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When you start a business, you must decide on a legal structure for it. Usually you’ll choose either a sole proprietorship, a partnership, a limited liability company (LLC) or a corporation. There’s no right or wrong choice that fits everyone. Your job is to understand how each legal structure works and then pick the one that best meets your needs. The best choice isn’t always obvious—after reading this chapter, you may decide to seek some guidance from a lawyer or an accountant.

 

For many small businesses, the best initial choice is either a sole proprietorship or—if more than one owner is involved—a partnership. Either of these structures makes especially good sense in a business where personal liability isn’t a big worry—for example, a small service business in which you are unlikely to be sued and for which you won’t be borrowing much money. Sole proprietorships and partnerships are relatively simple and inexpensive to establish and maintain.

Forming an LLC or a corporation is more complicated and costly, but it’s worth it for some small businesses. The main feature of LLCs and corporations that attracts small businesses is the limit they provide on their owners’ personal liability for business debts and court judgments against the business. Another factor might be income taxes: You can set up an LLC or a corporation in a way that lets you enjoy more favorable tax rates. In certain circumstances, your business may be able to stash away earnings at a relatively low tax rate. In addition, an LLC or corporation may be able to provide a range of fringe benefits to employees (including the owners) and deduct the cost as a business expense.

 

Given the choice between creating an LLC or a corporation, many small business owners will generally be better off going the LLC route. For one thing, if your business will have several owners, the LLC can be more flexible than a corporation in the way you can parcel out profits and management duties. Also, setting up and maintaining an LLC can be a bit less complicated and expensive than a corporation. But there may be times a corporation will be more beneficial. For example, because a corporation—unlike other types of business entities—issues stock certificates to its owners, a corporation can be an ideal vehicle if you want to bring in outside investors or reward loyal employees with stock options.

 

Keep in mind that your initial choice of a business form doesn’t have to be permanent. You can start out as sole proprietorship or partnership and, later, if your business grows or the risks of personal liability increase, you can convert your business to an LLC or a corporation.

 

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A.  Sole Proprietorships

The simplest form of business entity is the sole proprietorship. If you choose this legal structure, then legally speaking you and the business are the same. You can continue operating as a sole proprietor as long as you’re the only owner of the business.

 

Establishing a sole proprietorship is cheap and relatively uncomplicated. While you do not have to file articles of incorporation or organization (as you would with a corporation or an LLC), you may have to obtain a business license to do business under state laws or local ordinances. States differ on the amount of licensing required. In California, for example, almost all businesses need a business license, which is available to anyone for a small fee. In other states, business licenses are the exception rather than the rule. But most states do require a sales tax license or permit for all retail businesses. Dealing with these routine licensing requirements generally involves little time or expense. However, many specialized businesses—such as an asbestos removal service or a restaurant that serves liquor—require additional licenses which may be harder to qualify for. In addition, if you’re going to conduct your business under a trade name such as Smith Furniture Store rather than John Smith, you’ll have to file an assumed name or fictitious name certificate at a local or state public office. This is so people who deal with your business will know who the real owner is.

 

From an income tax standpoint, a sole proprietorship and its owner are treated as a single entity. Business income and business losses are reported on your own federal tax return (Form 1040, Schedule C). If you have a business loss, you may be able to use it to offset income that you receive from other sources.

 

1. Personal Liability

A potential disadvantage of doing business as a sole proprietor is that you have unlimited personal liability on all business debts and court judgments related to your business.

 

EXAMPLE 1: Lester is the sole proprietor of a small manufacturing business. When business prospects look good, he orders $50,000 worth of supplies and uses them up. Unfortunately, there’s a sudden drop in demand for his products, and Lester can’t sell the items he’s produced. When the company that sold Lester the supplies demands payment, he can’t pay the bill.

 

As sole proprietor, Lester is personally liable for this business obligation. This means that the creditor can sue him and go after not only Lester’s business assets, but his other property as well. This can include his house, his car and his personal bank account.

 

EXAMPLE 2: Shirley is the sole proprietor of a flower shop. One day Roger, one of Shirley’s employees, is delivering flowers using a truck owned by the business. Roger strikes and seriously injures a pedestrian. The injured pedestrian sues Roger, claiming that he drove carelessly and caused the accident. The lawsuit names Shirley as a co-defendant. After a trial, the jury returns a large verdict against Roger—and Shirley as owner of the business. Shirley is personally liable to the injured pedestrian. This means the pedestrian can go after all of Shirley’s assets, business and personal.

 

One of the major reasons to form a corporation or a limited liability company (LLC) is that, in theory at least, you’ll avoid most personal liability.

