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Start Your Own Business (21 page)

BOOK: Start Your Own Business

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Partnership

If your business will be owned and operated by several individuals, you’ll want to take a look at structuring your business as a partnership. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners.

Unless you expect to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form.

One of the major advantages of a partnership is the tax treatment it enjoys. A partnership does not pay tax on its income but “passes through” any profits or losses to the individual partners. At tax time, the partnership must file a tax return (Form 1065) that reports its income and loss to the IRS. In addition, each partner reports his or her share of income and loss on Schedule K-1 of Form 1065.

HOWDY, PARTNER!

I
f you decide to organize your business as a partnership, be sure you draft a partnership agreement that details how business decisions are made, how disputes are resolved, and how to handle a buyout. You’ll be glad you have this agreement if for some reason you run into difficulties with one of the partners or if someone wants out of the arrangement.

The agreement should address the purpose of the business and the authority and responsibility of each partner. It’s a good idea to consult an attorney experienced with small businesses for help in drafting the agreement. Here are some other issues you’ll want the agreement to address:
•
How will the ownership interest be shared?
It’s not necessary, for example, for two owners to equally share ownership and authority. However, if you decide to do it, make sure the proportion is stated clearly in the agreement.
•
How will decisions be made?
It’s a good idea to establish voting rights in case a major disagreement arises. When just two partners own the business 50-50, there’s the possibility of a deadlock. To avoid a deadlock, some businesses provide in advance for a third partner, a trusted associate who may own only 1 percent of the business but whose vote can break a tie.
•
When one partner withdraws, how will the purchase price be determined?
One possibility is to agree on a neutral third party, such as your banker or accountant, to find an appraiser to determine the price of the partnership interest.
•
If a partner withdraws from the partnership, when will the money be paid?
Depending on the partnership agreement, you can agree that the money be paid over three, five or 10 years, with interest. You don’t want to be hit with a cash-flow crisis if the entire price has to be paid on the spot in one lump sum.

Personal liability is a major concern if you use a general partnership to structure your business. Like sole proprietors, general partners are personally liable for the partnership’s obligations and debts. Each general partner can act on behalf of the partnership, take out loans and make decisions that will affect and be binding on all the partners (if the partnership agreement permits). Keep in mind that partnerships are also more expensive to establish than sole proprietorships because they require more legal and accounting services.

Corporation

The corporate structure is more complex and expensive than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires complying with more regulations and tax requirements.

The biggest benefit for a business owner who decides to incorporate is the liability protection he or she receives. A corporation’s debt is not considered that of its owners, so if you organize your business as a corporation, you are not putting your personal assets at risk. A corporation also can retain some of its profits without the owner paying tax on them.

WARNING

Many cities require even the smallest enterprises to have a business license. Municipalities are mainly concerned with whether the area where the business is operating is zoned for its intended purpose and whether there’s adequate customer parking available. You may even need a zoning variance to operate in some cities. Expect to pay a nominal license fee of around $30.

Another plus is the ability of a corporation to raise money. A corporation can sell stock, either common or preferred, to raise funds. Corporations also continue indefinitely, even if one of the shareholders dies, sells the shares or becomes disabled. The corporate structure, however, comes with a number of downsides. A major one is higher costs. Corporations are formed under the laws of each state with its own set of regulations. You will probably need the assistance of an attorney to guide you. In addition, because a corporation must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax preparation services.

WARNING

Any money you’ve invested in a corporation is at risk. Despite the liability protection of a corporation, most banks and many suppliers require business owners to sign a personal guarantee so they know corporate owners will make good on any debt if the corporation can’t.

Another drawback to forming a corporation: Owners of the corporation pay a double tax on the business’s earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.

One strategy to help soften the blow of double taxation is to pay some money out as salary to you and any other corporate shareholders who work for the company. A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. However, the IRS has limits on what it believes to be reasonable compensation.

S Corporation

The S corporation is more attractive to small-business owners than a regular (or C) corporation. That’s because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there’s just one level of federal tax to pay.

In addition, owners of S corporations who don’t have inventory can use the cash method of accounting, which is simpler than the accrual method. Under this method, income is taxable when received and expenses are deductible when paid (see Chapter 37).

S corporations can also have up to 100 shareholders. This makes it possible to have more investors and thus attract more capital, tax experts maintain.

S corporations do come with some downsides. For example, S corporations are subject to many of the same rules corporations must follow, and that means higher legal and tax service costs. They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. The legal and accounting costs of setting up an S corporation are also similar to those for a regular corporation.

CORPORATE CHECKLIST

T
o make sure your corporation stays on the right side of the law, heed the following guidelines:
• Call the secretary of state each year to check your corporate status.
• Put the annual meetings (shareholders and directors) on tickler cards.
• Check all contracts to ensure the proper name is used in each. The signature line should read “John Doe, President, XYZ Corp.,” never just “John Doe.”
• Never use your name followed by “dba” (doing business as) on a contract. Renegotiate any old ones that do.
• Before undertaking any activity out of the normal course of business—like purchasing major assets—write a corporate resolution permitting it. Keep all completed forms in the corporate book.
• Never use corporate checks for personal debts and vice versa.
• Get professional advice about continued retained earnings not needed for immediate operating expenses.

Another major difference between a regular corporation and an S corporation is that S corporations can only issue one class of stock. Experts say this can hamper the company’s ability to raise capital.

In addition, unlike in a regular corporation, S corporation stock can only be owned by individuals, estates and certain types of trusts. In 1998, tax-exempt organizations such as qualified pension plans were added to the list. This change provides S corporations with even greater access to capital because a number of pension plans are willing to invest in closely held small-business stock.

WARNING

If you anticipate several years of losses in your business, keep in mind you cannot deduct corporate losses on your personal tax return. Business structures such as partnerships, sole proprietorships and S corporations allow you to take those deductions.