. No tax is paid with this return. Just think of it as the feds’ way of letting you know they’re watching.

Personal Liability for Business Debts

Since a partnership is legally inseparable from its owners, just like a sole proprietorship, general partners are personally liable for business-related obligations. What’s more, in a general partnership, the business actions of any one partner bind the other partners, who can be held personally liable for those actions. So if your business partner takes out an ill-advised high-interest loan on behalf of the partnership, makes a terrible business deal, or gets in some other business mischief without your knowledge, you could be held personally responsible for any debts that result.

Example: Jamie and Kent are partners in a profitable landscape gardening company. They’ve been in business for five years and have earned healthy profits, allowing them each to buy a house, decent wheels, and even a few luxuries—including Jamie’s collection of garden sculptures and Kent’s roomful of vintage musical instruments. One day Jamie, without telling Kent, orders a shipment of exotic poppy plants that he is sure will be a big hit with customers. But when the shipment arrives, so do agents of the federal drug enforcement agency who confiscate the plants, claiming they could be turned into narcotics. Soon thereafter criminal charges are filed against Jamie and Kent, resulting in several newspaper stories. Though the partners are ultimately cleared, their attorney fees come to $50,000 and they lose several key accounts, with the result that the business runs up hefty debts. As a general partner, Kent is personally liable for these debts even though he had nothing to do with the ill-fated poppy purchase.

Before you get too worried about personal liability, keep in mind that many small businesses don’t face much of a risk of racking up large debts. For instance, if you’re engaged in a low-risk enterprise such as freelance editing, landscaping, or running a small band that plays weddings and other social events, your risk of facing massive debt or a huge lawsuit is pretty small. For these types of small, low-risk businesses, a good business insurance policy that covers most liability risks is almost always enough to protect owners from a catastrophe such as a lawsuit or fire. Insurance won’t cover regular business debts, however. If you have significant personal assets like fat bank accounts or real estate and plan to rack up some business debt, you may want to limit your personal liability with a different business structure, such as an LLC or a corporation.

Partnership Agreements

By drafting a partnership agreement, you can structure your relationship with your partners pretty much however you want. You and your partners can establish the respective shares of profits (or losses) each will receive, what the responsibilities of each partner will be, what should happen to the partnership if a partner leaves, and how any number of other issues will be handled. It is not legally necessary for a partnership to have a written agreement. The simple act of two or more people doing business together creates a partnership. But only with a clear written agreement will all partners be sure of the important—and sometimes touchy— details of their business arrangement.

In the absence of a partnership agreement, California’s version of the Revised Uniform Partnership Act (RUPA ) kicks in as a standard, bottom-line guide to the rights and responsibilities of each partner. For example, if you don’t have a partnership agreement, then California’s RUPA states that each partner has an equal share in the business’s profits, losses, and management power. Similarly, unless you provide otherwise in a written agreement, a California partnership won’t be able to add a new partner without the unanimous consent of all partners. (Cal. Corp. Code § 16401.) But you can override many of the legal provisions contained in the California RUPA if you and your partners have your own written agreement.

There’s nothing terribly complex about drafting partnership agreements. They’re usually only a few pages long, and cover basic issues that you’ve probably thought over to some degree already. Partnership agreements typically include at least the following information:

• name of partnership and partnership business
• date of partnership creation
• purpose of partnership
• contributions (cash, property, and work) of each partner to the partnership
• each partner’s share of profits and losses
• provisions for taking profits out of the company (often called partners’ draws)
• each partner’s management power and duties
• how the partnership will handle departure of a partner, including buy-out terms
• provisions for adding or expelling a partner, and
• dispute resolution procedures.

These and any other terms you include in a partnership agreement can be dealt with in more or less detail. Some partnership agreements cover each topic with a sentence or two; others spend up to a few pages on each provision. Of course, you need an agreement that’s appropriate for the size and formality of your business, but it’s not a good idea to skimp on your partnership agreement.

Resource: More information on partnerships. Form a Partnership: The Complete Legal Guide, by Ralph Warner and Denis Clifford, is an excellent step-by-step guide to putting together a solid, comprehensive partnership agreement. Also, Business Buyout Agreements: A Step-by- Step Guide for Co-Owners, by Anthony Mancuso and Bethany K. Laurence, explains how to draft terms that will enable you to deal with business ownership transitions. (Both books are published by Nolo.)

