Chapter 8
Deciding the Legal Structure for a Business
In This Chapter
Structuring the business to attract capital
Taking stock of the corporate legal structure
Partnering with others in business
Looking out for Number One in a sole proprietorship
Choosing a legal structure for income tax
The obvious reason for investing in a business rather than putting your hard-earned money in a safer type of investment is the potential for greater rewards. Note the word potential. As one of the owners of a business, you’re entitled to your fair share of the business’s profit, as are the other owners of course. At the same time you’re subject to the risk that the business could go down the tubes, taking your money with it.
Ignore the risks for a moment and look at just the rosy side of the picture: Suppose the doohickeys that your business sells become the hottest products of the year. Sales are booming, and you start looking at buying a five-bedroom mansion with an ocean view. Don’t make that down payment just yet — you may not get as big a piece of the profit pie as you’re expecting. There could be claims that rank ahead of you, and you may not see any profit after all these claims are satisfied. In any case, the way the profit is divided among owners depends on the business’s legal structure.
This chapter shows you how legal structure determines your share of the profit — and how changes beyond your control can make your share less valuable. It also explains how the legal structure determines whether the business as a separate entity pays income taxes. In one type of legal structure, the business pays income taxes and its owners pay a second layer of income taxes on the distributions of profit to them by the business. In this case, Uncle Sam gets two bites of the profit apple.
Securing Capital: Starting With Owners
Every business needs capital. Capital provides the money for the assets a business needs to make sales and carry on its operations. Common examples of assets are the working cash balance a business needs for day-to-day activities, products held in inventory for sale, and long-life operating assets (buildings, machines, computers, office equipment, and so on). A rough guideline is this: Businesses that sell products need capital equal to one-half of annual sales revenue. Of course, this ratio varies from industry to industry. Many manufactures need a high ratio of capital to sales, so they are referred to as capital intensive.
One of the first questions that sources of business capital ask is: How is the business entity organized legally? In other words, which specific form or legal structure is being used by the business? The different types of business legal entities present different risks and offer different rewards to business capital sources.
Where does a business get the capital it needs? Whatever its legal structure, the answer comes down to two basic sources: debt and equity. Debt refers to the money borrowed by a business, and equity refers to money invested in the business by owners plus profit earned and retained in the business (instead of being distributed to its owners). No matter which type of legal entity form it uses, every business needs a foundation of ownership (equity) capital. Owners’ equity is the hard-core capital base of a business.
I might add that in starting a new business from scratch, its founders typically must invest a lot of sweat equity, which refers to the grueling effort and long hours to get the business off the ground and up and running. The founders don’t get paid for their sweat equity, and it does not show up in the accounting records of the business. You don’t find the personal investment of time and effort for sweat equity in a balance sheet.
Contrasting two sources of owners’ equity
Every business — regardless of how big it is, whether it’s publicly or privately owned, and whether it’s just getting started or is a mature enterprise — has owners. No business can get all the capital it needs by borrowing. The owners provide the business with its start-up and its continuing base of capital, which as I just mentioned is generally referred to as equity. Without the foundation of equity capital a business would not be able to get credit from its suppliers, and it couldn’t borrow money. As they say in politics, the owners must have some skin in the game.
The equity capital in a business always carries the risk of loss to its owners. So, what do the owners expect and want from taking on this risk? Their expectations include the following:
They expect the business to earn profit on their equity capital in the business and to share in that profit by receiving cash distributions from profit, and from increases in the value of their ownership shares — with no guarantee of either.
They may expect to directly participate in the management of the business, or they may plan to hire someone else to manage the business. In smaller businesses, an owner may be one of the managers and may sit on the board of directors. In very large businesses, however, you are just one of thousands of owners who elect a representative board of directors to oversee the managers of the business and protect the interests of the non-manager owners.
Looking down the line to the eventual demise of the business, they expect to receive a proportionate share of the proceeds if the business is sold, or receive a proportionate share of ownership when another business buys or merges with the business, or they may end up with nothing in the event the business goes kaput and there’s nothing left after paying off the creditors of the business.
When owners invest money in a business, the accountant records the amount of money as an increase in the company’s cash account. And, using double-entry accounting, the amount invested in the business is recorded as an increase in an owners’ equity. (I explain double-entry accounting and debits and credits in Chapter 3.) Owners’ equity also increases when a business makes profit. See Chapters 4 and 7 for more on why earning profit increases the amount of assets minus expenses, which is called net worth, and that this push-up in net worth from profit is balanced by recording the increase in owners’ equity.
So, there are two distinct sources of owners’ equity. Also, certain legal requirements often come into play regarding the minimum amount of owners’ capital that has to be maintained by a business for the protection of creditors. Therefore, the owners’ equity of a business is divided into two separate types of accounts:
Invested capital: This type of owners’ equity account records the amounts of money that owners have invested in the business, which could have been many years ago. Owners may invest additional capital from time to time, but generally speaking they cannot be forced to put additional money in a business (unless the business issues assessable ownership shares, which is unusual). Depending on the legal form of the entity and other factors a business may keep two or more accounts for the invested capital from its owners.
