The Corporation

The textbook definition of a corporation is “a body of persons granted a charter legally recognizing them as a separate entity having its own rights, privileges, and liabilities separate from those of its members.”  Essentially, the corporation is a legally recognized entity separate from its members formed with the permission of the state.  As a legally recognized entity, it enjoys most of the rights and responsibilities of individuals – ownership of property, to sue or be sued, etc.

Formation: A corporation is formed when a person, the incorporator, files a document with the state known as the Articles of Incorporation.  This document contains the basic information about the corporation including the name and principle place of business, the corporation’s period of duration, the corporation’s stock, the registered agent, the directors and the incorporators of the company.  Most states maintain lengthy and detailed laws relating to the formation of corporations and may require the submission of materials in addition to the Articles of Incorporation.

Management: Although a corporation is a separate entity with rights of its own, it can’t think or act for itself but does so through its Board of Directors.  Directors are appointed by the shareholders and act like trustees, overseeing the business affairs of the corporation.  The directors generally oversee the strategic management of the corporation.  To manage the day to day operations, the directors appoint and hire officers.

Taxation: Since a corporation is an entity separate from its owners, the income of the corporation is taxed to the corporation itself at the applicable corporate tax rate.  In addition to the corporate tax, employees pay income tax on salaries and shareholders pay tax on dividends.  Thus, the revenue of the corporation is subject to taxation at two different levels before landing in the employee or shareholder’s bank account.

Liability: Generally no shareholder can be held personally liable for the debts, obligations or acts of the corporation beyond the amount of share capital he or she has contributed.

Transferability: Because the corporation is a separate legal entity, its existence does not depend on the continued membership of any of its members.  This trait makes transferring corporate ownerships fairly easy, subject to the rules the corporation subscribes for its shareholders in its organizing documents.

Dissolution: Dissolving a corporation can be a lengthy and complicated process.  At a minimum, the following steps are required:
•    Formal corporate action
•    Filing with the appropriate state offices
•    Statutory notice to creditors
•    Processing of all creditor claims
•    Sale and distribution of all remaining assets

Pros: Limited liability; possible tax advantages; clear management authority; ownership is transferable; continuous existence; easier to raise capital.

Cons: Highly regulated; Expensive formation and compliance; extensive record keeping necessary; double taxation of dividends; personal guarantees undermine limited liability advantage.

Bottom Line: A corporation is usually the most expensive and administratively complex entity to form, run and dissolve.  But, the corporate form offers the most definite division between ownership and the entity and therefore may provide the most liability protection for business owners.  Additionally, most investors prefer the corporate form as a barrier to personal liability and for its specificity of ownership and control via stock.

The Partnership

According to the IRS, a partnership is

1. An association of two or more persons;
2. Who have not incorporated; and
3. Carry on a business for profit as co-owners.

Partnerships are formed from the moment two or more people decide to enter into business together.  Since there are no other legal requirements, a partnership may exist even if the people involved do not know or intend for their relationsip to be considered a formal partnership.  Partnerships, unlike sole proprietorships, are legal entities separate from the partners themselves.  There are essentially two types of partnerships: general and limited.  In a general partnership, each partner has unlimited liability.  In a limited partnership, only the general partner is exposed to unlimited liability.

Formation: A general partnership may be formed by an oral or written agreement, the agreement should always be in writing to prevent future problems. Generally, each partner makes a contribution to the business in the form of cash, property or services. These investments are made in exchange for an “interest” (a legal term for some kind of ownership) in the partnership. Most states and localities impose registration requirements, so make sure to review local requirements or consult a small business expert in the region.

Management: In a general partnership, each general partner has equal responsibility and authority to run the business. Additionally, any partner may represent the business without the knowledge of the other partners, so the actions of one partner may bind the entire partnership. If one partner signs a contract on behalf of the partnership, the general partnership and each partner are responsible for that contract.  In a limited partnership, the general partners are vested with management authority, and the limited partners have little to no control over the partnership’s management.

Taxation: Partnerships are taxed on a flow-through basis. This means that the partnership itself does not pay taxes; instead each individual partner is taxed on his or her share of the profits and losses. When filing taxes, partners report their share of profits and losses on their personal tax returns, regardless of whether or not the profits are distributed to the partners or kept in the business.  Partners may also pay self-employment tax of 15.3% on their share of partnership income.

Liability: All general partners are personally liable for the business debts and liabilities of the partnership, including those incurred by other partners. Limited partnerships are generally formed to encourage limited partners to invest in the business without exposing them to personal liability for the actions of general partners. Limited partners are usually not personally liable for the debts of partnership beyond what they contribute to the business.

Transferability: Unless otherwise provided for in the partnership agreement, no person or entity may become a member of a partnership without the consent of all partners. However, a partner may assign his share of the profits and losses and right to receive distributions to a third person.

Dissolution: The partnership agreement may state that a partnership will have a definite life or operate for the attainment of a specific purpose and then automatically terminate. When the life is over or the goal has been accomplished, the partnership will terminate and dissolve. Technically, a partnership terminates upon the death, disability, or withdrawal of any one partner. Partnership agreements may provide for these types of events with the share of the departed partner being purchased by the remaining partners in the partnership. A partnership will continue to exist until the winding up of partnership affairs is completed, then it will cease to exist.

Pros: Generally less expensive and require less paperwork and formalities to start and run than a corporation; flexibility in defining the partners’ relationship and allocation of income and losses; easier transferability than a sole proprietorship or an S corporation.

Cons: General partners have unlimited liability for the actions of the partnership and other partners; partnership may automatically dissolve if a general partner dies, files for bankruptcy, retires or resigns; management is more difficult since rights are not as clear-cut as in a corporation.

