One of the great advantages to living in the United State of America is how accessible it is for one to become their own business owner. Starting you own business has never been easier, however, it is important that you are properly informed about how to structure your business entity before setting up shop and opening your business up to the public. At Modesto Bankruptcy Attorneys, our experienced attorneys can discuss your specific goals and concerns and advise the best way to conduct your business. When discussing business structures, we always focus on liability protection, tax consequences and ultimately ease of use. Below, we will discuss the various business structures available, their formation, any advantages and disadvantages that each structure may have.
We will focus on the following business structures that are available to any business owner: (1) Sole-Proprietorship, (2) Partnership, (3) Corporation and (4) Limited Liability Company.
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Sole Proprietorship
A sole proprietorship is the simplest way a single business owner can conduct business. A sole proprietorship consists of just a single business owner who conducts business either under their own name or under a fictitious business name, also know as a DBA. To operate as a sole proprietorship, there are no formal formation requirements with the Secretary of State or the IRS. The business will be conducted under the sole proprietor’s social security number or under an Employee Identification Number (EIN) given to them by the IRS. You simply need to apply for the appropriate business license with your local city and/or county and you are ready to conduct your business. From a tax perspective, a sole proprietorship’s taxes pass through and are reported on the individual owner’s personal tax return and the business does not file nor pay any state or federal taxes. There are not tax advantages to conducting as a sole proprietorship. It is this ease of formation and pass-through taxes that made the sole proprietorship option a favorite for many business owners.
When conducting a business, it is important to focus on limiting any potential liability that may result from lawsuits or other actions taken against the business. Ideally, a business owner wants to ensure that their personal assets (i.e., home, personal accounts etc.) are kept safe from any potential lawsuits. However, the greatest disadvantage to a sole proprietorship is the lack of any liability protection. Since there is no protection afforded to a sole proprietor, in the event of a lawsuit against the business, all of the sole proprietor’s personal assets are at risk if the business lacks enough insurance and/or business assets to cover its liabilities. For this reason, conducting a business as a sole proprietorship is generally not recommended.
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Partnership
A partnership is when two or more individuals or businesses agree to enter into an agreement to operate a business together. A partnership can be an at-will partnership, which does not require any formal written agreement for formation with the Secretary of State. A partnership can also be a general partnership, which often time will have a formal written partnership agreement, and the partners have the option to register the partnership with the Secretary of State. Lastly, there can also be a limited partnership, which allows for one or more partners to enter into a partnership and limit their liability only to the amount of their investment. An at-will partnership provides for equal share of profits and losses as well as liabilities. Regardless of the type of partnership, a partnership is required to file an annual tax return, however it does not pay any taxes. All profit and losses of the partnership are divided among the partners and pass-through to each partner’s individual tax return. Further, from a liability perspective, there is no liability protection for an at-will or general partnership. That means that in the event of a lawsuit, all partner’s risk their personal assets being taken to satisfy any judgment. However, with a limited partnership, the limited partners are able to limit their liability to the amount of their investment in the partnership and have thus created a liability protection from their personal assets.
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Corporation
A corporation is a type of business structure where the corporation itself owns and operates the business and the corporation is in turn owned by shareholders. A corporation is required to be formally registered with the Secretary of State by filing Articles of Incorporation and obtain its own EIN from the IRS. Additionally, a corporation requires a board of directors and executive officers to conduct and manage the business of the corporation. The board of directors is appointed by the shareholders of the company. The board of directors are responsible for making major decisions on behalf of the corporation and are responsible for appointing executive officers, such as a CEO, Treasurer and Secretary. A corporation is legally required to have a board of directors as well as corporate officers. However, in solo owned or privately held corporations, it is not uncommon for one or a few individuals to serve as board members as well as corporate officers. Additionally, a corporation is required to hold annual meetings. The corporation requires to have by-laws drafted which will control how the corporation is to be managed and operated. Further, many shareholders in closely held corporations will also require a buy-sell agreement. A buy-sell agreement is an agreement between the shareholder of the corporation which outlines the procedures for a shareholder to sell their interest, how a new shareholder may join, how to value a shareholder’s interest, and any rights of first refusal that existing shareholder’s may have when another shareholder wants to leave the corporation.
From a taxation perspective, a corporation can choose to be taxes as a subchapter C-Corporation or a subchapter S-Corporation. The subchapter refers to the section of the IRS code that allows for the different tax elections by a corporation. The default classification for a corporation is to be taxed as a subchapter C-Corporation. As a C-Corp, the corporation pays tax on its profits and then an additional tax is levied on dividends paid to shareholders. Although the corporate tax rate is lower, a C-Corp may be subjected to double taxation---once at the corporate level and then once at the shareholder dividend level. Because of this potential of double taxation, careful planning may be required to minimize your tax burden.