If you think you may need more than the simple partnership agreements provided in this book, there are more detailed partnership agreement forms on CD (as well as many other resources for running your business) in Quicken Legal Business Pro 2008. You can learn more about all of these resources at www.nolo.com.

Take a look at the short sample partnership agreements on the following pages to see how a very basic partnership agreement can be put together. (You’ll also find a blank partnership agreement in Appendix C and on the CD-ROM that comes with this book.) These samples are about as basic as it gets—the bare minimum—and you’ll almost surely want to use something more detailed for your business.

[Partnership Agreement #1] omitted for online sample chapter

[Partnership Agreement #2] omitted for online sample chapter

Limited Liability Companies (LLCs)

Like many business owners just starting out, you might find yourself in this common quandary: On the one hand, having to cope with the risk of personal liability for business misfortunes scares you; on the other, you would rather not deal with the red tape of starting and operating a corporation.

Fortunately for you and many other entrepreneurs, you can avoid these problems by taking advantage of a relatively new form of business called the limited liability company, commonly known as an LLC. LLCs combine the pass-through taxation of a sole proprietorship or partnership (business taxes are paid on each owner’s individual income tax returns) with the same protection against personal liability that corporations offer. And now that California no longer requires LLCs to have at least two members, solo business owners also have the option of forming an LLC.

However, professional services businesses may not use the LLC structure in California. "Professional services" are "any type of professional services that may be lawfully rendered only pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act" or the Yacht and Ship Brokers Act. (Cal. Corp. Code §§ 13401(a), 13401.3.)

If you’re a professional services provider and want a business structure with limited personal liability for the principals, all is not lost. You may recall from the discussion of partnerships, above, that accountants, lawyers, and architects may form limited liability partnerships (LLP s). If you want limited personal liability with another type of professional services business, you’ll need to use the corporate business structure, discussed below (see "Corporations").

Limited Personal Liability

Generally, owners of an LLC are not personally liable for the LLC’s debts. (There are some exceptions to this rule, discussed below.) This protects the owners from legal and financial liability in case their business fails or loses a lawsuit and can’t pay its debts. In those situations, creditors can take all of the LLC’s assets, but they generally can’t get at the personal assets of the LLC’s owners. Losing your business is no picnic, but it’s a lot better to lose only what you put into the business than it is to say goodbye to everything you own.

Example: Callie forms her own one-person mail-order business, using most of her $25,000 in savings to establish a cool website and buy mailing lists. Callie realizes that she’ll have to buy a significant portion of her sales inventory up front to be able to ship goods to her customers on time, so she plans to buy those items on credit. While she is willing to risk her $25,000 investment to pursue her dream, she is worried that if her mail-order business fails, she will be buried under a pile of debt. Callie decides to form an LLC so that if her business should fail, she’ll only lose the $25,000; no one will be able to sue her personally for the business debt that she owes. She feels more secure going into business knowing that even if her business fails, she can walk away without the risk of losing her house or her car.

Keep in mind that, like a general partner in a partnership, any member of a member-managed LLC can legally bind the entire LLC to a contract or business transaction. In other words, each member can act as an agent of the LLC. (Some LLCs are managed by managers, instead of by members. In manager-managed LLCs, any manager can bind the LLC to a business contract or deal.)

While LLC owners enjoy limited personal liability for many of their business debts, this protection is not absolute. There are several situations in which an LLC owner may become personally liable for business debts or claims. However, this drawback is not unique to LLCs. The limited liability protection given to LLC members is just as strong as (if not stronger than) that enjoyed by the corporate shareholders of small corporations. Here are the main situations in which LLC owners can still be held personally liable for debts:

• Personal guarantees. If you give a personal guarantee on a loan to the LLC, then you are personally liable for repaying that loan. Because personal guarantees are often required by banks and other lenders, this is a good reason to be a conservative borrower. Of course, if no personal guarantee is made, then only the LLC—not the members—are liable for the debt.
• Taxes. The IRS or the California Franchise Tax Board may go after the personal assets of LLC owners for overdue federal and state business tax debts, particularly overdue payroll taxes. This is most likely to happen to members of small LLCs who have an active hand in managing the business, rather than to passive members.
• Negligent or intentional acts. An LLC owner who intentionally, or even carelessly, hurts someone will usually face personal liability. For example, if an LLC owner takes a client to lunch, has a few martinis and injures the client in a car accident on the way home, the LLC owner can be held personally liable for the client’s injuries.
• Breach of fiduciary duty. LLC owners have a legal duty to act in the best interest of their company and its members. This legal obligation is known as a "fiduciary duty," or is sometimes simply called a "duty of care." LLC owners who violate this duty can be held personally liable for any damages that result from their actions (or inactions). Fortunately for LLC owners, they normally will not be held personally responsible for any honest mistakes or acts of poor judgment they commit in doing their jobs. Most often, breach of duty is found only for serious indiscretions such as fraud or other illegal behavior.
• Blurring the boundaries between the LLC and its owners. When owners fail to respect the separate legal existence of their LLC, but instead treat it as an extension of their personal affairs, a court may rule that the owners are personally liable for business debts and liabilities. Generally this is more likely to occur in one-member LLCs; in reality it only happens in extreme cases. You can easily avoid it by opening a separate LLC checking account, getting a federal employer identification number, keeping separate accounting books for your LLC, and funding your LLC adequately enough to be able to meet foreseeable expenses.

LLC Taxation

Like a sole proprietorship or partnership, an LLC is not a separate tax entity from its owners; instead, it’s what the IRS calls a "pass-through entity." This means the LLC itself does not pay any income taxes; instead, income passes through the business to each LLC owner, who pays taxes on the individual share of profit (or deducts his share of losses) on an income tax return (for the feds, Form 1040 with Schedule E attached). But a multi-owner LLC, like a partnership, does have to file Form 1065—an “informational return”—to let the government know how much the business earned or lost that year. No tax is paid with this return.

LLCs give members the flexibility to choose to have the company taxed like a corporation rather than as a pass-through entity. In fact, partnerships now have this option as well. (See Form 8832, Entity Classification Election, in Appendix C.)

You may wonder why LLC owners would choose to be taxed as a corporation—after all, pass-through taxation is one of the most popular features of an LLC. The answer is that, because of the income-splitting strategy of corporations (discussed in "Corporate Taxation," below), LLC members can sometimes come out ahead by having their business taxed as a separate entity at corporate tax rates.

For example, if the owners of an LLC become successful enough to keep some profits in the business at the end of the year (or regularly need to keep significant profits in the business for upcoming expenses), paying tax at corporate tax rates can save them money. That’s because federal income tax rates for corporations start at a lower rate than the rates for individuals. For this reason, many LLCs start out being taxed as partnerships, and when they make enough profit to justify keeping some in the business (rather than doling it out as salaries and bonuses), they opt for corporate-style taxation.

LLCs face significant taxes and fees at the state level. California charges a minimum annual tax of $800, which is due in the first quarter of operations, whether or not you’re making a profit. (LLC taxes are discussed in more detail in Chapter 8.)

LLCs vs. S Corporations

Before LLCs came along, the only way all owners of a business could get limited personal liability was to form a corporation. Problem was, many entrepreneurs didn’t want the hassle and expense of incorporating, not to mention the headache of dealing with corporate taxation. One easier option was to form a special type of corporation known as an S corporation, which is like a normal corporation in most respects, except that business profits pass through to the owner (as in a sole proprietorship or partnership), rather than being taxed to the corporation at corporate tax rates. In other words, S corporations offered the limited liability of a corporation with the pass-through taxation of a sole proprietorship or partnership. For a long time, this was an okay compromise for small-to-medium-sized businesses, though they still had to deal with many of the corporate requirements of running an S corporation (discussed in more detail below).

Now, however, LLCs offer a better option. LLCs are indeed similar to S corporations in that they combine limited personal liability with pass-through tax status. But a significant difference between these two types of businesses is that LLCs are not bound by the many regulations that govern S corporations.

Here’s a quick rundown of the major areas of difference between S corporations and LLCs. (Keep in mind that corporations, including S corporations, are explained in more detail in the next section.)

