FAQ - Business Enterprises

Tom Pedreira

  • What do I need to know if I am going into business for myself?

  • What form of business entity should I use?

  • What are the pro's and con's of a sole proprietorship?

  • What are the pro's and con's of a corporation?

  • What's an "S" corporation?

  • What are the pro's and con's of a partnership?

  • Is a limited partnership any different?

  • So what is a limited liability company and how is it different from a limited partnership?

  • Why not just use an "S" corporation rather than a limited liability company?

  • What is a franchise?

  • What are some of the most common mistakes that people make when they go into business for themselves?

  • What are some of the major risks in running a business?

  • What kind of tax liabilities do I have to worry about in my business?

  • Can I avoid payroll tax issues by hiring independent contractors?

    Q: What do I need to know if I am going into business for myself?

    A: You certainly need some business savvy in order to go into business for yourself. Assuming you have a good idea on how to make money, you should develop a detailed business plan before you do anything else. Going through this process will give you a much better idea of what you need to know about your business before you begin operations. Things to cover would include the following:
    • capital requirements
    • costs of operating
    • ownership and control
    • profits and losses
    • labor and employment laws
    • potential liability exposure
    • insurance coverage
    • tax consequences
    • regulatory hurdles
    • administrative issues
    • marketing angles

    Beyond all these issues, it is also extremely important for all business owners to know that they can't know everything. By definition, business is always a risky venture. The best way to quantify the risk is, when appropriate, to rely on other people for advice and consultation. Every business, for example, should have a working relationship with a lawyer, an accountant, an insurance agent and a banker.

    It likewise makes sense to delegate out certain job functions when it is either cost effective to do so (for example, payroll services) or when it helps to spread the risk of your business enterprise (for example, subcontracting out part of a project when someone else will assume the risk of doing a comparable job at a cheaper price).

    Return to index . . .

    Q: What form of business entity should I use?

    A: Although maybe not the best alternative in the long run, the simplest and cheapest way to start up a business is as a sole proprietorship. A sole proprietorship means you are doing business in your individual capacity and not through any type of business entity. You may operate the business in your own name (for example, John Doe's Painting), or you may operate under a fictitious name (for example, John Doe, doing business as, or "dba" Acme Painting). Before legally doing business under a fictitious name, you are required to file a fictitious business name statement in the county or township where your business is located.

    The time tested legal entity to use when forming a business enterprise is the corporation. A corporation is a legal entity that the law treats as a "person" in the sense that the organization has its own corporate identity and existence. As a separate legal entity, a corporation serves as a shield between the owners and third parties doing business with the organization. So long as corporate formalities are observed, the corporate shield makes it difficult for third parties to "pierce the corporate veil" to go after the owners. Instead, creditors and other third parties can be limited to going after the assets of the corporation. A corporation also has its' own name and identity separate from the owners. It pays taxes and has the ability to contract. It can own property. A corporation can sue and be sued. In some instances, a corporation can be charged with and convicted of crimes.

    Another alternative is a partnership. A partnership is an arrangement involving two or more people undertaking a business venture as co-owners, with the intent to make a profit. The simplest type of partnership entity is known as a general partnership. Forming a general partnership is the easiest way to go into business with another person. But the simplicity of a partnership can be a problem, so careful planning is important. One of the principal drawbacks of a general partnership is that a general partner can be held responsible for all debts and liabilities of the partnership. Thus, a general partner with only a one percent interest in a business could still be held liable for 100% of the debts and liabilities of the partnership. From a tax standpoint, it's sometimes better to invest in a partnership rather than incorporating.

    In order to address the issue of potentially unlimited personal liability, most states also recognize another type of business entity that is called a limited partnership. A limited partnership must have at least one general partner, but all of the other investors can be limited partners whose potential liability exposure can usually be limited to the extent of that partner's investment. So, for example, if a limited partner invests $10,000 in a business venture organized as a limited partnership, his or her potential liability would be limited to the $10,000 invested rather than the rest of the limited partner's personal assets. One of the resulting tradeoffs, though, is that an investor must take a passive role in the operation of the business in order to maintain the status of a limited partner. In many ways, a limited partner is comparable to a shareholder in a corporation.

