Setting Yourself up For Business – Part I: Organizing the Entity

There are quite a few different business structures.  We’d like to start out by having you understand that the legal structure (what you are from the state’s perspective, or what you are “chartered” as, that creates the new “legal” entity) can be different from how the federal government views you from an income tax perspective.

The reason for creating a legal “entity” is mainly asset protection.  A legal entity (with a few exceptions) will separate and protect your personal assets (your home, your car, your furniture, etc. etc.) from claims by customers/clients, creditors/vendors, or the general public (especially if you operate a place of business where the public is invited into the establishment – ex. a gym, a store, etc.).  Please note, we’re saying “generally” because using a “shell” entity, or using the entity in such a way as to not really be an operational entity (co-mingling accounts – i.e. not having separate business accounts from your personal; not signing documents with the full legal name, etc. ) may lead to a claim that the entity is just a sham and be disregarded.

Another important point to note here is that a sole proprietorship is not an entity.  It is merely you operating a business under a business name. It carries no separation between you (personal assets) and the business and therefore no protection of your personal assets.   Before going any further, it’s important to note that, insurance is also a key ingredient in protecting your assets if used properly as well but we will discuss types of insurance later in the series.

1) a Partnership.  A partnership can exist without registering with the state and is created by a contract between you and at least 1 other person, agreeing to share profits from the operation of the business.   The rules that affect a partnership are mainly created by the contract (called a Partnership Agreement), although many states will have some additional laws and regulations that apply generally to partnerships.  The main area affecting partnerships is with taxes.  It’s too big of a subject to go through all the rules that affect partnerships but suffice it to say there are ways to allocate (or adjust) the way expenses (the key to deductions) are made as between (or among) the partners.   It is best to consult an accountant who can walk through all the specifics.  The good thing about partnerships for federal income tax purposes is that they are a “flow-through” (i.e. income and expenses, and therefore, profits and losses) all flow through directly to the individuals (and can be matched against other non-business income or deductions that the individuals have.  The main thing from a legal perspective is that partners owe a duty to each other (good faith and fair dealing).  Whenever there is a duty, there is a legal obligation not to do something, in this case, self-deal (or do transactions that are solely in your own interest, rather than that of the partnership).

2) a Corporation,  A corporation is a legal entity where the management is separated from the ownership of the entity.  That is, you have separate shareholders (owners) and separate managers (a board of directors, CEOs, CFOs, COOs, V.P.s, Managers, Supervisors, etc.).  The management operates the business for the benefit of the shareholders (so the duties, like those for partnerships, are owed to the shareholders).  The board of directors are the “official” managers from a legal perspective and the rest (officers) are merely delegates of the board who perform their assigned responsibilities. The main documents that govern a corporation are (1) the Shareholders Agreement (similar to the Partnership Agreement) that addresses the relationship (rights and responsibilities) between the shareholder and the corporation, as well as between the shareholder and the other shareholders; and (2) bylaws, that address how meetings are organized and held, procedures for voting, and what are the roles and responsibilities of officers of the corporation.  The reason meetings are so important is that, as discussed above, if you do not adhere to the formalities of “being” and operating a corporation (holding meetings, creating minutes, or a record of the meetings, etc.), that entity may very well be considered a sham or shell and be disregarded for legal purposes.   There are other agreements such as a stock purchase agreement (discussing the actual purchase of the stock) and many others that may be detailed in the future.   From a federal income tax perspective (and this is what people most often confuse about corporations), there are two different types of classifications:  “C” corporations and “S” corporations.   Without going into the tax details, a “C” corporation is taxed at the entity level and when distributions to owners are made (the infamous “double” taxation) and has certain rules that apply to deductions and accounting whereas an “S” corporation is a flow-through (like a partnership). The only thing to be careful of with “S” corporations is that you have to file a form (make an election) to get that treatment and there are restrictions on the number, nationality, and types of persons that can be shareholders.  If you mess that up, the IRS may consider you a “C” corporation.

3) a Limited Liability Company.   A limited liability company is a very flexible entity and one of the most often used forms of entity.  It is often characterized as a hybrid (mixture of a partnership and a corporation).  The rules governing an LLC are contained in an “Operating Agreement” (which covers all the matters essentially that are in a partnership agreement and bylaws of a corporation).  For federal income tax, it can be treated as either a partnership or a corporation (and therefore, also, either a “C” corporation or an “S” corporation).  What is important to remember though is to get the treatment, you have to file forms (elections).

Always remember that to form an entity, you will need to contact your Secretary of State’s Office, but you may also need to register with the State’s Department of Revenue (especially if sales tax may apply to your operations).  Many states have a “one stop” portal that will register you with all the necessary state offices.  As mentioned above, keep in mind necessary filings with the IRS as well.

Stay tuned and subscribe to The Warrior Rising Newsletter for what’s next:  Part II:  Setting up Books and Records (Accounting) and Getting Started