When starting a new business, one of the earliest decisions is what legal structure to choose. The choice depends on size, risk, desired tax structure, flexibility required, and the needs of the participants in a particular structure.
Benjamin Branche, an associate at Szaferman, Lakind, Blumstein, and Blader at 101 Grovers Mill Road, Lawrenceville, will speak on “Legal and Tax Considerations When Forming a Small Business,” Tuesday, June 26, from 6:45 to 8:45 p.m. at the South Brunswick Public Library, 110 Kingston Lane in Monmouth Junction. Teaching the course, sponsored by SCORE, with Branche is Leon Petelle, a retired certificated public accountant. For more information, call 609-393-0505 or E-mail firstname.lastname@example.org.
Branche lays out the potential structures available to a business:
Sole proprietorship. In this case, a single person owns the business; and if the business is sued, his or her personal bank account, home, and other assets may be subject to claims of creditors for business debts or liable as a result of a suit.
Partnership. This is defined as two or more people who are involved in a transaction for purposes of generating a profit, says Branche. Partners are liable in the case of a suit just as sole proprietors are. Branche says he rarely uses these first two forms because of liability issues, but instead looks to use limited liability companies to protect assets.
Limited partnership or LP. This type of partnership includes two types of partners, limited and general partners. Limited partners have limited liability vis-a-vis the claims of creditors, while the assets of general partners may be subject to creditor claims.
Limited liability company, or LLC. Probably the newest and most common business format, the limited liability company involves either a single person or individuals who come together as partners to form this entity, which is similar to a corporate form but is more flexible and has fewer requirements. Except in cases where members do something that is intentional, illegal, or have exhibited personal negligence, liability is limited to the assets of the entity itself.
What distinguishes a limited liability company from a corporation is that it has pass-through taxes, that is, any profits or losses are “passed through” directly to the members, who either pay taxes or take losses on their personal returns.
If there is more than one member of the LLC, the company itself files a partnership return that is an informational document sent to the Internal Revenue Service. Otherwise, if it is a single member LLC, the member reports the profits and losses on Schedule C of his or her tax return.
While today this is the most common business form and it has been around since 1977, attorneys were reluctant to use it because there was so little case law behind it. However, in 1988 the IRS issued a favorable tax ruling for LLCs, and they began to become more popular in the 1990s. Since then a significant amount of case law has built up.
Corporation. The corporation, perhaps the most widely known business form, is owned by shareholders. The corporation pays corporate taxes, and the shareholders pay taxes on any dividend distributions they receive from the corporation.
S corporations. In this form, the corporation itself does not pay income tax. Rather all the income and losses flow through to the shareholders, who report them on their individual income tax returns. An s-corp may be advantageous to those who desire to reduce the amount of self-employment tax paid.
In an s-corp the shareholder employees will be paid a reasonable salary, which is subject to the self-employment tax, but any additional income will be distributed as dividends, which are not subject to this tax (currently 13.3 percent). By contrast, in a limited liability company, everything earned by the individuals involved in the entity is subject to the self-employment tax.
An s corporation does have some limitations. It is limited to 100 shareholders, which is not true for the corporation or the limited liability company, has more stringent reporting requirements, can only have one class of stock, is less flexible, and cannot have corporations or LLCs as members; further, trusts have to be drafted in a specific way to be members of an s corp.
Branche says, “In most cases, I don’t recommend s-corps because of one of the other disadvantages — more strict reporting requirements.” These entities are required to have an annual meeting every year and keep minutes. In addition, because of the limitation on members to citizens and residents of the United States (and limited trusts), such a structure limits who may invest in the business.
With a limited liability company, the structure is more flexible than an s-corporation. An operating agreement sets forth the terms of the relationship among the members who own the company. Each member has a capital account that determines what his or her ownership interest is. Members can be both investors and employees.
This form can be fairly flexible as long as it is in compliance with the Internal Revenue Code and is not structured for purposes of avoiding tax. If a transaction is among related parties, it is important to follow Section 704 of the Internal Revenue Code, which sets forth how distributions of profits must be allocated among the partners (similar to that of a corporation, where distributions are based on ownership).
If Section 704 is not followed, the distributions must have a “substantial economic effect.” Branche offers an example of how this might work: If a son is involved in his father’s business, he can only be allocated profits equal to what he has put into the company — which constitutes his “capital account.”
If the father has contributed $50,000 and the son only $1,000, then the father cannot distribute the profits 50-50 unless there is a substantial economic reason for doing so. If the parties to the same transaction were not related and there was an economic justification for the distribution of profits in this manner (other than to avoid taxes), such a distribution may be appropriate.
Another advantage of a limited liability company is the ease of moving from this form to a more complex corporate structure as the business grows. A move from a limited liability company to an s-corporation or corporation has little or no tax implications.
If a business starts instead as a corporation or s-corporation and then deems this structure too complex, it pays a price because the structural change would be deemed a liquidation for tax purposes. When clients express to Branche the expectation of going public at some point, usually he will still start them as a limited liability company and change the structure as the business’s needs change.
One downside of a limited liability company is cost. It requires payment of an annual fee for each member, which can get expensive if the company has lots of members. Additionally, given the costs of setting up a limited liability company, a filing fee of $125, and attorney fees, it may not make sense for certain types of businesses, for example, freelance writing.
Branche lived in New Mexico until age 11 and then moved to Yardley, Pennsylvania. His mother was an insurance analyst for the Branche Research Group and is now semi-retired and selling Native American jewelry.
Branche majored in economics and criminal justice at the University of Scranton, with the idea that he wanted to work in Federal Law Enforcement. But facing the realities of student loans after completing the Columbus School of Law at the Catholic University of America in 2004, he decided that a law firm was the way to go.
His first position was at Gimmel, Weiman, Ersek & Blomberg in Gaithersburg, Maryland, outside Washington, DC, and then he moved to Hill Wallack in Princeton. Now at Szaferman, Lakind, Blumstein, and Blader he specializes in business, tax, trusts, and estates.
A carefully selected business structure is important not just for peace of mind and protection of personal assets, but also for financial flexibility. The right structure can grow and develop just as the business grows and develops. But choosing the right format at the right time is a critical business decision.