Super Structures
BY ANNE GABRIEL
Every business owner knows the importance of attending to personal attire. But how about your company’s legal organizational structure?
While a commercial legal structure often doesn’t make a whole lot of impact on the daily operations of a small business, it usually does make a large difference when you’re paying taxes, dealing with a lawsuit, or looking to borrow money.
In short, it’s a smart idea to set things up correctly from the start.
Cover your assets
Commercial legal structures come in three basic flavors: sole proprietorship (a business owned and operated by one individual who has unlimited personal liability), partnership (voluntary association of two or more people, serving as co-owners of the business, and each carrying unlimited personal liability) and corporation (defined by the U.S. Treasury Department as a “group of people granted a charter legally recognizing them as a separate entity having its own rights, powers, privileges and liabilities distinct and separate from those of its members”).
No matter what route you take, many, if not most, experts will counsel you to consider a legal structure that doubles as a mechanism for significantly reducing your business risk.
Although gaining a liability shield was once reserved for corporations, today sole proprietorships and partnerships can easily and cost-effectively limit liability as well. “In the mid-1990s, states began looking for ways to extend the liability shields traditionally reserved for corporations,” says business entity legal expert Bill Habicht of Minneapolis law firm Messerli & Kramer PA. “They settled on the limited liability company (LLC), which was extended to cover sole proprietorships and partnerships.”
In a nutshell, an LLC is a business structure that is designed to blend a corporation’s limited liability features with the flexibility and tax efficiencies of a sole proprietorship or a partnership.
Becoming an LLC is a relatively painless procedure. The only required expense is the registration fee filed with the state (although it’s typically a good idea to meet with an attorney to draft the appropriate organizational documents). Owners of an LLC are called members, and may include individuals, corporations, other LLCs, and foreign entities.
According to the IRS, there is no maximum number of members, and most states (including Minnesota) also permit “singlemember” LLCs, those with only one owner. “A single-member LLC is disregarded as a separate taxable entity (unless its owners choose for it to be a separate taxable entity), says Bill Horn, a managing director of tax with RSM McGladrey, a Minneapolis tax and business consulting firm. “A multiple member LLC is typically taxed as a partnership. In either case, the LLC shields its members from personal liability for business debts.”
With all of that in mind, the LLC has become an increasingly popular option for sole proprietorships and partnerships that want to protect their personal assets or secure additional loans. The basic rules for partnerships also remain the same when structuring the business as a multi-member LLC, Habicht says. “Partnerships [consist of] two or more individuals or companies.
When companies form partnerships, they’re called joint ventures. All of these partnership forms may now enjoy the benefits of an LLC and a liability shield.”
What’s at stake
By selecting corporation or LLC status, business owners protect themselves personally from the risk of any claims against their company. While money invested by business owners is subject to loss, the liability for business debts does not attach to owners personally. For example, imagine that one of your business partners takes out a $200,000 loan using the business as collateral only to default on the loan later. If your personal investment in the business is only $75,000, then you could lose your $75,000 but not be liable for the loan.
While LLC status doesn’t eliminate the need for personal liability insurance, it can significantly reduce personal exposure to business risk. More importantly, it can save you and your family from losing personal assets to adversities beyond your control. That said, becoming an LLC isn’t a panacea— you’re still responsible for taxes as well as for any debts for which you have provided a personal guarantee of payment, such as those owed to financial institutions, credit card issuers, or suppliers.
The corporate route
Despite the benefits of LLC status, incorporating may provide the best advantage. A corporation is a legal entity, that, unlike either a sole proprietorship or partnership, is a completely separate legal and taxable entity from its owners. Incorporating shields owners and investors from liability. A corporation also is a separate entity for income tax purposes also.
An option when incorporating is electing to be an “S corporation” for income tax purposes. An S corporation is a corporation under state law, but the income is taxed to its owners. A principal benefit is that the income is only taxed once while the earnings of a regular corporation (or C corporation) could be subject to double-taxation. “Essentially, this means you receive a salary, minus withholding for taxes, plus you can receive a distribution of any profits that are not subject to Social Security taxes,” says Habicht. “And, the corporation carries the legal liability.”
But beware of incorporating as a tax dodge. “The IRS takes a hard look at S Corporations where owner/employees draw $20,000 salaries but receive an $80,000 distribution to avoid Social Security taxes,” Habicht adds.
“The tax considerations related to entity selection can be very complicated,” says RSM McGladrey’s Horn. “These include current operations, growth plans, and eventually an exit strategy. All impact your selection.” Deciding between S and C status largely depends on your ultimate business goals. “Choose C Corp status if you’re planning to grow rapidly and go public,” Habicht says. “Venture capital is nearly impossible to obtain as an S Corp due to legal
restrictions.”
Indeed, an S Corp may not include corporate shareholders unless a corporate shareholder owns 100 percent in the company. Additionally, S Corps are limited to 75 shareholders, and may issue only one class of stock, which means it’s nearly impossible to meet the trading requirements for becoming a public company.
On the other hand, an S Corp status may be the right move if you plan to expand your business to the point of eventually merging with a public company.
Even if going public is not in your plans, most closely owned businesses that incorporate should be better off taxwise as an S Corp, says Horn. “The single-tax structure can be a valuable benefit to a successful company.”
For those considering converting from a corporation to an LLC, Horn sounds a cautionary note. “Adverse tax consequences could result,” he says. “Competent professional guidance is key in unique situations.”
Beyond tax and limited liability advantages, both corporate and LLC status can broaden your available leadership via a board of directors. Having a board can provide entrepreneurs with support, advice, and guidance that can ease the personal stress of running a business. “By thoughtfully selecting individuals to be on your board, your business gains the expertise of seasoned professionals who can help your company grow and prosper,” Habicht points out.
Why worry?
If your business is in a low-liability industry, perhaps you’re wondering why it’s worth worrying about a liability shield at all. “Because no one plans to fail, they fail to plan,” says Habicht. “Business owners should ask themselves, ‘Do I have written agreements with my partners and investors regarding items such as dispute resolution, the process for purchasing equity from a withdrawing member, and business continuation in the event an equity partner needs to withdraw?’”
And, these are only a high-level sampling of concerns, he adds.
Having seen companies come and go, Habicht advises business owners to meet with three types of advisors at least once a year: an accountant, attorney and insurance agent. “Even if you’re in great shape, these three advisors will help you catch possible problems in advance,” he says.
In Habicht’s experience, successful startups typically are those with sufficient capital to seek professional advice. “Those who meet with advisors up front don’t just get off on the right foot,” he says. “They also save tens, or hundreds, of thousands of dollars, later on.”