Retained earnings: The profit earned by a business over the years that has been retained and not distributed to its owners is accumulated in the retained earnings account. If all profit had been distributed every year, retained earnings would have a zero balance. (If a business has never made a profit, its accumulated loss would cause retained earnings to have a negative balance, which generally is called a deficit.) If none of the annual profits of a business had been distributed to its owners, the balance in retained earnings would be the cumulative profit earned by the business since it opened its doors (net of any losses along the way).
Whether to retain part or all of annual net income is one of the most important decisions that a business makes; distributions from profit have to be decided at the highest level of a business. A growing business needs additional capital for expanding its assets, and increasing the debt load of the business usually cannot supply all the additional capital. So, the business plows back some of its profit for the year rather than giving it out to its owners. In the long run this may be the best course of action because it provides additional capital for growth.
Leveraging equity capital with debt
Suppose a business has $10 million in total assets. (You find assets in the balance sheet of a business — see Chapter 5.) This doesn’t mean that it has $10 million of owners’ equity. Assuming the business has a good credit rating, it probably has some amount of trade credit, which is recorded in the accounts payable liability account (as I explain in Chapter 5.) Also, there are other kinds of operating liabilities. Let’s say that its accounts payable and other operating liabilities total $2 million. This leaves $8 million to account for.
It’s possible that all $8 million is provided by equity capital (that is, the sum of money invested by its owners plus the accumulated balance of retained earnings). But more than likely, the business would have borrowed money, which is recorded in notes payable and similarly titled liability accounts. The basic idea of borrowing money is to leverage its owners’ equity capital. For example, suppose the $8 million in our example is split $3 million debt and $5 million owners’ equity. The business has three dollars of debt capital for every five dollars of equity capital. The business is leveraging its equity capital, or using its equity capital to increase the total capital of the business.
Some businesses depend on debt for more than half of their total capital. In contrast, some businesses have virtually no debt at all. You find many examples of both public and private companies that have no borrowed money. But as a general rule, most businesses carry some debt (and therefore, have interest expense).
The debt decision is not really an accounting responsibility as such; although once the decision is made to borrow money the accountant is very involved in recording debt and interest transactions. Deciding on debt is the responsibility of the chief financial officer and chief executive of the business. In medium-sized and smaller businesses, the chief accounting officer (controller) may also serve as the chief financial officer. In larger businesses, two different persons hold the top financial and accounting positions.
The loan contract between a business and its lender may prohibit the business from distributing profit to owners during the period of the loan. Or, the loan agreement may require that the business maintain a minimum cash balance. Generally speaking, the higher the ratio of debt to equity, the more likely a lender will charge higher interest rates and insist on tougher conditions, because the lender has higher risk that the business might default on the loan.
When borrowing money the president or another officer in his or her capacity as an official agent of the business signs a note payable document to the bank or other lender. In addition, the bank or other lender may ask the major investors in a smaller, privately owned business to guarantee the note payable of the business as individuals, in their personal capacities — and it may ask their spouses to guarantee the note payable as well. One way of doing this is for the individuals to endorse the note payable. Or, a separate legal instrument of guarantee may be used. In any case, the individuals promise to pay the note if the business can’t. You should definitely understand your personal obligations if you are inclined to guarantee a note payable of a business. You take the risk that you may have to pay some part or perhaps the entire amount of the loan from your personal assets.
Recognizing the Legal Roots of Business Entities
One of the most important aspects of our legal system, from the business and economic point of view, is that the law enables entities to be created for conducting business activities. These entities are separate and distinct from the individual owners of the business. Business entities have many of the rights of individuals. Business entities can own property and enter into contracts, for example. In starting a business venture, one of the first things the founders have to do is select which type of legal structure to use — which usually requires the services of a lawyer who knows the laws of the state in which the business is organized.
A business may have just one or more owners. A one-owner business may choose to operate as a sole proprietorship; a multi-owner business must choose to be a corporation, a partnership, or a limited liability company. The most common type of business is a corporation (although the number of sole proprietorships would be larger if you include part-time, self-employed persons in this category).
No legal structure is inherently better than another; which one is right for a particular business is something that the business’s managers and founders need to decide at the time of starting the business. The advice of a lawyer is usually needed. The following discussion focuses on the basic types of legal entities that owners can use for their business. Later in the chapter, I explain how the legal structure determines the income tax paid by the business and its owners, which is always an important consideration.
Incorporating a Business
The law views a corporation as a real, live person. Like an adult, a corporation is treated as a distinct and independent individual who has rights and responsibilities. (A corporation can’t be sent to jail, but its officers can be put in the slammer if they are convicted of using the corporate entity for carrying out fraud.) A corporation’s “birth certificate” is the legal form that is filed with the Secretary of State of the state in which the corporation is created (incorporated). A corporation must also have a legal name, like an individual. Some names cannot be used, such as the State Department of Motor Vehicles; you need to consult a lawyer on this point.
