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This article is published with
the permission of Alex Modelski to provide
information to entrepreneurs. It is intended to
be informational and does not constitute legal
advice regarding any specific situation. It may
be reprinted without the express permission of
Alex Modelski so long as it is reprinted in its
entirety including this title page.
If you have any questions
or would like additional information, contact
Alex using the contact information provided
below.
WHAT FORM SHOULD MY BUSINESS
TAKE?
December 1, 2000
Copyright@ 2000 Alex
Modelski
Alex Modelski
focuses his legal practice on Business and
Technology Law. He began his legal career as
corporate counsel at Texas Instruments
Incorporated and later became a name partner in
Hamilton & Modelski, P.C. in Dallas, TX
representing litigation clients in State and
Federal Courts. In 1998, Alex opened his
practice in Bellevue and represents many
technology clients and business start-ups with
issues such as: business formation and
financing; general business and corporate law;
intellectual property (trade secrets,
trademarks, copyrights); technology and software
licensing; drafting and negotiation of contracts
and employment law. With 19 years of legal
experience, Alex serves on the Executive
Committee of the Intellectual Property Section
of the Washington State Bar Association, is a
contributing member of the Law of Commerce in
Cyberspace Committee (Business Section,
Washington State Bar Association) and has
lectured on various Licensing issues.
Alex is also active in Bellevue
community affairs, sitting on the Board of
Directors of the Northwest Venture Group
(www.nwvg.org), the steering committee of the
Bellevue Economic Partnership
(www.bellevueadvantage.com) and the Board of
Directors of the Bellevue Schools Foundation.
Alex earned his bachelor’s
degree in Philosophy and History from the
University of Michigan with High Honors and
Distinction and his JD from the University of
Michigan School of Law.
WHAT FORM SHOULD
MY BUSINESS TAKE?
Q. What is a sole
proprietorship?
A. Sole Proprietorship is one individual or married couple in
business alone. Sole proprietorships are the most common form
of business structure. This type of business is simple to form
and operate, and may enjoy greater flexibility of management
and fewer legal controls. However, the business owner is
personally liable for all debts incurred by the
business.
Q. If I split business
profits with another person, is he my partner?
We don’t have any written partnership
agreement.
A. A Partnership is an association of two
or more persons to carry on as co-owners a business for
profit. The two essential elements are a community of interest
and sharing of profits. There need not be a written agreement.
It is wise to write down agreements about whether a partner is
expected to devote all of his/her time to the partnership,
which equipment or assets being used by the partnership are
being transferred to the partnership, how capital accounts are
being handled, how profits are split, how assets are
distributed in the event of termination of the partnership,
etc.
Q. How can partners
contribute money and share in profits, but not
be liable for the debts of the
partnership?
A. A Limited Partnership is composed of one or more general partners
and one or more limited partners. The general partners manage
the business and share fully in its profits and losses.
Limited partners share in the profits of the business, but
their losses are limited to the extent of their investment.
Limited partners are usually not involved in the day-to-day
operations of the business.
Q. Can partners
contribute money, share in profits, participate
in day-to-day operations, yet limit their
liability for debts of the
business?
A. A Limited Liability Partnership is similar to a General Partnership
except that a partner may, by meeting certain conditions,
avoid personal liability for the negligence of another
partner. This business structure is used most commonly by
professionals such as accountants and lawyers. However, all
partners are liable for the trade debt of the
partnership.
Q . What is a Limited
Liability Company (LLC)?
A. The Limited Liability Company (LLC) is a new creature of the law which
provides essentially the same limitations upon liability as a
corporation. It is a very flexible structure that offers many
advantages in terms of informality of operations, taxation and
management. On the other hand, Venture Capital firms in the
Northwest rarely fund LLC’s and shifting capital accounts can
cause accounting complexity and increased costs.
Q. How are LLC’s
and LLP’s formed?
A. An LLC or LLP is formed by one or
more individuals or entities through a special written
agreement. The agreement details the organization of the LLC
or LLP, including: provisions for management, assignability of
interests, and distribution of profits or losses. Limited
liability companies and limited liability partnerships are
permitted to engage in any lawful, for profit business or
activity other than banking or insurance.
Q. What are the
advantages of forming a
corporation?
