Business Organization 101
(To Incorporate or not to Incorporate, Is that the Question?)
by Ken McRae, Law Offices of Kenneth M. McRae, LLC
biz2biz news - August, 2011

When you start a business you think about the obvious – what do I want to do, how much should I charge, how am I going to make money at this? At some point you will need to answer another question, namely, how do I want to set up this business? Your accountant, lawyer or someone at biz2biz connections will ask, innocently enough, “Are you incorporated?” If you have not thought about the answer to that question, or you aren’t sure what the question means, it might be time for a (very brief) overview of the possible ways to set up your business. The most basic form of business structure is no structure at all, also called a sole proprietorship. You run the business, you don’t have to file any documents with the state, and everything is taxed directly to you. The obvious benefit to this organization is simplicity – you just do the work, collect the money, keep your records. At tax time you list the income and expenses on your personal return. But, you may want some help with your business.

The next step in the organization hierarchy is a general partnership. Again, there is no filing required with the state, and the income and expenses are listed on personal returns. There is no requirement for a formal partnership agreement, but you want to have a plan for how you are going to divide income, expenses, work, etc. A written agreement would be a very good idea, but it is not required. Proprietorship and partnership are the easiest forms of organization, but there are drawbacks. Primarily, you have unlimited risk if something goes wrong. Because there is no business, there is just you, the customer will look to you and your assets if there is a dispute. For example, Joe the Plumber is a sole proprietor who does some work for Hank Homeowner. If a problem comes up Hank can sue Joe and, if Hank wins, collect against Joe’s house, retirement account, college funds, savings, etc. Any asset in Joe’s name is at risk because Joe the person and Joe the Plumber are the same. This risk is even scarier if you are in a partnership, because your house could be at risk if your partner does something wrong.

Obviously business owners don’t like this vulnerability so we invented a fictional new entity – the corporation. With a corporation Joe the Plumber becomes Joe, Inc. Now if there is a problem with Hank’s home, he can sue Joe. Inc. and recover only what the corporation owns. Joe the person is now separate from Joe the Plumber, and the house, IRA and cars are safe. It is fairly easy to create a corporation – you file a few documents with the Secretary of State and pay a fee.

There are, however, some drawbacks to a traditional corporation. One of the bigger concerns is the taxation of the business. A general corporation (as known as a “C corp”) is required to file a corporate return. Any profit is taxed by the IRS before it is distributed to shareholders as dividends, who are then taxed on the dividends on their personal returns. So, while Joe is now protected from a lawsuit, he may have inadvertently doubled his tax bill.

Business owners did not like this dilemma; they wanted to have limited liability protection but the ability to pay taxes only once, on their personal return. In response, the IRS approved some business organizations which have become very popular. These include subchapter S corporation (or “S corp” if you want to drop some lingo at your next accountant party), Limited Liability Companies (LLCs) and Limited Liability Partnerships (LLPs). All of these entities provide limited liability for the business owner so if there is a problem with the product or service, or if a customer slips and falls in the store, the owner’s personal assets are not in jeopardy. These structures also allow the business income and expenses to “flow through” to the owners’ personal tax returns, thereby eliminating any double taxation. They are easy to create – a couple of forms and a filing fee to the Secretary of State. Of course, much like a general partnership, if there are multiple owners it would be a very good idea to spend some time creating a detailed plan for how decisions get made, work assigned and profits allocated.

If you have not considered your business structure and you are not sure what will work best for you, talk to your accountant and lawyer, research other similar companies in your industry, and ask questions.