We are proud to feature Sean Velarde our dear and blessed friend with a kind heart and an abundance of knowledge. For several years he has been helping us better serve hurting people and animals. He protects, guides and gently teaches us. I'll never forget our first conversation. We made an immediate connection and before long his beautiful daughter featured Gracie and I in her school report about heros.
Soon we spoke at her school and forged a plan to meet the students at the Denver Children's Hospital where they helped us with Free Storytime and Love Kit give-a-ways all year to bless and encourage those getting treatment. I'll never forget what one mother said during a visit. Pulling her little child in a red wagon, tubes, IV's in tow, and with tears in her eyes said, "I'll never forget this day as long as I live. It's the first time my son has smiled in months. Thank you!"
Sean helps to make these moments possible. We highly recommend him and encourage you to contact him and enlist his services.
What Form of Entity is Best for Your New Business?
By D. Sean Velarde, Esq.
Introduction
If you desire to protect your personal assets from creditors, or you desire to minimize the tax consequences to your new business and to yourself as an owner of the business, then the legal entity you choose for your business is very important. You and your advisors must consider many factors to insure that your goals are achieved. An attorney or an accountant may appear smart by quickly stating that a particular business form is suitable for every new business. However, the proper choice of entity cannot be determined until you and your attorney explore several factors, including the purposes for forming the entity together with your desire, if any, for a limited liability and tax savings.
You must also carefully consider the legal requirements and regulations applicable to the business or its industry, the choice of jurisdiction for the new business, and your short-term and long-term goals, including ownership succession or the future potential sale of the business. The ability to sell your ownership interest in a business, the ease of raising capital, the relationship between co-owners, and liability for the business’s tax or legal problems are all dependent upon the choice of entity.
Business owners can be held personally responsible – as opposed to just the business being sued – for liabilities and injuries by anyone who believes they have been harmed in any way by the business. Owners may also be held personally responsible for certain contracts and other agreements entered into on behalf of the business. With proper planning, your personal assets can be protected from those risks and your taxes minimized. Deciding on what entity to use is one of the most important decisions made by the owner of a new business.
This article outlines several types of entities available and some of the more important factors that should be considered when choosing the best form of entity for your new business. This article provides summaries of those factors and should not be relied upon as comprehensive. Each particular circumstance is unique and requires its own independent analysis.
There are numerous types of entities for the new business owner to consider. The options include the sole proprietorship, the general partnership, various types of limited partnerships, a C-corporation, an S-corporation, or a limited liability company.
Sole Proprietorship
An unincorporated, sole-proprietorship is one option for a new business when there is a single owner who is not concerned about limiting the owner’s liability for operating the business or his or her taxes in connection with the business. There is no legal separation between the owner and the business. Therefore, the owner is personally liable for all business-related debts, obligations, and judgments obtained against the business.
Formation of the sole proprietorship is easy and inexpensive. No filing with the secretary of state is required to form a sole proprietorship. However, the business may be required to register with certain state and local agencies and obtain applicable licenses and permits. All profits and losses from the business must be reported on the business owner’s personal tax return. Sole proprietorships have difficulty raising capital because they cannot sell interests in the business. If the owner sells a partial interest in the business, he or she and the new owner have formed a general partnership.
Given the relatively modest expense in creating an entity recognized by statute that will provide substantial protection for various personal liabilities and may also provide favorable tax treatment for the new business owner, sole proprietorships are generally viewed as an unwise choice. The single business owner who is not intentional in forming an entity with limited liability and favorable tax treatment may unwittingly operate the business as a sole proprietorship with all its attendant risks and disadvantages.
Partnerships
Generally, when two or more people associate to carry on, as co-owners, a business for profit, they have formed a partnership, whether they know it or not. Like a sole proprietorship, no filing with the secretary of state is required to form a general partnership. Again, the business may be required to register with certain state and local agencies and obtain applicable licenses and permits. Partnerships have many benefits, but can increase the risk of personal loss for business owners without proper planning. In a general partnership, all of the partners are personally exposed to the actions of the partnership and the other partners.
It is possible to form a general partnership without intending to do so. General partnerships generally are disfavored these days because each partner in a general partnership has unlimited liability for the obligations of the partnership and the acts of the other partners. If limited liability is desired, another type of entity is more desirable. For income tax purposes, general partnerships are a pass-through entity unless the partnership elects otherwise.