Bottom Line: A partnership is relatively easy to establish, but potential partners must spend time establishing the ground rules for the partnership in order to avoid future problems related to management, liability and transferability.

The Sole Proprietorship

According to the IRS, a sole proprietor is someone who owns an unincorporated business by himself or herself. Individuals need do nothing formal to establish a sole proprietorship. The sole proprietorship is the most common form of business structure for small companies. It is viewed as being one and the same as its owner from both a legal and tax perspective. This characteristic has the advantage of simplicity but also has the disadvantage of exposing the owner to personal liability.

Formation: Simply start doing business. Most states and localities impose registration requirements, so make sure to review local requirements or consult a small business expert in the region.

Management: The sole proprietor controls all business decisions alone.

Taxation: The sole proprietorship is a disregarded entity for tax purposes. All business income and expenses are reported on the owner’s federal tax
return. In addition to federal income taxes, self-employment tax of 15.3% generally applies.

Liability: The business owner is liable in contract and tort for the activities of the business. Creditors of the business may claim against both the sole proprietor’s personal and business assets. Conversely, personal creditors of the business owner may claim against both personal assets and those of the sole business.

Transferability: The existence of the sole proprietorship business is linked to the business owner. So, continuity of business operation is uncertain if the owner wants to transfer the business assets or operation to another person.

Dissolution: To dissolve the business, the sole proprietor simply stops doing business. The business owner still has an obligation to notify creditors of the cessation of business. Additionally, state and local regulations may impose notification requirements upon the sole proprietor. The sole proprietorship will also cease to exist upon the death of the owner.

Pros: Fewest legal formalities (easy to start, transfer assets and dissolve), unlimited control, minimal income tax filing requirements.

Cons: Unlimited liability, uncertain continuity in the event of owner’s death or incapacitation, limited access to investor capital.

Bottom Line: The sole proprietorship is the easiest entity to start, operate and manage from a legal and tax perspective. It may be a suitable choice where the nature of the business is simple and potential liability for the owner is minimal.

Negotiating a new commercial lease is a crucial moment for any business.  Since the business owner will have to live with the choices made at this critical juncture, I thought I would provide a top 5 list of the biggest mistakes I see potential tenants make when attempting to find and negotiate space for their business.  If you can avoid some or all of these mis-steps, you will be far ahead.

1.   Not forming a LLC or corporation first.  You should go into negotiations with your separate entity already formed and ready to be named as the lessee.  This one step may dramatically limit your personal liability on the lease.  If you can avoid a personal guarantee, you’ll sleep easier at night.

2.   Not knowing what to ask for from the landlord.  Do you want to abate the rent until you open for business?  Do you need financial help with the construction costs?  You need to think through what you will need before you sign the lease, because it will be too late afterwards.

3.   Not understanding the terms.  What is a triple net lease?  What services will the landlord provide and which services are you responsible to provide?  If you haven’t negotiated a lot of leases, the terms can be confusing.  Make sure you understand all of them before signing anything.

4.   Falling in love with one location.  There is a lot of commercial space out there and you should be willing to move on to the next opportunity if you can’t agree on terms that make sense to your business.  Often, an entrepreneur will make changes to his or her business model to fit the lease – a backward dynamic.  If you believe there is only one perfect location for your new business, then I would seriously consider a new business.

5.   Not understanding the costs of build out and start up before signing the lease.  Facing construction sticker-shock after you signed a long-term lease is a terrible way to start off in your new location.  Make sure you have a firm handle on the projected costs of having your proposed location prepared open BEFORE you sign a lease.  Once you’re in, you’re in and the landlord is not going to be sympathetic when you can’t make the rent payment because you under-estimated the start-up costs.

Keep in mind that in most commercial lease situations, the landlord and its agent will have much more experience than you.  They do this type of work everyday while most entrepreneurs will only negotiate a handful of leases in their working lives.  This makes it crucially important to have experienced help in the form of a real estate agent and/or lawyer on your side to make sure you get the best deal possible.

One of the first decisions a business owner must make when embarking on a new venture is how the company should be structured. The decision has far-reaching and long-term implications, so a proper consideration of the available options and their implications is vital.

Traditionally, the most popular business entities were the sole proprietorship, the corporation and the partnership. But, these traditional entities now require consideration of variations like the S corporation, limited liability partnership or newer business forms such as the limited liability company.

The choice of entity analysis requires a careful assessment of relevant income tax considerations. Each entity option offers certain tax benefits or traps that may pose problems in the future. Good business planning involves a review of the tax benefits and traps of each entity type and their potential relevance to the specific business model contemplated.

Some perceive the choice of entity decision solely as a tax-driven exercise. Although tax implications are vitally important, there are many important non-tax factors that can impact the ultimate decision. In most situations, the analytical process requires the business owner and the planner to make some predictions on what is likely to happen in the business’ future. Some of those predictions include:

• Potential for liability;
• Projected earnings and losses;
• Capital expansion needs;
• Possibility of adding new owners;
• Potential exit strategies;
• Likelihood of a sale;
• Estate planning needs of the owners;
• and a variety of other factors.

Consequently, the decision making process is not an exact science that produces a single perfect answer for every situation. There is a need to weigh and consider a number of factors, while being sensitive to the consequences of the alternative options.

This article is the just the introduction in a series in which we will break down the choice of entity in more detail and discuss many of the subtle issues involved. However, any entrepreneur considering forming or changing a business entity would be best served by gathering the relevant business facts and consulting with a qualified Tax-Business Attorney.