• Ownership restrictions. An S corporation may not have more than 75 shareholders, all of whom must be U.S. citizens or residents. This means that some of the C corporation’s main benefits—namely, the ability to set up stock option and bonus plans and to bring in public capital—are pretty much out of the question for S corporations. And even if an S corporation initially meets the U.S. citizen or resident requirement, its shareholders can’t sell shares to another company (like a corporation or an LLC) or a foreign citizen, on pain of losing S corporation tax status. In an LLC, any type of person or entity can become a member—a U.S. citizen, a citizen of a foreign country, another LLC, corporation, or limited partnership.
• Allocation of profits and losses. Shareholders of an S corporation must allocate profits according to the percentage of stock each owner has. For example, a 25% owner has to receive 25% of the profits (or losses), even if the owners want a different division. Owners of an LLC, on the other hand, may distribute profits (and the tax burden that goes with them) however they see fit, without regard to each member’s ownership share in the company. For instance, a member of an LLC who owns 25% of the business can receive 50% of the profits if the other members agree (subject to a few IRS rules).
• Corporate meeting and record-keeping rules. For S corporation shareholders to keep their limited liability protection, they have to follow the corporate rules—issuing stock, electing officers, holding regular board of directors’ and shareholders’ meetings, keeping corporate minutes of all meetings, and following the mandatory rules found in the corporation code. By contrast, LLC owners don’t need to jump through most of these legal hoops—they just have to make sure their management team is in agreement on major decisions and go about their business.
• Tax treatment of losses. S corporation shareholders are at a disadvantage if their company goes into substantial debt—for instance, if it borrows money to open the business or buy real estate. That’s because an S corporation’s business debt cannot be passed along to its shareholders unless they have personally cosigned and guaranteed the debt. LLC owners, on the other hand, normally can reap the tax benefits of any business debt, cosigned or not. This can translate into a nice tax break for owners of LLCs that carry debt.

Forming an LLC

To form an LLC, you must file Articles of Organization with the California Secretary of State. You should also execute an operating agreement, which governs the internal workings of your LLC. Before you decide the LLC is the best thing since easy cheese, you should be aware that an LLC is generally not as cheap to start as a partnership or sole proprietorship. While the filing fee itself isn’t terribly expensive ($70), the California Franchise Tax Board requires that you pay a minimum annual LLC tax of $800 when you start your LLC.

Many brand-new business owners aren’t in a position to pay this kind of money right out of the starting gate, so they start out as partnerships until they bring in enough income to cover these costs. Since California lowered its corporate start-up fees in 2000, some entrepreneurs are tempted to start out as corporations, which are now cheaper to start than LLCs. However, keep in mind that the added expenses of running a corporation (legal and accounting fees, for example) can often make a corporation more expensive in the long run than an LLC.

CAUTION: Some LLCs must comply with securities laws. LLCs that have owners who do not actively participate in the business may have to register their membership interests as securities or, more likely, qualify for an exemption to the registration requirements. For information about the federal securities laws, visit the Securities and Exchange Commission’s website at www.sec.gov and click on “Information for: Small Business.”

Resource: For more on LLCs. Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo), gives detailed information on LLCs, including step-by-step instructions and forms for creating one in every state. For a briefer treatment, consult Nolo’s Quick LLC: All You Need to Know About Limited Liability Companies, also by Anthony Mancuso. It offers an overview of LLCs as well as comparisons to other business structures, but does not include any start-up forms.

Corporations

For many, the term “corporation” conjures up the image of a massive industrial empire more akin to a nation-state than a small business. In fact, a corporation doesn’t have to be huge, and most aren’t. Stripped to its essentials, a corporation is simply a specific legal structure that imposes certain legal and tax rules on its owners (also called shareholders). A corporation can be as large as IBM or, in many cases, as small as one person.

One fundamental legal characteristic of a corporation is that it’s a separate legal entity from its owners. If you’ve already read this chapter’s sections on sole proprietorships and partnerships, you’ll recognize that this is a major difference between those unincorporated business types and corporations. Another important corporate feature is that shareholders are normally protected from personal liability for business debts. Finally, the corporation itself—not just the shareholders—is subject to income tax.

CAUTION: Publicly traded corporations are a different ball game. This section discusses privately held corporations owned by a small group of people who are actively involved in running the business. These corporations are much easier to manage than public corporations, whose shares are sold to the public at large. Any corporation that sells its stock to the general public is heavily regulated by state and federal securities laws, while corporations that sell shares, without advertising, only to a select group of people who meet specific state requirements are often exempt from many of these laws. If you plan to sell shares of a corporation to the general public, you should consult a lawyer.

Limited Personal Liability

Generally, owners of a corporation are not personally liable for the corporation’s debts. (There are some exceptions to this rule, discussed below.) Limited personal liability is a major reason why owners have traditionally chosen to incorporate their businesses: to protect themselves from legal and financial liability in case their business flounders or loses an expensive lawsuit and can’t pay its debts. In those situations, creditors can take all of the corporation’s assets (including the shareholders’ investments), but they generally can’t get at the personal assets of the shareholders.

