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CHAPTER FIVE - Legal Structure of Your Business

Introduction - Before reading this chapter and the next, please understand that any issues relating to legal matters should only be decided by a practicing attorney with your guidance and perhaps the input of an accountant. In writing this book we are not professing to be giving legal or accounting advice, but rather, the intent is to provide an overview of the legal environment which you will encounter as you try to determine the type of structure that would be best for your organization. Hopefully the content in this chapter and the next will give you sufficient information to be able to ask better questions of your attorney when you make these decisions.

Key Issues to Consider when Selecting an Organization Legal Structure - There are five major issues that must be considered when selecting the right type of structure for your business. To the extent possible, it would be best that you familiarize yourself with each of them, and possibly determine how you feel about each of these before meeting with your attorney as the time with this individual will be reduced, thus saving you time and professional fees.

 Owners Liability - This refers to the extent of the financial exposure you will have as an owner of the business. Unless the form selected provides limited liability, the owner's personal assets are exposed to claims of creditors or claimants of the business. The type of organization does not protect the owner from tort claims although insurance can be obtained to handle this situation. A tort claim is a claim against the business or its employees for damage to or loss of property or personal injury or death.

 Control - Control of the entity is an issue anytime more than one person is involved as an owner or shareholder in the business. The extent to which owners can participate in the management will depend heavily on the choice of business entity.

 Transferability of Ownership Interests - This is the consideration for the ability to transfer the ownership of the business entity without disturbing the continuity of the business. All ownership interests are transferable, but the convenience or ease of transfer differs substantially among various forms of business entity.

 Organization and maintenance costs - This refers to the needs of the entity to maintain books and records in order to comply with public rep* Tax Considerations - The tax considerations relative to going into business or changing the form of a business are extensive and very complex. They can certainly affect the type of structure that is selected for the entity.

Overview of the Various Business Structures - The following will summarize the most important information the entrepreneur needs to know about the various business structures that are available. Its focus is on the major issues relating to each structure, and is not intended to be a thorough legal interpretation of the details, advantages and disadvantages of each.

 Sole Proprietorship - This is a situation where one individual operates a business solely without any type of incorporation. It is the easiest business to organize and has the fewest reporting requirements. The profit or loss from this business is reported on Schedule C of the Federal Tax return. The owner is free to make all decisions in this structure. The owner is personally responsible for all the debts of the business. One of the major drawbacks of the sole proprietorship is that the business ends with the death of the proprietor. Therefore, the small business started and 100% owned by the father, must change its form if the venture is to be carried on by the son when the father leaves the business.

 Partnership - This is an arrangement whereby two or more people make a legal contract to operate a business. It is very easy to organize. A written partnership agreement is strongly recommended but is not required. Partnership income and expenses flow through to the individual partners and is reported on Schedule C of the individual partner's federal tax return. Decisions make by the partnership depend on how the ownership of the entity has been decided. A general partner is personally liable for all debt of the entity. For limited partners the liability is generally limited to the investment they have in the partnership.

Many people come to SCORE thinking that a partnership is the best way to organize their company. They want another person to share the costs of start up, help with getting the sales and marketing started or reduce the psychological risk of going it alone. Partnerships have some very strong negatives that must be considered before they are entered into by the entrepreneur. Specifically:

 It can be very difficult to establish the criteria for decision-making in the partnership. Who can make what decisions, and who is the final authority when it comes to making the 'hard' decisions. In effect, who is the boss! This becomes an even more difficult situation when the partnership involves several individuals rather than only two. I was involved in a consultancy that had five equal partners, and the business did not really begin to prosper until the partnership decided to elect one of the partners the boss who was assigned the responsibility for decisions and generally running the business.

 It is very difficult to eliminate a partner from an organization if the relationship is not working out. The ' outed' partner will want payment for his share, and often there is relatively little real equity in the organization that can pay the partner. Further, the outed partner will almost always feel their contribution was worth more than the others would attribute to this individual.

 How do you handle the death or disability of a partner? This is another very difficult decision that must be addressed in advance of finalizing any partnership arrangement.

  Limited Liability Corporation (LLC) - The LLC is probably the most commonly used corporate form among small business. This is a corporate entity that is formed under state law that combines the pass-through attributes of a partnership with the limited liability of a corporation. An LLC must be registered with the state to which the owners must apply for LLC status. Income passes through to the owners and is reported on Schedule C of the federal tax return. Decisions in an LLC are made based on the agreements of the owners. It is recommended strongly that an owner's agreement be developed for an LLC to establish the degrees of ownership and control among the various owners of the entity. The ownership agreement may restrict the transfer of ownership interest. The LLC does provide protection from financial liabilities of the entity. The specific amount of protection varies from state to state.