As a S-Corp, the corporation itself is required to file a tax return, however, it does not pay any tax. Instead, the profits and losses flow through onto the returns of the individual shareholders. Because of this, there is no double taxation issue. Further, a S-Corp allows its shareholders to reduce their self-employment tax by paying themselves part salary and then taking the remainder of profits as a distribution. This makes an S-Corp favorable for many professionals and businesses that are often subjected to high self-employment taxes.
Lastly, a corporation, regardless of being classified as a C or S Corp, has the advantage of limited liability. This means that in the event of a lawsuit, only the assets of the corporation are at risk. There is no risk of a shareholder’s personal assets being at risk to satisfy a judgment absent a showing of wrongdoing by a shareholder that would bring rise to piercing the corporate veil. This is a concept where a court may find a shareholder’s actions in violation of certain rules, thus resulting in them being personally liable for the actions of the corporation as well.
Although operating as a corporation does require many formal requirements to be met, given the fact that a corporation offers limited liability, as well as the possibility of reducing taxes, makes it a strongly recommended option for many clients.
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Limited Liability Company
A limited liability company, commonly known as an LLC for short, is another business structure that is becoming increasingly popular. An LLC is formed by formally filing Articles of Organization with the Secretary of State. An LLC can be a single member LLC or can be a multi-member LLC. An LLC can be managed by one or more members or managed by a manager who is not a member. The members are the actual owners of the LLC, in the same way shareholders are the owners of a corporation. An LLC does not require as many formal requirements as a corporation. For example, there is no requirement for a board of directors or corporate officers (i.e., CEO, Treasurer and Secretary), or holding an annual meeting. An LLC will generally contain an operating agreement which states the members of the LLC and their respective ownership interests and operates similarly to the way by-laws would in a corporation. Further, the members can choose to enter into a buy-sell agreement to control how members interests will be valued and sold.
From a tax perspective, an LLC is a pass-through entity, meaning that all profits and losses flow through onto each individual member’s tax return. Although the LLC is required to file a tax return, it does not pay any tax. Thus, the LLC tax treatment is like that of a sole proprietor and partnership. However, an LLC can also choose to elect to be taxed as a corporation. By doing so, the LLC can possibly reduce the tax liability by electing to be taxed as S-Corp.
Lastly, an LLC offers the same limited liability protection that is afforded to corporations, ensuring that the LLC member will not be held personally liable for any lawsuits. Given the fact an LLC has fewer formal requirements and offers liability protection and potential tax savings, it has become increasingly popular and the best choice for most of our clients.
What Happens if I have personal debt?
Personal debt is growing year by year in America. With the advent of internet shopping, credit card access, personal loan companies, etc., overspending is becoming much easier than it was decades ago. That being said, financial hardships are becoming increasingly evident. However, if you are facing a personal consumer debt issue, looking at bankruptcy options could help you personally and as a business owner.
If I file Chapter 7 Bankruptcy, what happens to my business?
The above question would require a detailed analysis of your business and personal finances. Since Chapter 7 is a liquidation chapter, the value of your assets, personal and business, are of extreme importance when filing Chapter 7. In a Chapter 7, you are giving direct permission to the Bankruptcy Court (specifically to the Chapter 7 Trustee assigned by the Bankruptcy Court) to take your non-exempt assets, sell them, and use those funds to pay your creditors. The important aspect of that situation is making a determination on what is exempt and what is non-exempt. For example, let’s assume you are the 100% shareholder of a corporation, your business. Those shares would need to be valued on your bankruptcy filing. That value, ultimately, will either be exempt, non-exempt, or partially exempt. This analysis will determine what would happen to your business in a Chapter 7.
If I file Chapter 13 Bankruptcy, what happens to my business?
As mentioned above, the valuation of your business is crucially important when filing for bankruptcy. However, filing for Chapter 13 allows for much more freedom in your continued operation of the business. While the value of the business does factor into the Chapter 13, the business would not be at risk of being taken from you as long as you can successfully complete the Chapter 13.
A Chapter 13 case is one where you enter into a payment plan under the supervision of the Bankruptcy Court. Once filed, you are protected from creditors due to the automatic stay being active. The Chapter 13 would require you to make payments for generally 3 to 5 years based on the rules of the Court. During this process, you as the debtor would be able to continue to operate your business and you will be able to use the income generated from this business to help you make your monthly Chapter 13 payments.
At Modesto Bankruptcy Attorneys, we understand that starting a new business is a serious decision. It is our goal to assist our clients by informing them of all their options and provide them with the best choice for their specific circumstance. If you are interested in scheduling a consult to discuss either forming a new business entity, to determine if your existing business structure is best for you, or if you are a business owner and have personal debt, please click here to schedule a time to speak with one of our experienced bankruptcy attorneys. You can also contact our office at 209-314-3010.