    Another business entity is the limited liability company. This type of business entity is perhaps best described as a hybrid of a corporation and a general partnership. It's treated as a corporation for limited liability purposes but as a general partnership for tax purposes. The owners are called "members." Unlike a shareholder or a limited partner, they don't have to take a passive role in the business

    Yet another alternative for a business entity that is sometimes overlooked is a non-profit corporation. Just because a business is non-profit doesn't mean that it can't make money. If you think your business idea might be able to operate as a non-profit entity, this is something you would want to discuss with your attorney.

    Return to index . . .

    Q: What are the pros and cons of a sole proprietorship?

    A: As the simplest way to do business, a sole proprietorship is operating a business in his or her individual capacity rather than through a formal business entity. Sometimes, a person will run a business as a sole proprietorship in his or her own name. However, it's a common practice to operate under a fictitious name (which is sometimes called a "dba"). It's important to understand, though, that a sole proprietorship doing business under a fictitious name is still just a sole proprietorship.

    The biggest benefit to operating as a sole proprietorship is its simplicity. You're your own boss and don't have to worry about many of the rules and regulation that apply to corporations and other types of business entities. You don't have to worry about filing separate tax returns. In theory, you don't even need to keep separate books and records for your business.

    However, the simplicity of a sole proprietorship can also be a business owner's worst enemy. Why? Because a sole proprietorship doesn't give any protection against the inherent risks and potential liability exposure of running a business. Creditors are free to go after not only the assets of the business but also all of your personal assets, such as bank and savings accounts, land holdings, investments, heirlooms and household furnishings. So if you operate as a sole proprietor, you'll want to try to protect your assets through insurance, homesteading a residence, retirement accounts and perhaps eventually bankruptcy.

    Many sole proprietors operate their businesses with a false sense of security that insurance provides them with adequate protection against the perils of personal liability exposure. To the contrary, there are many risks that are typically not covered by insurance, such as damages for breach of contract and claims arising out of an employment relationship (like sexual harassment or wrongful termination).

    Return to index . . .

    Q: What are the pros and cons of a corporation?

    A: A corporation can serve as an excellent investment vehicle. At the same time, though, there are complex bodies of securities law at both state and federal levels that govern the offering and issuance of shares of stock in corporations. Extreme care must be taken before taking on investors. This should never be done without the advice of an attorney.

    It's not always an easy process to form and maintain a corporation, as there are many formalities that must be followed. There are also costs in forming and maintaining a corporation that can be avoided if you choose to operate as a different type of business entity. For example, most states charge a "franchise" tax every year for the benefit of operating and maintaining a corporation in the state, regardless of whether the corporation has taxable income. And state laws generally require that a corporation maintain an organizational structure that includes directors, officers and shareholders.

    The biggest benefit of incorporating is that it provides the owners (the stockholders) with a shield against potential liability exposure. The protection isn't absolute, but it may be the best protection against personal liability exposure you can get in today's business world. And a business owner can take advantage of certain tax laws by operating through a corporation. It may also be possible to provide better employee benefits through a corporation. In addition, it may be possible to deduct certain business expenses when operating through a corporation that might not be as easy to justify or to validate if operating as one of the other types of business entities.

    Return to index . . .

    Q: What's an "S" corporation?

    A: Corporations are generally subject to federal taxation under Subchapter C of the Internal Revenue Code (and this is where the term "C Corp" comes from). However, in certain instances, a corporation can make an election to be treated under Subchapter S of the Internal Revenue Code. Under Subchapter S, a corporation is generally treated as a partnership for tax purposes. What this means is that income and expenses of the corporation pass straight through to the shareholders, which helps to minimize concerns about double taxation. In consideration of such special treatment, however, the shareholders of an S corporation must generally be individuals, and there can't be more than 75 in a corporation. There are a number of other tricky rules, including when you can decide to form an S corporation.

    Return to index . . .

    Q: What are the pros and cons of a partnership?

    A: A partnership is an arrangement involving two or more people undertaking a business venture as co-owners, with the intent to make a profit. The simplest type of partnership entity is known as a "general" partnership.

    While it is almost always preferable to put things in writing, the law doesn't require that there be a written agreement in order to find that there is a legally binding partnership. Indeed, many people find themselves on the wrong end of a legal dispute because they went into a partnership without clearly defining their business relationship. Partnerships, like marriages, are easy to get into but hard to get out of.