Example: Tim and Chris publish Tropics Tripping, a monthly travel magazine with a focus on Latin America. Because they both have significant personal assets, and because they will have to borrow a lot of capital to start up their magazine, they form their business as a corporation to protect their personal assets in case their magazine fails. They do great for a few years, but suddenly their subscription and advertising revenue starts to suffer when a recession plus political unrest in several Latin American countries reduce interest in travel to that area. Hoping the situation will turn itself around, Tim and Chris forge ahead—and go deeper into debt as it proves impossible to pay printing and other bills on time. Finally, when their printer won’t do any more print runs on credit, Tim and Chris are forced to call it quits. Tropics Tripping’s debts total $250,000, while business assets are valued at only $90,000—leaving a $160,000 debt to creditors. Thankfully for Tim and Chris, they won’t have to use their personal assets to pay the $160,000, because as owners of a corporation, they’re shielded from personal liability.

Tip: Corporations aren’t the only option. With the advent of limited liability companies, corporations aren’t the only business entities that provide limited liability status for all owners. (See the section on LLCs, above.)

Forming a corporation to shield yourself from personal liability for business obligations provides good, but not complete, protection for your personal assets. Here are the principal areas in which corporation owners still face personal liability.

• Personal guarantees. If you give a personal guarantee on a loan to the corporation, then you are personally liable for the repayment of that loan. Because banks and other lenders often require a personal guarantee, this is a good reason to be a conservative borrower. Of course, if no personal guarantee is made, then only the corporation—not the shareholders—is liable for the debt.
• Taxes. The IRS or the California Franchise Tax Board may go after the personal assets of corporate owners for overdue corporate federal and state tax debts, particularly overdue payroll taxes. This is most likely to happen to owners of small corporations who have an active hand in managing the business, rather than to passive shareholders.
• Negligent or intentional acts. A corporate owner whose negligent (that is, careless), or perhaps even intentional actions end up hurting someone can’t hide behind the corporate barrier to escape personal liability. Shareholders are subject to personal liability for wrongs they commit—such as attacking a customer or leaving a floor wet in a store—that result in injury.
• Breach of fiduciary duty. Corporate owners have a legal duty to act in the best interest of the company and its shareholders. This legal obligation is known as a "fiduciary duty," sometimes simply called a "duty of care." An owner who violates this duty can be held personally liable for any damages that result from those actions (or inactions). Fortunately for corporate owners, run-of-the-mill mistakes or lapses in judgment aren’t usually considered breaches of the duty of care. Most often, breach of duty is found only for serious indiscretions such as fraud or other illegal behavior. For example, if a corporate officer has falsified some financial data in order to seal a deal with a client, that officer may be held personally liable for any damages that result from that breach of duty to the company.
• Blurring the boundaries between the corporation and its owners. When corporate owners ignore corporate formalities and treat the corporation like an unincorporated business, a court may ignore the existence of the corporation (in legal slang, it may "pierce the corporate veil") and rule that the owners are personally liable for business debts and liabilities. To avoid this, it’s important for corporate owners not to allow the legal boundary between the corporation and its owners to grow fuzzy. Owners need to scrupulously respect corporate formalities by holding shareholders’ and directors’ meetings, keeping attentive minutes, issuing stock certificates, and maintaining corporate accounts strictly separate from personal funds.

Also, bear in mind that although limited personal liability can prevent you from losing your home, car, bank account, and other assets, but it won’t protect you from losing your investment in your business. A business can quickly get wiped out if a customer, employee, or supplier wins a big lawsuit against it and the business has to be liquidated to cover the debt. In short, even if you incorporate to protect your personal assets, you should purchase appropriate insurance to protect your business assets. (Insurance is discussed in Chapter 7.) But remember, insurance won’t help if you simply can’t pay your normal business debts.

Corporate Taxation

The words “corporate taxes” raise a lot of fear and loathing in the business world. Fortunately, the reality of corporate taxation is usually less depressing than the hype. Here are the basics—think of it as Corporate Tax Lite. If you decide to incorporate, you’ll likely want to consult an accountant or small business lawyer who can fill you in on the fine print. (See Chapter 16 for information on finding and hiring a lawyer.)