The corporate legal form offers several important advantages. A corporation has unlimited life; it stays alive until the shareowners vote to terminate the entity. The ownership interests in a corporation, specifically the shares of stock issued by the corporation, are generally transferable. You can sell your shares to another person or bequeath them in your will to your grandchildren. You don’t need the approval of the other shareholders to transfer ownership of your shares. Each ownership share has one vote in the election of directors of a business corporation (generally speaking). In turn, the directors hire and fire the key officers of the corporation. This provides a practical way to structure the management of a business.
Just as a child is separate from his or her parents, a corporation is separate from its owners. The corporation is responsible for its own debts. The bank can’t come after you if your neighbor defaults on his or her loan, and the bank can’t come after you if the corporation you have invested money in goes belly up. If a corporation doesn’t pay its debts, its creditors can seize only the corporation’s assets, not the assets of the corporation’s owners.
This important legal distinction between the obligations of the business entity and its individual owners is known as limited liability — that is, the limited liability of the owners. Even if the owners have deep pockets, they have no legal exposure for the unpaid debts of the corporation (unless they’ve used the corporate shell to defraud creditors). The legal fence between a corporation and its owners is sometimes called the “corporate shield” because it protects the owners from being held responsible for the debts of the corporation. So, when you invest money in a corporation as an owner, you know that the most you can lose is the amount you put in. You may lose every dollar you put in, but the corporation’s creditors cannot reach through the corporate entity to grab your assets to pay off the liabilities of the business. (But, to be prudent, you should check with your lawyer on this issue — just to be sure.)
Issuing stock shares
When raising equity capital, a corporation issues ownership shares to persons who invest money in the business. These ownership shares are documented by stock certificates, which state the name of the owner and how many shares are owned. The corporation has to keep a register of how many shares everyone owns, of course. (An owner can be an individual, another corporation, or any other legal entity.) Actually, many public corporations use an independent agency to maintain their ownership records. In some situations stock shares are issued in book entry form, which means you get a formal letter (not a fancy engraved stock certificate) attesting to the fact that you own so many shares. Your legal ownership is recorded in the official “books,” or stock registry of the business.
The owners of a corporation are called stockholders because they own stock shares issued by the corporation. The stock shares are negotiable, meaning the owner can sell them at any time to anyone willing to buy them without having to get the approval of the corporation or other stockholders. Publicly owned corporations are those whose stock shares are traded in public markets, such as the New York Stock Exchange and NASDAQ. There is a ready market for the buying and selling of the stock shares.
The stockholders of a private business have the right to sell their shares, although they may enter into a binding agreement restricting this right. For example, suppose you own 20,000 of the 100,000 stock shares issued by the business. So, you have 20 percent of the voting power in the business (one share has one vote). You may agree to offer your shares to the other shareowners before offering the shares to someone outside the present group of stockholders. Or, you may agree to offer the business itself the right to buy back the shares. In these ways, the continuing stockholders of the business control who owns the stock shares of the business.
Offering different classes of stock shares
Before you invest in stock shares, you should ascertain whether the corporation has issued just one class of stock shares. A class is one group, or type, of stock shares all having identical rights; every share is the same as every other share. A corporation can issue two or more different classes of stock shares. For example, a business may offer Class A and Class B stock shares, where Class A stockholders are given the vote in elections for the board of directors but Class B stockholders do not get a vote.
State laws generally are liberal when it comes to allowing corporations to issue different classes of stock shares. A whimsical example is that holders of one class of stock shares could get the best seats at the annual meetings of the stockholders. But whimsy aside, differences between classes of stock shares are significant and affect the value of the shares of each class of stock.
Two classes of corporate stock shares are fundamentally different: common stock and preferred stock. Here are two basic differences:
Preferred stockholders are promised a certain amount of cash dividends each year (note I said “promised,” not “guaranteed”), but the corporation makes no such promises to its common stockholders. Each year, the board of directors must decide how much, if any, cash dividends to distribute to its common stockholders.
Common stockholders have the most risk. A business that ends up in deep financial trouble is obligated to pay off its liabilities first and then its preferred stockholders. By the time the common stockholders get their turn, the business may have no money left to pay them.
Neither of these points makes common stock seem too attractive. But consider the following points:
Preferred stock shares usually are promised a fixed (limited) dividend per year and typically don’t have a claim to any profit beyond the stated amount of dividends. (Some corporations issue participating preferred stock, which gives the preferred stockholders a contingent right to more than just their basic amount of dividends. This topic is too technical to explore further in this book.)
Preferred stockholders generally don’t have voting rights, unless they don’t receive dividends for one period or more. In other words, preferred stock shareholders usually do not participate in electing the corporation’s board of directors or vote on other critical issues facing the corporation.
The advantages of common stock, therefore, are the ability to vote in corporation elections and the unlimited upside potential: After a corporation’s obligations to its preferred stock are satisfied, the rest of the profit it has earned accrues to the benefit of its common stock.