    Partnerships are perhaps the easiest and simplest way to go into business with another person. But the simplicity of a partnership can be its downfall, so careful planning is important. Partners should have a clear understanding as to why they're entering into a partnership instead of some other business entity.

    One particular benefit to a partnership is that it's not a tax-paying entity. While a partnership must file its own tax returns, the profits and losses from the partnership are passed through to the partners. At the same time, however, the tax and accounting rules that deal with partnerships can be exceedingly complicated.

    One of the principal drawbacks of a partnership is that it doesn't protect against potential liability exposure any more than a sole proprietorship. A general partner, for example, can be held 100% responsible for the debts and liabilities of the partnership. This is usually true with a general partnership even though a given partner may have only a minority interest therein. So a general partner with only a one percent interest in a business could still be held liable for 100 percent of the debts and liabilities of that partnership.

    Return to index . . .

    Q: Is a limited partnership any different?

    A: From a tax standpoint, partnerships serve as great investment vehicles. However, investors are oftentimes very leery of investing in a general partnership, as every general partner can be held responsible for 100 percent of the debts and liabilities of the partnership. To address the issue, most states recognize another entity that is called a limited partnership. Generally, a limited partner's potential exposure is designed to be limited to the extent of that partner's investment. For example, if a partner invests $10,000 in a business venture organized as a limited partnership, his or her potential liability would be limited to that $10,000 investment rather than allowing creditors to go after the rest of the limited partner's personal assets.

    The tradeoff is that limited partners must take a passive role in the operation of the business in order to maintain such a status. In many regards, a limited partner would be comparable to a shareholder in a corporation.

    Return to index . . .

    Q: So what is a limited liability company and how is it different from a limited partnership?

    A: The best way to describe a limited liability company ("LLC") is as a hybrid between a corporation and a partnership. When properly organized and capitalized, an LLC has the limited liability benefits of a corporation while at the same time having the tax benefits of a partnership. At the same time, an LLC goes a big step beyond a limited partnership by allowing the owners (who are called "members") be actively involved in the management and control of the entity (as opposed to limited partners in a limited partnership, who must remain passive investors).

    The LLC is a creature of statute that, in relative terms, has only come into existence in recent years. Thus, the business world is not entirely familiar with the LLC mode of operation (as evident by the fact that even sophisticated investors will refer inaccurately to an LLC as a "limited liability corporation"). An LLC isn't a corporation and doesn't have shareholders, nor does it have to have directors or officers. Instead, the owners are called "members" and one or more "managers" make the day-to-day decisions of the business. You file "Articles of Organization" when forming an LLC. An "operating agreement" governs the affairs of the organization (rather than articles of incorporation and bylaws, as with a corporation).

    Return to index . . .

    Q: Why not just use an "S" corporation instead of a limited liability company?

    A: If you're asking this question, you are showing a pretty high level of understanding about business enterprises. It is true that an "S" corporation generally has the same benefits as your standard corporation, including protection against unlimited liability exposure. At the same time, it has essentially the same tax benefits as a partnership, as profits and loses are passed through directly to the shareholders.

    In many instances, an "S" corporation may also be the better way to go. From a practical standpoint, corporations have been around a lot longer than LLC's. People you're going to deal with in the business world will be more familiar with the "S" corporation. In fact, in some lines of business, you may not even be able to operate as an LLC. Overall, the "rules of the road" for corporations are better defined than they are for LLC's, and people are more familiar with them.

    However, there are significant limitations to an "S" corporation. In general, all shareholders have to be individuals, and this can be a significant drawback when some of your investors want to invest through business entities, retirement plans or other investment vehicles. The number of shareholders is also limited to 75 or few individuals, and there can be only one class of stock. "S" corporations must also use a calendar year for tax reporting purposes. The rules for making an "S" election and preserving the "S" status of the corporation can be complicated.

    Return to index . . .

    Q: What is a franchise?

    A: A franchise is not a type of business entity. Instead, it refers to an arrangement where someone (called the "franchisor") has developed a business idea and methodology that is packaged up in a plan that is sold to other folks (called "franchisees") who want to go into business for themselves. Under a franchise agreement, the franchisee is authorized to use and market goods or services under the franchisor's trademarks, service marks and trade names for a specific length of time, usually in exchange for payment of a fee to the franchisor. A typical arrangement will require some payment up front and then a percentage of sales.