  'S' Corporation - The 'S' Corporation is a very common corporate from among small business, particularly in states such as New York where there is an advertising requirement if you wish to start an LLC. A domestic corporation with only one class of stock and less than 75 shareholders can elect to be taxed as an ' S' corporation. It is set up as a regular corporation and the owners must make the election to be treated as an ' S' form. This is a stock corporation and the ownership can be transferred by sale of stock. Income from the S Corporation is reported on Schedule C of the federal return. The shareholders of an S Corporation have limited liability, just the same as in the LLC.

  'C' Corporation - This is a business entity that has its own legal status that is separate and distinct from that of the owners of the corporation. It is very difficult and expensive to organize, and there is a requirement for them to hold periodic board meetings, and comply with both state and federal regulations. A ' C' Corporation pays tax on its profits. When the owners take profits from the business they pay taxes on them at the individual rates. The current rate for ' C' Corporations is 35%. Shareholders are not liable for debts incurred by the corporation. It is very unusual for a small start up company to be set up as a 'C' corporation.

Other Business Partners/Advisors in Your Business - In addition to the formal legal structure of your business, there are some other elements that must be considered when forming a new organization. Specifically, this refers to the external resources that should be identified as integral parts of the overall organization. For a small company these will be external ' consultants' , however, as the business grows any or all of these services could be brought in-house to be a salaried part of the organization. The key resources should therefore be:

 Attorney - While your needs for an attorney may not be significant, it is vital to develop a relationship with this person, as you might need legal assistance in the future. Some organizations begin the association by retaining their attorney to set up a corporation. However, it is simple in most states to set up an LLC (Limited Liability Corporation,) the most common small business corporate structure. You may do it yourself in less than an hour for a fraction of what your attorney would charge. However, you might want to consult with your attorney relative to the type of organization structure that would work best for you in light of the plans for the company.

 Accountant - Every new company should develop a relationship with a CPA firm. They will have a point of view as to the type of organization structure you form, and also will oversee the work of your bookkeeper. The accountant is also a very helpful resource to prepare tax reports for the city, state and federal governments as required. They also will be very helpful to you in helping you determine what types of expenses can legitimately be charged to the business, and what would be challenged if the company were audited.

 Bookkeeper - While many small businesses choose to keep their own books, normally to save money, it is generally very helpful to hire a bookkeeper in the beginning to help you set up the accounting system. You can do the regular entry of data, but the bookkeeper will set you on a course that will ensure that the chart of accounts is correct and the other elements of your system are consistent with what would be required by your accountant to prepare your taxes.

 Payroll Service - One of the best values in business services is generally the payroll company Even if you only have one person on your payroll, having this executed with an outside provider is a benefit as they will ensure that all the appropriate taxes are paid on time. It is strongly recommended that any new business use this service, as it is a small price to pay for the assurance that you have covered your taxes, and that you do not have to fill out and file the quarterly reports that are required of most companies that have a payroll.

 Insurance Agent - A qualified insurance agent is a vital part of any new business organization. More often than not small business organizations have less than perfect knowledge of the insurance needs of their organization. Perhaps the most common misconception is the extent of liability protection that one gets from forming a Limited Liability Corporation (LLC). Because it is a corporation many people do not feel they need to have liability insurance as the owners would be protected in the event of a claim against them for personal injury, product liability or personnel-related claims (i.e., sexual harassment, improper firing etc). The LLC generally protects the corporate entity against contractual issues, and only when the contract is signed in the name of the LLC without personal guarantees.

For the above and many other important issues it is vital that the small business owner work with an insurance agent to ensure that the company is adequately protected from claims against the organization.

 Computer/IT Professional - Consider this -it is 9 am on Monday morning and you turn on the computers in the office to begin entering the records from the weekend, but your primary computer will not start, or gives you an error message. In the current environment it is almost impossible to operate a business without a functioning computer system. Therefore you need to have people who are available to you that could solve problems that occur. They always seem to happen at the most inoppor tune moments and you must be prepared!

 Advisory Board - While not required, one of the best resources that a new company can establish is an advisory board of senior people who will be available to provide advice and counsel to the company on an ongoing basis. This can be formed from many different sources, such as former colleagues, family, and friends or from organizations such as SCORE. We SCORE mentors provide this type of service to a large number of organizations, with our only goal being the success of the company. In most cases, an advisory board can be formed and operational for virtually no costs, as normally the participants are volunteers, seeking to help you get started.

SUMMARY - There are many options available to the small business entrepreneur relative to the form of the entity. Consult with your attorney and accountant to ensure that you have the right form for your company in your state. A little time doing this in the planning stage will save you many headaches in the future, if you have made a mistake in your choice of business form.