Each state has adopted rules regarding how partnerships operate in their state and most states have several different types of partnerships. Depending on the limited liability and tax goals of the owners, limited partnerships are often preferable to general partnerships.
In many states, a limited liability partnership is a general partnership that has elected for most or all the partners to have their liability limited to the amount of property and money they have contributed to the partnership. A limited partnership is a partnership which has at least one general partner who has unlimited liability for the obligations of the partnership, and at least one limited partner that has liability limited to his or her contribution to the limited partnership. Management of a limited partnership is vested in the general partner and may be governed by a partnership agreement or the applicable state statutes.
To form a limited partnership, the owners or the organizer of the partnership must file the appropriate articles or registration statement with the secretary of state in the state of organization. Limited liability limited partnerships, limited partnership associations, and other types of partnerships may be available depending on the state of organization and may provide unique benefits to the business owner. Limited liability partnerships, limited partnerships, limited liability limited partnerships, and limited partnership associations all are pass-through entities for tax purposes.
Corporations
A corporation is a separate legal entity owned by one or more co-owners, legally referred to as “shareholders” or “stockholders.” A corporation is formed by filing articles of incorporation with the secretary of state in the state of incorporation and paying the appropriate filing fee. Each state requires that certain information be included in the articles of incorporation, although those requirements vary from state to state. Each state also allows the incorporator to add other permissive and discretionary provisions to articles of incorporation which may be very important to the governance of the business and limiting risk.
A corporation is an independent legal entity distant from its shareholders. The corporation has a legal authority to enter into contracts, own property, litigate disputes, and transact other business consistent with its purposes. A corporation generally is characterized by providing limited liability for its shareholders, perpetual existence independent from its shareholders, transferability of ownership interests, and centralized management by its officers and directors.
Limited liability means that shareholders are not typically liable for the obligations of the corporation. Instead, their liability is limited to the amount of their investment in the stock of the corporation. Shareholders may be liable for corporate obligations if corporate formalities are not followed and a creditor can convince a court that it was appropriate to “pierce the corporate veil” to reach the shareholder’s personal assets. A shareholder may also be responsible for corporate obligations arising out of the shareholder’s own bad acts, such as breaching a legal duty to other shareholders or the corporation. Finally, a shareholder may voluntarily waive some of the limited liability protection offered by a corporation by personally guaranteeing certain obligations of the corporation like a line of credit or lease.
A corporation is governed by its articles and its bylaws. Like articles, bylaws may include various permissive and discretionary provisions which may be very important to the governance of the business and limiting risk. A corporation must also follow “corporate formalities” such as keep minutes of annual and special meetings of its shareholders and directors to avoid having its corporate veil pierced. The shareholders may also desire to have certain management and shareholder agreements like a buy-sell agreement which restricts the shareholders’ ability to sell his or her ownership. Buy-sell agreements determine how business owners may later part ways and can prevent the remaining owners from having to be in business with someone not of their choosing.
Management of the corporation as governed by its bylaws unless no bylaws are prepared, in which case it is governed by state statute. Management of a corporation is entrusted to its directors who are elected by its shareholders. Directors may delegate certain duties of management to officers. In new, small, and closely-held corporations, the shareholders often appoint themselves as directors and officers. In that case, the shareholders should avail themselves of many of the permissive and discretionary provisions which may included in the corporation’s articles and bylaws. Some of the optional provisions include providing for the indemnification and elimination of liability of directors in certain circumstances.
A common type of corporation is the C-corporation which is a for-profit, state-incorporated business. C-corporations can take advantage of corporate benefit plans, health plans, and retirement plans that are not available to some non-corporate businesses. Also, the C-corporation is easiest entity for raising capital. The primary disadvantage of a C-corporation is that it is subject to double taxation. That is, the corporation’s income is taxed at the corporate level and then, when its shareholders receive dividends or other distributions, taxed again on the shareholders’ personal tax returns.