    Many new business owners choose to purchase a franchise business because of the assistance they can get from a company with experience in the business. If you purchase a franchise from a reputable franchise company, the risks of opening a business may be significantly less than starting a new business "from the ground up."

    Generally, the franchisee will pay an up-front fee as well as continuing fees based on the dollar amount of goods or services sold. The franchisor trains the franchisee and provides market research to determine a favorable location for the business. The franchisor typically has strict rules and standards as to how business is conducted, the goods and services to be sold and the design and construction of the business location.

    Each state has strict rules and regulations on franchises. Generally, franchisors must comply with strict disclosure requirements, so that people are fully aware of what they are getting into before they sign up to buy a franchise business. If you're looking at buying a franchise, you should be sure that it has been properly registered. You should also be very careful to read and understand all the documentation given to you.

    Return to index . . .

    Q: What are some of the most common mistakes that people make when they go into business for themselves?

    A: The enthusiasm of going into business for yourself must be tempered with being realistic about the risks involved. Statistics show, for example, that most small businesses do not succeed in the long run. Some of the reasons for failure include:
    • Lack of a business plan that thoroughly addresses all of the "what if's"
    • Taking on partners when you don't really need to do so
    • Not understanding the business or the business marketplace
    • Lack of capitalization and underestimating the costs of doing business
    • Failing to take into account tax liabilities
    • Trying to cut corners by trying to do everything yourself
    • Not relying on or taking advantage of professional advice
    • Underestimating the competition
    • Inability to effectively manage the business
    • Not thinking through your long term goals and an exit strategy

    Return to index . . .

    Q: What are some of the major risks in running a business?

    A: There is no such thing as a business venture without risk. The risks involved can come in many forms, all of which translate into the possibility that you could end up going out of business and lose all of your investment (and possibly much more).

    Businesses are always going to be subject to market risks from competition and the economy in general. From a legal perspective, though, the problems that most often seem to bring down a business would include:

    • A failure to comply with licensing requirements or other regulations
    • Lax internal procedures and accounting standards
    • Not staying on top of payables and receivables
    • Labor and employment issues, including sexual harassment or discrimination claims
    • Underestimating and failing to pay tax liabilities, which notably include payroll taxes
    • Disputes among partners
    • Getting sued, with the risks of being buried in costs of litigation as well as being liable for any judgment that may be entered against you or the business
    • Possible criminal liability exposure for violating the laws regulating your business

    When you are going into business, you usually don't think about the risks of going out of business if the enterprise fails. Once a business is in trouble, though, many of these risks come back to the forefront in terms of whether you will ultimately be able to avoid bankruptcy. The risks include the possibility of personal liability exposure for the following:

    • Personal guarantees on bank loans and other obligations of the business
    • Unpaid taxes assessed against the business, including interest and penalties
    • Other continuing or long term obligations of the company, which notably include office and equipment leases
    • Pending lawsuits in which you are named personally as a plaintiff or defendant
    • Investigations by governmental agencies

    All of these risks only underscore the need for proper planning before you go into business. This planning should include using the right business entity to shield you from the potential liabilities of operating a business.

    Return to index . . .

    Q: What kind of tax liabilities do I have to worry about in my business?

    A: If you're a first-time business owner or operator, the taxes levied on your business will be shocking. There are federal, state and local taxes assessed against every business, and a lot of the time you can be held personally liable for them. These taxes include:
    • Business license fees (essentially a tax on the cost of doing business)
    • Payroll taxes and withholdings (both the employer and the employee portions)
    • Excise taxes on products, goods or services (e.g., petroleum products)
    • Franchise taxes (for the privilege of doing business)
    • Permit and application fees (essentially another tax on the cost of doing business)
    • Sales and use taxes
    • Property taxes
    • Federal and state income taxes (personal and corporate)
    • Federal and state capital gains taxes (personal and corporate)
    • Penalties and interest that accrue on taxes that are not timely paid.

    Failing to pay payroll taxes is a classic example of where many businesses get into trouble. As an employer, a business has the responsibility for withholding certain taxes from an employee's paycheck (for example, income tax withholdings, social security, federal and state unemployment and disability taxes). These amounts are not the employer's money and the employer is responsible for collecting them on behalf of the government. The IRS and other tax authorities are very unforgiving about failing to pay over these withholdings in a timely manner. In addition, the employer is responsible for the business's portion of social security and other payroll taxes that must also be paid on time. If the employer fails to pay in these taxes and withholdings, penalties can be assessed against the owners and/or managers of the business up to 100% percent of the amounts owed.

