Beginning a new business “from scratch” conjures up exciting, even romantic, visions of innovation, creation and success. In that light, here’s Act 1, Scene 1: A solitary genius toiling away alone, inexhaustibly, day and night in a garret apartment, dank library stack, or silent laboratory to bring about “The Next Big Thing,” the genius perseveres and then ultimately has the “Eureka!” moment of creation. And then, the genius monetizes it. With angel capital funding. Then, VC funding. And then, an IPO. Well…the last four sentences are not that romantic at all, but they are often the desired result of outcome-oriented entrepreneurs.
And now you want to decide the format in which you will establish your for-profit business. Will it be a sole proprietorship, a partnership, a corporation or a limited liability company? Or a variation on one of those themes? How to decide?
There are three basic elements which lead to a decision – liability limitation, tax treatment and formality.
Act 1 – Liability Limitation
The scene – you are sitting with your attorney to discuss how much risk you can face by choosing one or another business entity. You learn the world of business entity liability breaks down “roughly” into two halves.
One half is when the owner or owners of a business is subject to unlimited liability, meaning he or she can roughly lose everything they own based upon a loss suffered by a business. Examples of unlimited liability structures are sole proprietorships and general partnerships. But since people you know do business in those formats you inquired about what can be done to allow the owner or general partners to sleep at night. Insurance. And personal asset protection. And not signing personal guarantees for loans or leases, if that is possible.
And the other half is when the owner or owners of a business enjoy limited liability, meaning the most they can usually lose is the amount of their investment in the company. Examples of unlimited liability structures are limited liability partnerships and limited partnerships, limited liability limited partnerships, corporations and limited liability companies. Limited liability partnerships and limited partnerships are not completely bullet-proof, but they can offer greater protection than general partnerships.
Please see the subtle literary trick of using roughly and usually above. Even a limited liability entity can be stripped of that protection if the veil is pierced by the owners’ using their company merely as an alter ego, as a personal piggy bank or for fraudulent or illegal purposes or without maintaining at least the required formalities.
Act 2 – Tax
The scene – you are now visiting with your accountant, who tells you the world is divided into three parts for tax purposes.
One is individual taxation, which applies to sole proprietorships. In essence, all tax outcomes relate personally to an owner, and are attended to directly on the owner’s tax return and paid accordingly.
Then there is pass through treatment, which applies to all partnership forms, corporations which take a federal “S” election and limited liability companies. In essence, tax outcomes pass through the entity and are attended to by the owners on their tax returns. For pass-through entities, it is not just that tax activities are invisible to the companies; rather those companies report tax-related activities to the owners and the IRS for final disposition and payment by the owners on their tax returns. As a result, there is only one level of tax returns at the owner level.
And then there is dual taxation treatment, which applies to “C” corporations. These are corporations which do not take an “S” election, and “C” double-taxation is, accordingly, the default federal tax format for corporations. In essence, a “C Corp” pays income tax itself, and then the owners pay a second level of income tax on their dividend distributions.
See again the clever use of in essence above. The single-sentence descriptions of the three basic business federal tax structures do not even come close to explaining the complexity of those structures, or their qualifications, exceptions and exclusions. This is why it is crucial to discuss entity selection with an accountant or tax attorney.
And, the brief discussions above do not bring up the related topics of state and local taxes, such as occupation/business taxes, income taxes, sales taxes and employment taxes, among the menu of taxes levied on business entities.
Act 3 – Formality
The scene – back with your lawyer. All artificial business entities are creatures of statute, meaning their formation, structure and operations emerge from a state’s code of laws. In Florida, this is found in Chapter XXXVI, “Business Organizations.”
These statutes describe the regulations for creating a business entity and the regulator. In Florida that is the Department of State – Division of Corporations, basically, each artificial entity has to:
- File a constituting document, such as articles of incorporation for a corporation of articles of organization for an LLC, with the state regulator.
- Create “rules of the game,” such as a partnership agreement, bylaws for a corporation or operating agreement for an LLC which it keeps with its operating documents.
Then the company has to actually observe the terms of the statutes and its constituting document and rules of the game. For example, it may have to notice and convene annual and periodic owner or director meetings, properly conduct votes at those meetings and keep records of its actions. And, later file annual business reports and tax returns. The consequence of not doing those core activities is that the limited liability veil can be pierced as described at the end of Act 1.
Epilogue
In the end you take in all the input from your lawyer and accountant, and also from your insurance agent and commercial banker, and you make the decision. Shall I form a business entity? And if yes, which one? And with a repeat nod to “The Bard,” you end up with your answer to the question.
The scene – the curtain falls and then re-opens for applause. And perhaps for a further curtain call when the business grows and thrives. And you live happily ever after. The end.
NOTICE: The article above is not intended to serve as legal advice, and readers should not rely on it as such. It is offered only as general information. Readers should consult with an attorney regarding their legal matters, as every situation is unique.
For more information, call Philip N. Kabler, Esq. of the Gainesville, FL office of Bogin, Munns & Munns, P.A. at (352) 332-7688 or email him at https://www.boginmunns.com/
PHILIP N. KABLER is an Incubator Resource for the Santa Fe College Center for Innovation and Economic Development (CIED), and has taught various courses at the UF Levin College of Law and at the UF Warrington College of Business (undergraduate and graduate). He is also the current president of the North Florida Association of Real Estate Attorneys, and a member of The Florida Bar’s Professional Ethics Committee.