A. Limitation of Liability. One of the main advantages of incorporating
is that, in most circumstances, it limits investors’ personal
liability. This is because the corporation is a separate
entity from the individuals who own or operate it—even if one
individual owns all of the stock and is the sole employee!
This breadth of protection from liability is not offered by
partnerships, limited partnerships nor limited liability
partnerships. If a court judgment is entered against the
corporation, investors stand to lose only the money that
they’ve invested. Generally, as long as one acts in their
corporate capacity (as an employee, officer or director) and
without the intent to defraud creditors, their assets can't be
touched by a creditor who has won a lawsuit against the
corporation.
On the other hand, any individual
within a corporation is still personally liable
for their own negligence or other
torts.
Stock Ownership . Only corporations have the legal
framework to issue ownership interests as shares of stock.
Because state laws allow corporations to attach different
rights to different types of stock, corporate stock is often
favored by investors who want to custom-tailor their ownership
rights to lessen their exposure to risk and maximize their
return. Employees, too, seek corporation stock incentives as
part of their compensation package. The ability to issue stock
as part of a tax favored employee stock option, bonus or
purchase plan is a unique advantage of doing business as a
corporation. And, of course, the ability to make a public
stock offering is a huge advantage for any business that feels
ready to tap into the public capital markets. No other type of
business has the corporation's unique ability to make a public
offering of ownership interests.
Income Tax
Splitting . Because the first $75,000 of profits
retained in a corporation are taxed at separate corporate
income tax rates that are lower than the individual income tax
rates of business owners, owners who work for their own
corporation can split business income between themselves,
individually, and their business. Profits they pay to
themselves as corporate salaries are taxed at the owners'
individual income tax rates, while profits retained in the
business are taxed at lower corporate income tax rates. Owners
can use this technique, know as income splitting, to achieve
an overall income tax savings.
Built-In Separation of
Ownership from Management . State
corporate laws set up a built-in division of rights and
responsibilities between owners and managers of a corporation.
While these extra rules and formalities are unnecessary for
smaller companies, the delegation of corporate management to a
centralized board of directors is an extremely workable model
for larger businesses. Directors have wide latitude to operate
the business using their best business judgment, while
remaining accountable to the shareholders of the corporation,
who have legal and financial inspection and disclosure rights.
This centralization of management coupled with disclosure
requirements is often the best and only way to operate a
business after it reaches a critical mass. Generally, this
happens when a business begins to look for investment capital
outside the ranks of the initial circle of people who got it
off the ground.
Q. How are corporations
taxed?
A. Under federal income tax laws, a regular 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. This leads to the problem of double taxation. If income is taxed when earned by the
corporation and taxed when paid out to shareholders as
dividends, the same profits get taxed twice.
In practice, however, a regular
corporation may not have to pay any income tax
even though it is a separate taxable entity. 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 corporate
profits, so there's no taxable income left for
the corporation to pay taxes on.
Q. What is an S
Corporation?
A. An S corporation is the same as a
regular corporation under state law, meaning that it is formed
and operated under the same legal statutes and procedures that
apply to any corporation. However, S corporations are treated
differently for federal and state tax purposes. Specifically,
the shareholders of a corporation can file an S corporation
tax election form (IRS Form 2553) with the IRS and the state's
tax agency. After this election is filed, profits and losses
of the corporation are not taxed at corporate income tax
rates. Instead, corporate profits and losses pass through the
corporation and are allocated and taxed to each shareholder
individually, in proportion to share holdings. The
shareholders pay individual income taxes on these allocated
profits, even if some or all of these profits actually stay in
the corporation--that is, even if all profits are not actually
paid out to the shareholders each year
Generally, a corporation cannot elect
S corporation tax treatment unless it has 75 or
fewer individual shareholders who are U.S.
citizens. Most types of entity shareholders,
such as corporations, LLCs and partnerships, are
prohibited from owning shares in an S
corporation. Also, an S corporation can't issue
preferred shares of stock with special
liquidation, dividend or conversion rights.
Q. Can I change form of
entity once the business
begins?
A. Yes, your initial choice of
business form need not 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. Handled
correctly, a contribution of assets from one business form
into a corporation may be a non-taxable transaction. Of
course, attorneys and accountants should be
consulted.
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