Under the Internal Revenue Code, Subchapter S, certain corporations may elect “S-corporation” treatment. An S-corporation is a corporation that elects not to have its income taxed at the corporate level. Rather, it is a “pass-through” entity which means its shareholders are allocated a pro rata share of the corporation’s net income that they then must report on their individual tax returns. To qualify for S-corporation treatment, the corporation must have a limited number of shareholders who generally must be U.S. citizens or resident aliens, must have no more than one class of stock, and generally may not have any entities as shareholders. Further, all of the corporation’s shareholders must approve the election to be taxed as an S-corporation and file the appropriate IRS forms within seventy-five days after incorporation. The S-corporation offers the same limited liability protection for its shareholders, perpetual existence independent from its shareholders, and centralized management. However, given the Internal Revenue Service regulation, transferability of ownership interests is not as easy as that of a C-corporation.
Limited Liability Companies
Limited liability companies (LLCs) provide limited liability to its owners, usually referred to as “members.” An LLC is formed when it files articles of organization with the secretary of state in the state of organization and pays the appropriate filing fee. Like partnerships, most limited liability companies are pass-through entities for federal income tax purposes. However, its members may elect corporate tax treatment. If an LLC has only one member, the member can elect to have the entity disregarded for federal tax purposes. The LLC will enjoy state provided limited liability, but sole proprietorship tax treatment.
An LLC may be managed by its members or managers chosen by its members. Depending on the owner’s desires, the election of how the LLC is managed from the beginning can be very important. The governing document for an LLC is its operating agreement – the rough equivalent of corporate bylaws. An operating agreement need not be in writing, but most state statutes offer the LLC and its members additional limited liability and other permissive provisions that must be specifically included in the operating agreement for the LLC to avail itself of the maximum possible protection. Operating agreements may also include a buy-sell agreement and a management agreement within the document.
In short, forming a sole proprietorship, a partnership, a corporation, or a limited liability company is easy. The sole proprietorship and general partnership do not require any special filing to be formed. Corporations, LLCs, and limited partnerships are formed simply upon the filing of the articles of incorporation or organization with the secretary of state in the desired state and paying the applicable filing fee. No attorney or accountant is necessary. The proper forms may be found online. If you prefer limited assistance, you can find people on the internet willing to charge a nominal fee to file the articles for you. Once filed, your corporation, LLC, or limited partnership becomes its own distinct entity, separate and apart from you. At that point, you will have some of the limited liability that the state of organization offers, but many critical issues have yet to be addressed. As mentioned, most state statutes offer additional, optional elections the business owner can make to further limit liability and risk.
When forming your new business, you should consider, among other things, the following issues:
- How the entity and your income from the entity will be taxed
- Self-employment taxes for the owners, which are imposed differently depending on the entity selected
- Franchise taxes (taxes charged to certain entities based on capital contributions of the owners which, in some cases, can be expensive) as well as entity filing fees and annual reports
- How the entity will be managed and by whom
- The choice of jurisdiction (the state of incorporation or organization—this decision may be influenced by a number of factors including whether the company seeks public or private financing and the body of law developed through the state’s court system which may lead to more predictable litigation outcomes)
- Whether to require the corporation to indemnify and/or limit the risk of certain liabilities for directors of the corporation
- Property tax issues
- Sale and use tax issues
- Succession planning, including buy-sell agreements and estate tax planning measures
- Employee stock ownership plans
- Whether the company is required to register to do business in foreign jurisdictions
- Employee and independent contractor issues, agreements, handbooks, and policies
- Intellectual property protection for copyrights, trademarks, patents, and trade secrets
- Employee benefits (including owner-employees) such as ERISA benefit plans, health insurance plans, vacation and leave policies
- Various business insurance
Most lawyers tend to have two types of clients: the first type of client is the client who is willing to seek and pay for preventative legal measures to limit future risks and taxes; the second type of client is the one who is unwilling to seek advice and plan in advance. Depending on the level of planning up front, which in some instances may be perceived as expensive, the first type of client almost always pays a small fraction in legal fees than the second type of client. This is true because it often is the second type of client who later finds himself or herself in expensive, unpredictable, and largely uncontrollable litigation possibly resulting in a judgment against the business and, in some instances, the owners themselves. Good planning with competent legal counsel from the beginning can help you protect your business, your personal assets, and (like preventative medicine or car maintenance) can save you significant money later.
Copyright © 2010 D. Sean Velarde, Esq. All Rights Reserved
6400 S. Fiddler's Green Circle
Suite 1000
Greenwood Village, CO 80111
Phone (303) 796-2626
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