The first thing you need to know is that you’ll be treated differently for tax purposes, depending on whether you operate as a regular corporation (also called a C corporation) or you elect S corporation status. An S corporation is the same as a C corporation in most respects, but when it comes to taxes, C and S corporations are very different animals. A regular, or C, corporation must pay taxes, while an S corporation is treated like a partnership for tax purposes and doesn’t pay any income taxes itself. Like partnership profits, S corporation profits (and losses) pass through to the shareholders, who report them on their individual returns. (In this respect, S corporations are very similar to LLCs, which also offer limited liability along with partnership-style tax treatment.) These two types of corporations are explained in more detail just below.

C Corporations

As a separate tax entity, a regular corporation must file and pay income taxes on its own tax return, much like an individual does. After deductions for such things as employee compensation, fringe benefits, and all other reasonable and necessary business expenses have been subtracted from its earnings, a corporation pays tax on whatever profit remains. In small corporation in which all of the owners of the business are also employees, all of the corporation’s profits are often paid out in tax deductible salaries and fringe benefits—leaving no corporate profit and thus no corporate taxes due. (The owner/employees must, of course, pay tax on their salaries on their individual returns.)

Initial rates of corporate taxation are comparatively low (15%–25%). (See "Marginal Tax Rates for Corporations," below.) Corporations that keep some profits in the business from one year to the next—rather than paying out all profits as salaries and bonuses—can take advantage of these low tax brackets. This practice, sometimes called income-splitting, basically involves strategically setting salaries at a level so that money left in the business is taxable only at the 15% or 25% corporate tax rate (which applies to profits up to $50,000 or $75,000). Since any amount of "reasonable" compensation to employees is deductible, corporate owners have lots of leeway in setting salaries to accomplish this.

Example: Alexis and Matt run Window to the Past, Inc., a glass manufacturing business that specializes in custom work for architectural renovations. Toward the end of the year, they calculate that year’s profit to be approximately $145,000. They decide to give themselves each a $50,000 bonus out of the profit (on top of their $40,000 salaries). Because both salaries and bonuses are tax-deductible business expenses, this reduces Window to the Past’s taxable income to $45,000. The resulting corporate profit of $45,000 will be taxed at only 15%, the lowest rate. (If Alexis and Matt had left all the profits in the business, the profits over $75,000 would have been taxed at 34%, and profits over $100,000 would have been taxed at a whopping 39%.) Of course, the bonuses Alexis and Matt give themselves increase their personal incomes, which will be taxed on their individual returns. Still, their personal tax rates are lower than the high corporate rates of 34% and 39%.

This income-splitting strategy is available only to shareholders who also work for the corporation. If they’re not at least part-time employees, then shareholders won’t be in a position to earn salaries or bonuses, and will be able to take money from the corporation only as dividends.

Double Taxation

This brings us to the vexing problem of double taxation, routinely faced by larger corporations with shareholders who aren’t active employees. Unlike salaries and bonuses, dividends paid to shareholders cannot be deducted as business expenses from corporate earnings. Because they’re not deducted, any amounts paid as dividends are included in the total corporate profit and taxed. And when the shareholder receives the dividend, it is taxed at the shareholder’s individual tax rate as part of personal income. As you can see, any money paid out as a dividend gets taxed twice: once at the corporate level, and once at the individual level.

You can avoid double taxation simply by not paying dividends. This is usually easy if all shareholders are employees, but probably more difficult if some shareholders are passive investors anxious for a reasonable return on their investment.

S Corporations

Unlike a regular corporation, an S corporation does not pay taxes itself. Any profits pass through to the owners, who pay taxes on income as if the business were a sole proprietorship, a partnership, or an LLC. Yet the business is still a corporation. This means, of course, that its owners are protected from personal liability for business debts, just as shareholders of C corporations and owners of LLCs.

Until the relatively recent arrival of the LLC (discussed above), the S corporation was the business form of choice for those who wanted limited liability protection without the two-tiered tax structure of a C corporation. Today, relatively few businesses are organized as S corporations, because S corporations are subject to many regulations that do not apply to LLCs. (See "LLC’s vs. S Corporations," above, for more information.)