 

2. Income Taxes

As a sole proprietor, you and your business are one entity for income tax purposes. The profits of your business are taxed to you in the year that the business makes them, whether or not you remove the money from the business (called “flow-through” taxation, because the profits “flow through” to the owner’s income tax return). You report business profits on Schedule C of Form 1040.

 

By contrast, if you form an LLC or a corporation, you have a choice of two different types of tax treatment.

·          Flow-Through Taxation. One choice is to have the IRS tax your LLC or corporation like a sole proprietorship or partnership (discussed above). The owners report their share of LLC or corporate profits on their own tax returns, whether or not the money has been distributed to them.

·          Entity Taxation. The other choice is to make the business a separate entity for income tax purposes. If you form an LLC and make that choice, the LLC will pay its own taxes on the profits of the LLC. And as a member of the LLC, you won’t pay tax on the money earned by the LLC until you receive payments as compensation for services or as dividends.

 

Similarly, if you form a corporation and choose this option, you as a shareholder won’t pay tax on the money earned by the corporation until you receive payments as compensation for services or as dividends. The corporation will pay its own taxes on the corporate profits.

 

For now, just be aware that this tax flexibility of LLCs and corporations offers some tax advantages over a sole proprietorship if you’re able to leave some income in the business as “retained earnings.” For example, suppose you want to build up a reserve to buy new equipment or your small label manufacturing company accumulates valuable inventory as it expands. In either case, you might want to leave $50,000 of profits or assets in the business at the end of the year. If you operated as a sole proprietor, those “retained” profits would be taxed on your personal income tax return at your marginal tax rate. But with an LLC or corporation that’s taxed as a separate entity, the tax rate will almost certainly be lower.

 

3. Fringe Benefits

If you operate your business as a sole proprietorship, tax-sheltered retirement programs are available. A Keogh plan, for example, allows a sole proprietor to salt away a substantial amount of income free of current taxes. You can’t really do any better by setting up an LLC or a corporation.

 

An LLC or a corporation that chooses to be taxed as a separate entity does have an advantage when it comes to medical expenses for the owner and his or her spouse and dependents. As a sole proprietor, in 2000, you can deduct only 60% of your family’s health insurance premiums on Form 1040. (In future years, that percentage will increase.) You can deduct the remaining 40% as an itemized deduction on Schedule A, but only to the extent that the 40% of the premiums, plus other uncovered medical expenses, exceed 7.5% of your adjusted gross income for the year.

 

If you form an LLC or a corporation, however, and choose to have it taxed as a separate entity, you can have the business hire you as an employee. The business can pay 100% of your family’s health insurance premiums and uncovered medical expenses and then take these amounts as a business deduction; you won’t be personally taxed for the value of this employment benefit.

If you choose to do business as a sole proprietor, there’s a way you can deduct more of your family’s medical expenses. First, hire your spouse at a reasonable wage. Then, set up a written health benefit plan covering your employees and their families. A sample form is shown below. Your business can then deduct 100% of the medical expenses it pays.

But balance whether such a plan can save you enough money to justify the effort. There may be some expense for setting up the plan and handling the associated paperwork. And remember that your business will be obligated for payroll taxes on your spouse’s earnings. But this isn’t all bad, since your spouse will become eligible for Social Security benefits in his or her own right, which can be of some value—especially if he or she hasn’t already worked long enough to qualify.

If you’re audited, the IRS will look closely to make sure your spouse is really an employee and performing needed services for the business.

               

4. Routine Business Expenses

As a sole proprietor, you can deduct day-to-day business expenses the same way an LLC, corporation or partnership can.  Whether it’s car expenses, meals, travel or entertainment, the same rules apply to all of these types of business entities.

 

You’ll need to keep accurate books for your business that are clearly separate from your records of personal expenditures. The IRS has strict rules for tax-deductible business expenses, and you need to be able to document those expenses if challenged. One good approach is to keep separate checkbooks for your business and personal expenses—and pay for all of your business expenses out of the business checking account. But whatever your system, please pay attention to this basic advice: It’s simple to keep track of business income and expenses if you keep them separate from the start—and murder if you don’t.

 

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B.     Partnerships

If two or more people are going to own and operate your business, you must choose between establishing a partnership, a corporation or a limited liability company (LLC). This section looks at the general partnership, which is the type of partnership that most small businesses will be considering.

Ellen, Mary and Barbara Kate, librarians all, planned to open an electronic information searching business with an emphasis on information of special interest to women. They would hold on to their daytime jobs until they could determine if their new business could support all three women.

