A Brief History Lesson
People have been running their own businesses since the dawn of time, but until very recently businesses were not recognized as separate entities. In olden times the business was the person who ran it, and they were responsible for all the actions and debts of the business. The rug merchants and bakers in the bazaars of ancient times were no different than the sole proprietors of modern day.
When the burden of running the business became too large for one person, they might take in a partner, agreeing to share both the labors and the fruits of those labors. Until relatively modern times, the sole proprietorship and the partnership were the only forms of business entities recognized, and they were not really entities at all, but merely extensions of their owners.
The concept of the modern corporation was born in 1600 when the English monarchy granted a charter to the British East India Company to conduct foreign trade. The company earned their shareholders a return of 150% a year for 15 years, and the concept of the company as a separate entity was born. In this new entity, the corporation, individuals could buy a percentage of a business called shares.
However, until the 19th century, corporate charters where granted only by the state, and required a legislative act to form the company. In the United States corporate charters where only granted by Congress or by State legislatures until the early 1800’s when New Jersey saw a money making opportunity and began offering simple corporate charters. Delaware soon followed suit, but when New Jersey began taxing their newly chartered corporations, Delaware did not. Since that time Delaware has continued to expand and promote their business friendly attitude, and today Delaware is still the favored state of incorporation for most big business.
Business Formation Issues
One of the first things you need to do when starting a new business venture is decide on the type of business entity you wish to be. A business can be run as:
• a sole proprietorship,
• a partnership,
• a corporation or
• a limited liability company.
Choosing which type of entity to use in your business venture generally comes down to two issues; limited liability, and taxation.
Corporations and Limited Liability Companies (LLC) offer limited liability to their shareholders while sole proprietorships and partnerships do not. In the interest of brevity, I will not further explain sole proprietorships and partnerships other than to say that if you are in business online today either one of these are clearly not a good idea. This will become clearer as we explain the many benefits of limited liability with regard to corporations and the LLCs.
Truth & Misconception of Limited Liability
There are many misconceptions concerning the concept of limited liability. The premise of limited liability relates only to the investor’s financial responsibility for the debts of the entity. In a limited liability entity, once the shareholder has made their investment they have no further obligation with respect to the entity’s debts. However, a shareholder, particularly a shareholder who is active in the business operations, is still liable for the criminal and tortuous (i.e. negligence, fraud, sexual harassment, etc.) acts they might commit in connection with the business. Generally, Limited liability entities do not shield you from lawsuits based on issues other than debt.
Double Taxation Issues
While a business conducted as a sole proprietorship or a partnership does not provide limited financial liability to the owners, these entities have an advantage over the corporation when the tax man cometh. For the purpose of calculating taxable profit, corporations are treated as a separate entity and charged taxes on the profit they generate, with the added liability of being assessed at a higher rate than the rate used for individuals or partnerships (which are taxed are the individual’s rate.) Adding further insult to injury, distributions to shareholders are taxed to the recipient, which in effect taxes the profits of the corporation twice; once as a corporation, and once again when distribution and doled out as income to shareholders.
As you can see, when deciding between running your business as a corporation or as a sole proprietorship or partnership, you need to balance the need for limited financial liability against the prospect of higher tax rates and double taxation. But there is a work around that many smaller corporations use to avoid the double taxation issue.
Single Taxation Solution with Limited Liability
For hundreds of years businesses had to accept double taxation in exchange for limited liability. However, in the 20th century two new options were created for US businesses. One involved registering the corporation with the IRS as an S-Corporation, rather than the standard C-Corporation. This allowed the corporation’s shareholders to maintain the limited liability of the corporation; however, they were taxed like a partnership at the individual’s rate as long as they adhered to a strict set of accounting principles. Unfortunately, these strict accounting principles were a nightmare to handle and created large accounting bills for the S-Corps and consequently S-Corps were not widely created.
The other workaround from the double taxation issue is a late 20th century invention called the Limited Liability Company. This beauty has all the creature comforts of our beloved corporations with regard to limited liability, while streamlined accounting standards and requirements make it the preferred form of new business entity formation in these modern times.
In the 1980’s the first Limited Liability Companies were formed under new laws in Wyoming and Florida when the IRS agreed to tax these limited liability entities as partnerships. The states wrote very simple regulations for these LLC’s and by the late 1990’s almost every state had adopted LLC legislation. By providing partnership taxation treatment along with limited liability for shareholders and greatly simplified regulations, the LLC has become the most popular business entity in the U.S. today.
Other considerations in choosing your entity:
- Accountants generally charge far less for preparing an LLC return than a corporate return.
- Pass through taxation of the LLC at individual rates.
- Flexible management and ownership Structure.
- Less formalities and paperwork.
- If you are starting a venture where you will have employees, you may find the corporate structure more flexible for the benefits you wish to provide. However, an LLC can be converted to a corporation later in time with very little difficulty. You may wish to plan to begin as an LLC and convert to a corporation later should your tax professional advise you to do so.
Note: If it were not obvious yet, I feel that the LLC is the best option for new ventures and budding entrepreneurs. However, many of the reasons for choosing one operating entity over another are accounting related. Discussing your plans and the reason for picking an entity with your accountant would be a wise move.
Formation and Registration of Your Entity
Corporations and LLC’s are governed by the laws of the state of registration. New corporations file their Articles of Incorporation with the State’s Secretary of State and then operate under the corporate laws of that state. Similarly, LLC’s file their Articles of Organization with the Secretary of State and then operate under the LLC laws of the state.
These are the steps you need to take to officially form and register your entity:
Step 1: Choose Your Entity
Step 2: Choose your State
Step 3: Choose a Name
Step 4: Choose a Registered Agent
Step 5: File the Articles of Organization
Step 6: Apply for an Employer Identification Number (EIN)
Step 7: Hold an Organizational Meeting
Once you have held your Organizational Meeting the company is good to go!