Forming and Running a Corporation

Unlike sole proprietorships and partnerships, you can’t clap your hands twice and conjure up a corporation. In addition to tax complexity, the major drawbacks to forming a corporation—either a C or an S type—are time and expense. Now that California has reduced the up-front fees for incorporating, however, most of the expense involves legal and other professional fees that are almost always incurred in forming a corporation. To incorporate, you must file Articles of Incorporation with California’s Secretary of State, along with a filing fee of $100. (Significantly, the minimum annual tax of $800 is no longer due in the first business year for corporations created on or after January 1, 2000.) You will have to file a Statement by Domestic Stock Corporation every year, beginning within 90 days of filing your Articles of Incorporation. (These requirements are covered in detail in Chapter 6.) And if you decide to sell shares of the corporation to the public—as opposed to keeping them in the hands of a relatively small number of owners—you’ll have to comply with lots of complex federal and state securities laws.

Finally, to protect your limited personal liability, you need to act like a corporation, which means adopting bylaws, issuing stock to shareholders, maintaining records of various meetings of directors and shareholders, and keeping records and transactions of the business separate from those of the owners.

Caution: Corporations must comply with securities laws. Corporations must either register their shares with the Securities and Exchange Commission or qualify for an exemption to securities registration requirements. For information about small business exemptions to the federal securities laws, visit the Securities and Exchange Commission’s website at www.sec.gov and click on “Information for: Small Business.”

Resource: More on running corporations. For more information on the many complexities of running a corporation, read either How to Form Your Own California Corporation or The Corporate Records Handbook: Meetings, Minutes & Resolutions, both by Anthony Mancuso (Nolo).

Choosing the Best Structure for Your Business

Although there are many differences between the various types of business organizations, most business owners choose an operating structure based on one major legal issue: the personal liability of owners for business debts. It’s true that the issue of personal liability can have a huge impact on successful small businesses a few years down the road. But business owners who are just starting out on a shoestring often care most about spending as little money as possible on the legal structure of their business. This is certainly an understandable approach; far more new businesses die painful deaths because they don’t control costs than because they lose costly lawsuits. In short, for many new small businesses, incorporating or organizing as an LLC is as unnecessary an expense as a swank downtown office or a gleaming chrome espresso machine in the lunchroom.

That said, owners of any business that will engage in a high-risk activity, rack up large business debts, or have a significant number of investors should always insist on limited personal liability, either with an LLC or a corporation. This is even more true if the business can’t find or afford appropriate insurance.

If you decide that your personal liability is worth the extra cost, you still need to decide whether to form a corporation or an LLC. Many business owners who want limited liability protection realize that incorporation normally makes sense only if a business needs to take advantage of the corporate stock structure to attract key employees and investment capital. No question, corporations may have an easier time attracting capital investment by issuing stock privately or publicly. And some businesses may find it easier to attract and retain key employees by issuing employee stock options. But for businesses that never go public, choosing to operate as an LLC rather than a corporation normally makes the most sense, if limited liability is your main concern. If the corporate stock structure isn’t something you want or need for your business, the simplicity and flexibility of LLCs offer a clear advantage over corporations.

Introduction

You probably already have a rough idea of the type of legal structure your business will take, whether you know it or not. That’s because in large part, the ownership structure that’s right for your business—a sole proprietorship, partnership, LLC, or corporation—depends on how many people will own the business and what type of services or products it will provide, things you’ve undoubtedly thought about quite a bit.

For instance, if you know that you will be the only owner, then a partnership is obviously not your thing. (A partnership by definition has more than one owner.) And if your business will engage in risky activities (for example, trading stocks or repairing roofs), you’ll want not only to buy insurance, but also to consider forming an entity that provides personal liability protection (a corporation or a limited liability company), which can shield your personal assets from business debts and claims. If you plan to raise capital by selling stock to the public, or want to give your employees stock options, then you should form a corporation.

If you’ve considered these issues, then you’ll be ahead of the game in choosing a legal structure that’s right for your business. Still, you’ll need to consider the benefits and drawbacks of each type of business structure before you make your final decision.

In California, the basic types of business structures are:

• sole proprietorships
• partnerships
• limited liability companies (LLCs), and
• corporations.

To help you pick the best structure for your business, this chapter explains the basic attributes of each type.

Stephen Parr, owner and director of Oddball Film and Video, a stock footage company in San Francisco, California: What a business really is, is you deciding you have a business. It’s really nothing more than that.

This chapter will help you answer the most common question new entrepreneurs ask about choosing a business form: Should I choose a business structure that offers protection from personal liability—a corporation or an LLC? Here’s a hint as to what the best advice will be: If you focus your energy and money on getting your business off the ground as a sole proprietorship or a partnership, you can always incorporate or form an LLC later.