At a planning meeting to discuss buying personal computers and modems, Ellen said she wanted the business to be run as professionally as possible, which to her meant promptly incorporating or forming an LLC. The discussion about equipment was put off while the three women tried to decide how to organize the legal structure of their business. After several frustrating hours, they agreed to continue the discussion later and to do some research about the organizational options in the meantime.

Before the next meeting, Ellen conferred with a small business advisor who suggested that the women refocus their energy on the computers and modems and getting their business operating, keeping its legal structure as simple as possible. One good way to do this, she suggested, was to form a partnership, using a written partnership agreement. Each partner would contribute $10,000 to buy equipment and contribute roughly equal amounts of labor. Profits would be divided equally.

Later, if the business succeeded and grew, it might make sense to incorporate or form an LLC and consider other issues, like a health plan, pensions and other benefits. But for now, real professionalism meant getting on with the job—not consuming time and dollars forming an unneeded corporate or LLC entity.

The best way to form a partnership is to draw up and sign a partnership agreement. Legally, you can have a partnership without a written agreement, in which case you’d be governed entirely by either the Uniform Partnership Act or the Revised Uniform Partnership Act Beyond a written agreement, the paperwork for setting up a partnership is minimal—about on a par with a sole proprietorship. You may have to file a partnership certificate with a public office to register your partnership name, and you may have to obtain a business license or two. The income tax paperwork for a partnership is marginally more complex than that for a sole proprietorship.

1.     Personal Liability

As a partner in a general partnership, you face personal liability similar to that of the owner of a sole proprietorship. Your personal assets are at risk in addition to all assets of the partnership. In other words, you have unlimited personal liability on all business debts and court judgments related to your business.

 

In a partnership, any partner can take actions that legally bind the partnership entity. That means, for example, that if one partner signs a contract on behalf of the partnership, it will be fully enforceable against the partnership and each individual partner, even if the other partners weren’t consulted in advance and didn’t approve the contract. Also, the partnership is liable, as is each individual partner, for injuries caused by any partner while on partnership business.

EXAMPLE 1: Ted, a partner in Argon Associates, signs a contract on behalf of the partnership that obligates the partnership to pay $50,000 for certain goods and services. Esther and Helen, the other partners, think Ted made a terrible deal. Nevertheless, Argon Associates is bound by Ted’s contract even though Esther and Helen didn’t sign it.

EXAMPLE 2: Juan is a partner in Universal Contractors. Elroy, one of his partners, causes an accident while using a partnership vehicle. Juan and all the other partners will be financially liable to people injured in the accident if the car isn’t covered by adequate insurance. The same would be true if Elroy used his own car while on partnership business.

In both of these situations, the personal assets (home, car and bank accounts) of each partner will be at stake, in addition to partnership assets. But remember that a partnership can protect against many risks by carrying adequate liability insurance.

2.      Partners’ Rights and Responsibilities

Each partner is entitled to full information—financial and otherwise—about the affairs of the partnership. Also, the partners have a “fiduciary” relationship to one another. This means that each partner owes the others the highest legal duty of good faith, loyalty and fairness in everything having to do with the partnership.

EXAMPLE: Wheels & Deals, a partnership, is in the business of selling used cars. No partner is free to open a competing used-car business without the consent of the other partners. This would be an obvious conflict of interest and, as such, would violate the fiduciary duty the partners legally owe to one another.

Unless agreed otherwise, a person can’t become a new partner without the consent of all the other partners. However, in larger partnerships, it’s common for partners to provide in the partnership agreement that new partners can be admitted with the consent of a certain percentage of the existing partners—75%, for example.

State laws regulating partnerships dictate what occurs if one partner leaves your partnership and you don’t have a partnership agreement that provides for what happens. In about half the states, the partnership is automatically dissolved when a partner withdraws or dies; the business is then liquidated. In such a state, it’s an excellent idea to put a provision in your partnership agreement that allows the business to continue without interruption, despite the technical dissolution of the partnership. A partnership agreement, for instance, may provide a “buy-sell” provision that calls for a buy-out if one of the partners dies or wants to leave the partnership, avoiding a forced liquidation of the business.

EXAMPLE: Tom, Dick and Mary are equal partners. They agree in writing that if one of them dies, the other two will buy the deceased partner’s interest in the partnership for $50,000 so that the business will continue. (Be aware that often a partnership agreement doesn’t fix a precise amount as the buy-out price but uses a more complicated formula based on such data as yearly sales, profits or book value.) To fund this arrangement, the partnership buys life insurance covering each partner in an amount large enough to cover the buyout. If Tom dies first, under the terms of the agreement, his wife and children will receive $50,000 from the partnership to compensate them for the value of Tom’s ownership interest in the business. Technically, the remaining partners would operate as a new partnership, but the important point is that the business would keep functioning.