    Return to index . . .

    Q: Can I avoid payroll tax issues by hiring independent contractors?

    A: The advantages of independent contractors include:
    • Your business can save money, because you won't have to pay for the independent contractor's federal payroll taxes, social security, unemployment insurance, workers' comp health insurance, vacations and sick leave
    • You also won't have to rent space and pay for office furniture for the independent contractor
    • An independent contractor can't sue you for discrimination or being fired
    • You don't have to train an independent contractor, and they can usually start productive work right away

    The disadvantages of independent contractors include:

    • Independent contractors can sue you if they're injured on the job due to your negligence, because they aren't covered by workers' comp
    • If you later find out that someone you thought was an independent contractor is really considered an employee, you may have to pay back taxes and penalties (up to 35 percent)
    Employee Versus Independent Contractor

    Different governmental agencies use different tests for deciding when someone is an independent contractor versus an employee.

    Internal Revenue Service

    Of most concern is the IRS, which has developed a 20-factor test for determining whether someone is an employee for whom you must pay payroll taxes:

    Do you have the right to control how the worker does the work?

    • Do you give the worker extensive instructions on how, when or where to do the work?
    • Do you provide the worker with training about procedures and methods?
    • Do you set the working hours of the worker?

    Do you have financial control over the worker?

    • Do you reimburse the worker for business expenses?
    • Do you absorb the profit or loss from the worker's performance?

    How do you and the worker see your relationship?

    • Does the worker receive benefits, like health insurance or a retirement plan?
    • Do you have a written employment contract which allows you to fire the worker?
    • Does the worker have a continuing relationship with your business?
    • Is the worker paid by the hour?

    The presence of these factors makes it more likely that the IRS will consider the worker an employee rather than an independent contractor for tax purposes.

    State Agency Tests

    State laws vary as to when a worker is considered an employee versus an independent contractor for unemployment compensation, workers' comp and state tax purposes.

    Some state agencies use what's called an economic reality test that focuses on how economically dependent the worker is on the hiring business.

    In many states, unemployment compensation laws follow what's called the ABC test, which focuses on:

    • Whether the worker is operating a business independent of the hiring business.
    • Where the work is actually performed (onsite at the hiring business or elsewhere).
    • What control the hiring business has over the worker while the job is being performed.

    When You Want to Hire an Independent Contractor

    To make sure you're actually hiring an independent contractor:

    • Find out ahead of time how your state's unemployment compensation, workers' comp and state tax agencies determine who is an independent contractor.
    • Have the prospective worker fill out an "independent contractor form" rather than a job application. This should include information such as the name, address and phone number of the independent business, number of employees, professional and business credentials of the business, names of other businesses the worker's company does business with and the worker's business insurance.
    • Ask the prospective worker to provide you with documenting evidence for business credentials and insurance, such as articles of incorporation and insurance policies.
    • Get a signed independent contractor contract with the worker, which sets out the specifics of the relationship, including where the work will be performed, how the worker will be paid and the fact that the worker is responsible for paying his or her own federal and state taxes, social security and other expenses. The contract should make it clear that your business owns the work product of the worker for all purposes.

    Return to index
    • Immigration to Labor Law: Every Legal Issue. One Legal Source. Lawyers.com

    tax lien

    a statutory lien on property for taxes due giving the taxing authority a security interest in the property

    Cyber attack is met with speculation and shrugs; Some think N. Korea launched the virus whose targets included the White House and NYSE.

    Despite a broad and persistent cyber attack whose targets included the White House, the New York Stock Exchange and the Washington Post, government websites...

    Dogfighting ring busted: St. Joseph teacher among dozens facing charges across six states

    Jul. 9--A physical education teacher at a state school in St. Joseph was arrested Wednesday as part of what Humane Society of Missouri officials describe...

    Stricter rules for mortgage brokers keep hundreds out

    In its first year of licensing mortgage professionals, Massachusetts disqualified hundreds of applicants from working in the industry because they had...

    More Legal News


    Terms & Conditions   Privacy   Copyright © 2009 LexisNexis, a division of Reed Elsevier Inc. All rights reserved.