Here are some important things to understand about common stock shares:
Each stock share is equal to every other stock share in its class. This way, ownership rights are standardized, and the main difference between two stockholders is how many shares each owns.
The only time a business must return stockholders’ capital to them is when the majority of stockholders vote to liquidate the business (in part or in total). Other than this, the business’s managers don’t have to worry about the stockholders withdrawing capital.
A stockholder can sell his or her shares at any time, without the approval of the other stockholders. However, as I mention earlier, the stockholders of a privately owned business may agree to certain restrictions on this right when they first became stockholders in the business.
Stockholders can put themselves in key management positions, or they may delegate the task of selecting top managers and officers to the board of directors, which is a small group of persons selected by the stockholders to set the business’s policies and represent stockholders’ interests.
Now don’t get the impression that if you buy 100 shares of IBM you can get yourself elected to its board of directors. On the other hand, if Warren Buffett bought 100 million shares of IBM, he could very well get himself on the board. The relative size of your ownership interest is key. If you put up more than half the money in a business, you can put yourself on the board and elect yourself president of the business. The stockholders who own 50 percent plus one share constitute the controlling group that decides who goes on the board of directors.
Note: The all-stocks-are-created-equal aspect of corporations is a practical and simple way to divide ownership, but its inflexibility can also be a hindrance. Suppose the stockholders want to delegate to one individual extraordinary power, or to give one person a share of profit out of proportion to his or her stock ownership. The business can make special compensation arrangements for key executives and ask a lawyer for advice on the best way to implement the stockholders’ intentions. Nevertheless, state corporation laws require that certain voting matters be settled by a majority vote of stockholders. If enough stockholders oppose a certain arrangement, the other stockholders may have to buy them out to gain a controlling interest in the business. (The limited liability company legal structure permits more flexibility in these matters. I talk about this type of legal structure later in the chapter; see the section “Differentiating Partnerships and Limited Liability Companies.”)
Determining the market value of stock shares
If you want to sell your stock shares, how much can you get for them? There's a world of difference between owning shares of a public corporation and owning shares of a private corporation. Public means there is an active market in the stock shares of the business; the shares are liquid. The shares can be converted into cash in a flash by calling your stockbroker or going online to sell them. You can check a daily financial newspaper — such as The Wall Street Journal — for the current market prices of many large publicly owned corporations. Or you can go to one of many Internet websites (such as http://finance.yahoo.com) that provide current market prices. But stock shares in privately owned businesses aren't publicly traded, so how can you determine the value of your shares in such a business?
Well, I don’t mean to sidestep the question, but stockholders of a private business don’t worry about putting a precise market value on their shares — until they are serious about selling their shares, or when something else happens that demands putting a value on the shares. When you die, the executor of your estate has to put a value on the shares you own (excuse me, the shares you used to own) for estate tax purposes. If you divorce your spouse, a value is needed for the stock shares you own, as part of the divorce settlement. When the business itself is put up for sale, a value is put on the business; dividing this value by the number of stock shares issued by the business gives the value per share.
Other than during events like these, which require that a value be put on the stock shares, the shareowners of a private business get along quite well without knowing a definite value for their shares. This doesn’t mean they have no idea regarding the value of their business and what their shares are worth. They read the financial statements of their business, so they know its profit performance and financial condition. In the backs of their minds they should have a reasonably good estimate regarding how much a willing buyer might pay for the business and the price they would sell their shares for. So even though they don’t know the exact market value of their stock shares, they are not completely in the dark about that value.
My son, Tage, and I discuss the valuation of small businesses in our book Small Business Financial Management Kit For Dummies (John Wiley & Sons). Space does not permit an extended discussion of business valuation methods here. Generally speaking, the value of ownership shares in a private business depends heavily on the recent profit performance and the current financial condition of the business, as reported in its latest financial statements. The financial statements may have to be trued up, as they say, to bring some of the historical cost values in the balance sheet up to current replacement values.
Business valuation is highly dependent on the specific circumstances of each business. The present owners may be very eager to sell out, and they may be willing to accept a low price instead of taking the time to drive a better bargain. The potential buyers of the business may see opportunities that the present owners don’t see or aren’t willing to pursue. Even Warren Buffett, who has a well-deserved reputation for knowing how to value a business, admits that he’s made some real blunders along the way.
Keeping alert for dilution of share value
Watch out for developments that cause a dilution effect on the value of your stock shares — that is, that cause each stock share to drop in value. Keep in mind that sometimes the dilution effect may be the result of a good business decision, so even though your share of the business has decreased in the short term, the long-term profit performance of the business (and, therefore, your investment) may benefit. But you need to watch for these developments closely. The following situations cause a dilution effect:
A business issues additional stock shares at the going market value but doesn’t really need the additional capital — the business is in no better profit-making position than it was before issuing the new stock shares. For example, a business may issue new stock shares in order to let a newly hired chief executive officer buy them. The immediate effect may be a dilution in the value per share. Over the long term, however, the new CEO may turn the business around and lead it to higher levels of profit that increase the stock’s value.