Other states—generally those that have adopted the revised version of the Uniform Partnership Act—follow a slightly different rule. In those states, if your partnership was created to last for a fixed length of time or was created for a specific project, and a partner leaves before the fixed time expires or the project is done, the partnership isn’t automatically dissolved. Instead, the remaining partners have the opportunity to continue the existing partnership rather than having to form a new one. But even if your state follows this more flexible approach, you’ll still want to use buy-sell provisions to specify how the departing partner—or the family of a partner who’s died—gets compensated for his partnership interest.

3.     Income Taxes

In terms of income and losses, the tax picture for a partnership is basically the same as that of a sole proprietorship. A partnership doesn’t pay income taxes. It must, however, file an informational return that tells the government how much money the partnership earned or lost during the tax year and how much profit (or loss) belongs to each partner. Each partner uses Schedule C of Form 1040 to report the business profits (or losses) allocated to him and then pays income tax on his or her share, whether or not this income was actually distributed during the tax year. If the partnership loses money, each partner can deduct his or her share of losses for that year from income earned from other sources (subject to some fairly complicated tax basis rules).

The above analysis assumes that the partner who deducts losses from other income actively participates in the business. If, instead, a partner is a passive investor (as is often the case in partnerships designed to invest in real estate) or receives income from passive sources (such as royalties, rents or dividends), any loss from the partnership business is treated as a passive loss for that partner. That means that for federal income tax purposes the loss can be deducted only from other passive income—not from ordinary income.

4.     Fringe Benefits and Business Expenses

When it comes to retained earnings, tax-sheltered retirement plans and fringe benefits, a partnership is like a sole proprietorship, and the discussion in Section A3, above, applies to partnerships as well.

 

Likewise, business expenses can be deducted in the same way for a partnership as for a sole proprietorship; the discussion in Section A4, above, applies here as well.

           

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C.     Corporations

If you’re concerned about limiting your personal liability for business debts, you’ll want to consider organizing your business as either a limited liability company (LLC) or a corporation. (Of course, you may have other reasons in addition to limited liability for considering these two business structures.) Since the corporation has a longer legal history, I’ll deal with it first, but the LLC—which is covered in Section D—may well be preferable for your particular business, despite its relative newness.

 

This information deals primarily with the small, privately owned corporation. I’ll assume that all of the corporate stock is owned by one person or a few people, and that all shareholders are actively involved in the management of the business—with the possible exception of friends and relatives who have provided seed money in exchange for stock. Because there are many complexities involved in selling stock to the public, I don’t discuss public corporations.

 

The most important feature of a corporation is that, legally, it’s a separate entity from the individuals who own or operate it. You may own all the stock of your corporation, and you may be its only employee, but—if you follow sensible organizational and operating procedures—you and your corporation are separate legal entities.

All states have adopted legislation that permits a corporation to be formed by a single incorporator. All states permit a corporate board that has a single director, although the ability to set up a one-person board may depend on the number of shareholders. In addition, many states have streamlined the procedures for operating a small corporation to permit decisions to be made quickly and without needless formalities. For example, in most states, shareholders and directors can take action by unanimous written consent rather than by holding formal meetings, and directors’ meetings can be held by telephone.

1.     Limited Personal Liability

One of the main advantages of incorporating is that, in most circumstances, it limits your personal liability. If a court judgment is entered against the corporation, you stand to lose only the money that you’ve invested. Generally, as long as you’ve acted in your corporate capacity (as an employee, officer or director) and without the intent to defraud creditors, your home and personal bank accounts and other valuable property can’t be touched by a creditor who has won a lawsuit against the corporation.

EXAMPLE: Andrea is the sole shareholder, director and officer of Market Basket Corporation, which runs a food store. Ronald, a Market Basket employee, drops a case of canned food on a customer’s foot. The customer sues and wins a judgment against the business. Only corporate assets are available to pay the damages. Andrea is not personally liable.

Liability for your own acts. If Andrea herself had dropped the case of cans, the fact that she is a shareholder, officer and director of the corporation wouldn’t protect her from personal liability. She would still be personally liable for the wrongs (called torts, in legal lingo) that she personally commits. So much for theory. In practice, incorporating may not actually give you broad legal protection.

 

In the real world, banks and some major corporate creditors often require the personal guarantee of individuals within the corporation. So the limited liability gained from incorporating isn’t always as valuable a legal shield as it first seems.