A business issues new stock shares at a discount below its stock shares’ current value. For example, the business may issue a new batch of stock shares at a price lower than the current market value to employees who take advantage of an employee stock-purchase plan. Selling stock shares at a discount, by itself, has a dilution effect on the market value of the shares. But in the grand scheme of things, the stock-purchase plan may motivate its employees to achieve higher productivity levels, which can lead to superior profit performance of the business.
Now here’s one for you: The main purpose of issuing additional stock shares is to deliberately dilute the market value per share. For example, a publicly owned corporation doubles its number of shares by issuing a two-for-one stock split. Each shareholder gets one new share for each share presently owned, without investing any additional money in the business. As you would expect, the market value of the stock drops in half — which is exactly the purpose of the split because the lower stock price is better for stock market trading (according to conventional wisdom).
Recognizing conflicts between stockholders and managers
Stockholders are primarily concerned with the profit performance of the business; the dividends they receive and the value of their stock shares depend on it. Managers’ jobs depend on living up to the business’s profit goals. But whereas stockholders and managers have the common goal of optimizing profit, they have certain inherent conflict of interests:
The more money that managers make in wages and benefits, the less stockholders see in bottom-line net income. Stockholders obviously want the best managers for the job, but they don’t want to pay any more than they have to. In many corporations, top-level managers, for all practical purposes, set their own salaries and compensation packages.
Most public business corporations establish a compensation committee consisting of outside directors that sets the salaries, incentive bonuses, and other forms of compensation of the top-level executives of the organization. An outside director is one who has no management position in the business and who, therefore, should be more objective and should not be beholden to the chief executive of the business. This is good in theory, but it doesn’t work out all that well in practice — mainly because the top-level executive of a large public business typically has the dominant voice in selecting the persons to serve on its board of directors. Being a director of a large public corporation is a prestigious position, to say nothing of the annual fees that are fairly substantial at most corporations.
The question of who should control the business — managers who are hired for their competence and are intimately familiar with the business, or stockholders, who may have no experience relevant to running this business but whose money makes the business tick — can be tough to answer.
In ideal situations, the two sides respect each other’s contributions to the business and use this tension constructively. Of course, the real world is far from ideal, and in some companies, managers control the board of directors rather than the other way around.
As an investor, be aware of these issues and how they affect the return on your investment in a business. If you don’t like the way your business is run, you can sell your shares and invest your money elsewhere. (However, if the business is privately owned, there may not be a ready market for its stock shares, which puts you between a rock and a hard place.)
Differentiating Partnerships and Limited Liability Companies
Suppose you’re starting a new business with one or more other owners, but you don’t want it to be a corporation. You can choose to create a partnership or a limited liability company, which are the main alternatives to the corporate form of business.
A partnership is also called a firm. You don’t see this term used to refer to a corporation or limited liability company nearly as often as you do to a partnership. The term firm connotes an association of a group of individuals working together in a business or professional practice.
Compared with the relatively rigid structure of corporations, the partnership and limited liability company forms of legal entities allow the division of management authority, profit sharing, and ownership rights among the owners to be very flexible. Here are the key features of these two legal structures:
Partnerships: Partnerships avoid the double-taxation feature that corporations are subject to (see “Choosing the Right Legal Structure for Income Tax,” later in this chapter for details). Partnerships also differ from corporations with respect to owners’ liability. A partnership’s owners fall into two categories:
• General partners are subject to unlimited liability. If a business can’t pay its debts, its creditors can reach into general partners’ personal assets. General partners have the authority and responsibility to manage the business. They are roughly equivalent to the president and other high-level managers of a business corporation. The general partners usually divide authority and responsibility among themselves, and often they elect one member of their group as the senior general partner or elect a small executive committee to make major decisions.
• Limited partners escape the unlimited liability that the general partners have hanging around their necks. Limited partners are not responsible, as individuals, for the liabilities of the partnership entity. These junior partners have ownership rights to the business’s profit, but they don’t generally participate in the high-level management of the business. A partnership must have one or more general partners; not all partners can be limited partners.
Many large partnerships copy some of the management features of the corporate form — for example, a senior partner who serves as chair of the general partners’ executive committee acts in much the same way as the chair of a corporation’s board of directors.
In most partnerships an individual partner can’t sell his interest to an outsider without the consent of all the other partners. You can’t just buy your way into a partnership; the other partners have to approve your joining the partnership. In contrast, you can buy stock shares and thereby become part owner of a corporation without the approval of the other stockholders.
Limited liability company (LLC): The LLC is an alternative type of business entity. An LLC is like a corporation regarding limited liability, and it’s like a partnership regarding the flexibility of dividing profit among the owners. An LLC can elect to be treated either like a partnership or as a corporation for federal income tax purposes. Usually a tax expert should be consulted on this choice.
The key advantage of the LLC legal form is its flexibility — especially regarding how profit and management authority are determined. For example, an LLC permits the founders of the business to put up, say, only 10 or 20 percent of the money to start a business venture but to keep all management authority in their hands. The other investors share in profit but not necessarily in proportion to their invested capital.
LLCs have a lot more flexibility than corporations, but this flexibility can have a downside. The owners must enter into a very detailed agreement that spells out the division of profit, the division of management authority and responsibility, their rights to withdraw capital, and their responsibilities to contribute new capital as needed. These schemes can get very complicated and difficult to understand, and they may end up requiring a lawyer to untangle them. If the legal structure of an LLC is too complicated and too far off the beaten path, the business may have difficulty explaining itself to a lender when applying for a loan, and it may have difficulty convincing new shareholders to put capital into the business.
A partnership treats salaries paid to partners (at least to its general partners) as distributions from profit. In other words, profit is determined before the deduction of partners’ salaries. LLCs are more likely to treat salaries paid to owner-managers as an expense (like a corporation). I should warn you that the accounting for compensation and services provided by the owners in an LLC and the partners in a partnership gets rather technical and is beyond the scope of this book.
The partnership or LLC agreement specifies how to divide profit among the owners. Whereas owners of a corporation receive a share of profit directly proportional to the number of common stock shares they own, a partnership or LLC does not have to divide profit according to how much each owner invested. Invested capital is only one of three factors that generally play into profit allocation in partnerships and LLCs:
Treasure: Owners may be rewarded according to how much of the treasure — invested capital — they contributed. So if Jane invested twice as much as Joe did, her cut of the profit may be twice as much as Joe’s.
Time: Owners who invest more time in the business may receive more of the profit. Some partners or owners, for example, may generate more billable hours to clients than others, and the profit-sharing plan reflects this disparity. Some partners or owners may work only part-time, so the profit-sharing plan takes this factor into account.
Talent: Regardless of capital and time, some partners bring more to the business than others. Maybe they have better business contacts, or they’re better rainmakers (they have a knack for making deals happen), or they’re celebrities whose names alone are worth a special share of the profit. Whatever it is that they do for the business, they contribute much more to the business’s success than their capital or time suggests.
A partnership needs to maintain a separate capital (ownership) account for each partner. The total profit of the entity is allocated into these capital accounts, as spelled out in the partnership agreement. The agreement also specifies how much money each partner can withdraw from his capital account. For example, partners may be limited to withdrawing no more than 80 percent of their anticipated share of profit for the coming year, or they may be allowed to withdraw only a certain amount until they’ve built up their capital accounts.
Going It Alone: Sole Proprietorships
A sole proprietorship is basically the business arm of an individual who has decided not to carry on his or her business activity as a separate legal entity (as a corporation, partnership, or limited liability company). This is the default when you don’t establish a legal entity.
This kind of business is not a separate entity; it’s like the front porch of a house — attached to the house but a separate and distinct area. You may be a sole proprietor of a business without knowing it! An individual may do house repair work on a part-time basis or be a full-time barber who operates on his own. Both are sole proprietorships. Anytime you regularly provide services for a fee, sell things at a flea market, or engage in any business activity whose primary purpose is to make profit, you are a sole proprietor. If you carry on business activity to make profit or income, the IRS requires that you file a separate Schedule C “Profit or Loss From Business” with your annual individual income tax return. Schedule C summarizes your income and expenses from your sole proprietorship business.
As the sole owner (proprietor), you have unlimited liability, meaning that if your business can’t pay all its liabilities, the creditors to whom your business owes money can come after your personal assets. Many part-time entrepreneurs may not know this or may put it out of their minds, but this is a big risk to take. I have friends who are part-time business consultants and they operate their consulting businesses as sole proprietorships. If they are sued for giving bad advice, all their personal assets are at risk — though they may be able to buy malpractice insurance to cover these losses.
Obviously, a sole proprietorship has no other owners to prepare financial statements for, but the proprietor should still prepare these statements to know how his or her business is doing. Banks usually require financial statements from sole proprietors who apply for loans. See the “One More Thing” section in this chapter regarding accounting methods that a small, sole proprietorship business could adopt (instead of generally accepted accounting principles that large public companies must follow).
One other piece of advice for sole proprietors: Although you don’t have to separate invested capital from retained earnings like corporations do, you should still keep these two separate accounts for owners’ equity — not only for the purpose of tracking the business but for the benefit of any future buyers of the business as well.
Choosing the Right Legal Structure for Income Tax
While deciding which type of legal structure is best for securing capital and managing their business, owners should also consider the dreaded income tax factor. They should know the key differences between the two alternative kinds of business entities from the income tax point of view:
Taxable-entity, C corporations: These corporations are subject to income tax on their annual taxable income. Plus, their stockholders pay a second income tax on cash dividends that the business distributes to them from profit, making C corporations and their owners subject to double taxation. The owners (stockholders) of a C corporation include in their individual income tax returns the cash distributions from the after-tax profit paid to them by the business.
Pass-through entities — partnerships, S corporations, and LLCs: These entities do not pay income tax on their annual taxable income; instead, they pass through their taxable income to their owners, who pick up their shares of the taxable income on their individual tax returns. Pass-through entities still have to file tax returns with the IRS, even though they don’t pay income tax on their taxable income. In their tax returns, they inform the IRS how much taxable income is allocated to each owner, and they send each owner a copy of this information to include with his or her individual income tax return.
Most LLCs opt to be treated as pass-through entities for income tax purposes. But an LCC can choose instead to be taxed as a C corporation and pay income tax on its taxable income for the year, with its individual shareholders paying a second tax on cash distributions of profit from the LLC. Why would an LCC choose double taxation? Keep reading.
The following sections illustrate the differences between the two types of tax entities for deciding on the legal structure for a business. In these examples, I assume that the business uses the same accounting methods in preparing its income statement that it uses for determining its taxable income — a generally realistic assumption. (I readily admit, however, that there are many technical exceptions to this general rule.) To keep this discussion simple, I consider just the federal income tax, which is much larger than any state income tax that may apply.
C corporations
A corporation that cannot qualify as an S corporation (which I explain in the next section) or that does not elect this alternative if it does qualify, is referred to as a C corporation in the tax law. A C corporation is subject to federal income tax based on its taxable income for the year, keeping in mind that there are a host of special tax credits (offsets) that could reduce or even eliminate the amount of income tax a corporation has to pay. I probably don’t need to remind you how complicated the federal income tax is.
Suppose a business is taxed as a C corporation. Its abbreviated income statement for the year just ended is shown in Figure 8-1. (See Chapter 4 for more about income statements.)
Figure 8-1: Abbreviated annual income statement for a C corporation.
Now, at this point I had to make a decision. One alternative was to refer to income tax form numbers and to use the tax rates in effect at the time of writing this chapter. The income tax form numbers have remained the same for many years, but the rest of the tax law keeps changing. For instance, Congress shifts tax rates every so often. Furthermore, tax rates are not flat; they’re progressive, which means that the rates step up from one taxable income bracket to the next higher bracket — for both businesses and individuals. As I have already alluded to, there are many special deductions to determine taxable income, and there are many special tax credits that offset the normal amount of income tax.
Given the complexity and changing nature of the income tax law, in the following discussion I avoid going into details about income tax form numbers and the income tax rates that I use to determine the income tax amounts in each example. By the time you read this section, the tax rates probably will have changed anyway. Let me assure you, however, that I use realistic income tax numbers in the following discussion. (I didn’t just look out the window and make up income tax amounts.)
Refer to the C corporation income statement example again (Figure 8-1). Based on its $2.2 million taxable income for the year, the business owes $748,000 income tax — using the current 34 percent tax rate for this level of corporate taxable income. (Most of the annual income tax should have been paid in installments to the IRS before year-end.) The income tax is a big chunk of the business’s hard-earned profit before income tax. Finally, don’t forget that net income means bottom-line profit after income tax expense.
Being a C corporation, the business pays $748,000 income tax on its profit before tax, which leaves $1,452,000 net income after income tax. Suppose the business distributes $500,000 of its after-tax profit to its stockholders as their just rewards for investing capital in the business. The stockholders include the cash dividends as income in their individual income tax returns. Assuming that all the individual stockholders have to pay income tax on this additional layer of income, as a group they would pay something in the neighborhood of $75,000 income tax to Uncle Sam (based on the current 15 percent rate on corporate dividends).
A business corporation is not legally required to distribute cash dividends, even when it reports a profit and has good cash flow from its operating activities. But paying zero cash dividends may not go down well with all the stockholders. If you’ve persuaded your Aunt Hilda and Uncle Harry to invest some of their money in your business, and if the business doesn’t pay any cash dividends, they may be very upset. The average large public corporation pays out about 30 percent of its after-tax annual net income as cash dividends to its stockholders. It’s difficult to say what privately owned corporations do regarding dividends, since the information is not available to the public.
S corporations
A business that meets the following criteria (and certain other conditions) can elect to be treated as an S corporation:
It has issued only one class of stock.
It has 100 or fewer people holding its stock shares.
It has received approval for becoming an S corporation from all its stockholders.
Suppose that the business example I discuss in the previous section qualifies and elects to be taxed as an S corporation. Its abbreviated income statement for the year is shown in Figure 8-2.
Figure 8-2: Abbreviated annual income statement for an S corporation.
An S corporation pays no income tax itself, as you see in this abbreviated income statement. But it must allocate its $2.2 million taxable income among its owners (stockholders) in proportion to the number of stock shares each owner holds. If you own one-tenth of the total shares, you include $220,000 of the business’s taxable income in your individual income tax return for the year whether or not you receive any cash distribution from the profit of the S corporation. That probably pushes you into a high income tax rate bracket.
When its stockholders read the bottom line of this S corporation’s annual income statement, it’s a good news/bad news thing. The good news is that the business made $2.2 million net income and does not have to pay any corporate income tax on this profit. The bad news is that the stockholders must include their respective shares of the $2.2 million in their individual income tax returns for the year. I can only speculate on the total amount of individual income tax that would be paid by the stockholders as a group. But I would hazard a guess that the amount would be $300,000 or more. An S corporation could distribute cash dividends to its stockholders, to provide them the money to pay the income tax on their shares of the company’s taxable income that is passed through to them.
The main tax question concerns how to minimize the overall income tax burden on the business entity and its stockholders. Should the business be an S corporation (assuming it qualifies) and pass through its taxable income to its stockholders, which generates taxable income to them? Or should the business operate as a C corporation (which always is an option) and have its stockholders pay a second tax on dividends paid to them in addition to the income tax paid by the business? Here’s another twist: In some cases, stockholders may prefer that their S corporation not distribute any cash dividends. They are willing to finance the growth of the business by paying income tax on the taxable profits of the business, which relieves the business from paying income tax. Many factors come into play in choosing between an S and C corporation. There are no simple answers. I strongly advise you to consult a CPA or other tax professional.
Partnerships and LLCs
The LLC type of business entity borrows some features from the corporate form and some features from the partnership form. The LLC is neither fish nor fowl; it’s an unusual blending of features that have worked well for many business ventures. A business organized as an LLC has the option to be a pass-through tax entity instead of paying income tax on its taxable income. A partnership doesn’t have an option; it’s a pass-through tax entity by virtue of being a partnership.
Following are the key income tax features of partnerships and LLCs:
A partnership is a pass-through tax entity, just like an S corporation.
When two or more owners join together and invest money to start a business and don’t incorporate and don’t form an LLC, the tax law treats the business as a de facto partnership. Most partnerships are based on written agreements among the owners, but even without a formal, written agreement, a partnership exists in the eyes of the income tax law (and in the eyes of the law in general).
An LLC has the choice between being treated as a pass-through tax entity and being treated as a taxable entity (like a C corporation). All you need to do is check off a box in the business’s tax return to make the choice. (It’s hard to believe that anything related to taxes and the IRS is as simple as that!) Many businesses organize as LLCs because they want to be pass-through tax entities (although the flexible structure of the LLC is also a strong motive for choosing this type of legal organization).
The partners in a partnership and the shareholders of an LLC pick up their shares of the business’s taxable income in the same manner as the stockholders of an S corporation. They include their shares of the entity’s taxable income in their individual income tax returns for the year. For example, suppose your share of the annual profit as a partner, or as one of the LLC’s shareholders, is $150,000. You include this amount in your personal income tax return.
Once more, I must mention that choosing the best legal structure for a business is a complicated affair that goes beyond just the income tax factor. You need to consider many other factors, such as the number of equity investors who will be active managers in the business, state laws regarding business legal entities, ease of transferring ownership shares, and so on. After you select a particular legal structure, changing it later is not easy. Asking the advice of a qualified professional is well worth the money and can prevent costly mistakes.
Sometimes the search for the ideal legal structure that minimizes income tax and maximizes other benefits is like the search for the Holy Grail. Business owners should not expect to find the perfect answer — they have to make compromises and balance the advantages and disadvantages. In its external financial reports, a business has to make clear which type of legal entity it is. The type of entity is a very important factor to the lenders and other creditors of the business, and to its owners of course.
One other thing I think bears mentioning here. In this Internet age, many people form their own entities, whether it be a corporation or an LLC, through the assistance of online software and websites, with the assumption that they now have the limited liability asset protection afforded that entity. However, forming an entity and keeping it legal can be a complex task and every state has different rules. One little misstep can make it easy for the corporate shield to be pierced in the event of a lawsuit. It is prudent to hire a competent business attorney to make sure you are protected. Consider it a form of insurance.
One More Thing
Until recently the size and public-versus-private ownership of a business were not considered germane for the accounting and financial reporting standards that should be used by a business. The business world in the United States was under the dominion of one set of accounting and financial reporting standards, called generally accepted accounting principles (GAAP) that applied to all businesses. GAAP were considered the gold standard and good for the rest of the world as well. Then about ten years ago the movement toward adopting international standards gained momentum, which continues to this day (see Chapter 2). U.S. GAAP may or may not be replaced with international financial reporting standards (IFRS). Frankly, the future for international standards has become doubtful. In any case, public companies in the United States must follow GAAP or IFRS (as the case may turn out to be).
Recently there have been serious efforts promoting more “easy-to-use” accounting and financial reporting standards for private businesses. The Private Company Council (PCC) was established by the Financial Accounting Foundation, which is the mother organization behind the Financial Accounting Standards Board (FASB). The PCC is tasked with making recommendations to the FASB for modifying and making exceptions to GAAP to alleviate the burden on private companies in complying with complex GAAP standards. The PCC has yet to make any recommendations, and I can’t say what will happen in this regard. As if this were not enough, there is also a movement within the AICPA to allow small- and medium-sized owner-managed entities to deviate even further from GAAP under a frame of reference called Other Comprehensive Basis of Accounting. Have you got all this sorted out? I’m not sure that I have. I grew up with only one set of standards that were called GAAP. But things are changing, that’s for sure. Stay tuned.