EXAMPLE: Market Basket Corporation borrows $75,000 from a bank. Andrea signs the promissory note as president of the corporation, but the bank also requires her to guarantee the note personally. The corporation runs into financial difficulties and can’t repay the debt. The bank sues and wins a judgment against the business for the unpaid principal plus interest. In collecting on the judgment, the bank can go after Andrea’s assets as well as the corporation’s property. Incorporation offers no advantage over a sole proprietorship when an owner personally guarantees a loan.

As mentioned in Sections A and B, above, liability insurance can protect against many of the risks of doing business. Because of this, many businesses can structure themselves as sole proprietorships or partnerships without worrying about unlimited personal liability. But if you operate a high-risk business—child care center, chemical supply house, asbestos removal service or college town bar—and you can’t get (or can’t afford) liability insurance for some risks that you’re concerned about, incorporation may be the wisest choice.

EXAMPLE: Loren is afraid that a clerk at his After Hours beverage store might inadvertently sell liquor to an under-aged customer or one who has had too much to drink. If that customer got drunk and hurt someone in a car accident, there might be a lawsuit against the business.

Loren contacts his insurance agent to arrange for coverage, but learns that his liquor store can afford only $50,000 worth of liability insurance. Loren buys the $50,000 worth of insurance, but also forms a corporation—After Hours Inc.—to run the business. Now if an injured person wins a large verdict, at least Loren won’t be personally liable for the portion not covered by his insurance.

The lesson of these examples is clear: Before you decide to incorporate your business primarily to limit your personal liability, analyze what your exposure will be if you simply do business as a sole proprietor (or a partner in a partnership).

 

The limited liability feature of corporations can be valuable, protecting you from personal liability for:

•  Debts that you haven’t personally guaranteed, including most routine bills for supplies and small items of equipment.

•  Injuries suffered by people who are injured by business activities not covered adequately by insurance.

 

Also, for a business with more than one owner, incorporating can offer a great deal of protection from the misdeeds or bad judgment of your co-owners. In contrast, in a partnership, as noted above, each partner is personally liable for the business-related activities of the other partners.

EXAMPLE: Ted, Mona and Maureen are partners in Mercury Enterprises. Mona writes a nasty letter about Harold, a former employee, which causes Harold to lose the chance of a good new job. Harold sues for defamation and wins a $60,000 judgment against the partnership. Ted and Maureen are each personally liable to pay the judgment even though Mona wrote the letter.

If Mercury Enterprises had been a corporation, Mona and the corporation would have been liable for the judgment, but Ted and Maureen would not. Ted and Maureen would lose money if the assets of the corporation were seized to pay the judgment, but their own personal assets would be safe.

 

Payroll taxes. Limited liability doesn’t protect you if you fail to deposit taxes withheld from employees’ wages—especially if you have anything to do with making decisions about what bills the corporation pays first. Also, because unpaid withheld taxes aren’t dischargeable in bankruptcy, you want to pay these before you pay other debts (most of which can be wiped out in bankruptcy) in case your business goes downhill.

 

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D.     Limited Liability Companies

The limited liability company (LLC) is the newest form of business entity. It has enjoyed a meteoric rise in popularity among both entrepreneurs and lawyers—and for good reason. It’s often a very attractive alternative to the traditional ways of doing business, which are described in Sections A, B and C, above.

The state laws controlling how an LLC is created and the federal tax regulations controlling how an LLC is taxed are still evolving. Fortunately, the evolutionary trends are extremely favorable to small businesses. On the formation side, it’s becoming simpler and simpler to set up an LLC. On the tax side, LLCs are benefitting from increased flexibility.

 

Once you’ve decided that your business should be organized as an entity that limits your personal liability for business debts, you’ll have to weigh the pros and cons of forming an LLC against the pros and cons of forming a corporation. Sometimes, one or the other will clearly emerge as the better choice. Other times, the differences are more subtle—which often means that either will suit your needs equally well.

1.     Limited Personal Liability

As with a corporation, all of the owners of an LLC enjoy limited personal liability. This means that being a member of an LLC doesn’t normally expose you personally to legal liability for business debts and court judgments against the business. Generally, if you become an LLC member, you risk only your share of capital paid into the business. You will, however, be responsible for any business debts that you personally guarantee (of course, you can reduce your risk to zero by not doing this) and for any wrongs (torts) that you personally commit.

 

By contrast, as discussed in Sections A and B above, owners of a sole proprietorship or general partnership have unlimited liability for business debts, as do the general partners in a limited partnership.

Although there are many similarities between corporations and LLCs, there are many differences as well—especially when it comes to terminology, as shown in the following chart:

 

TERM                                                 CORPORATION                                      LLC      

What an Owner Is Called                      Shareholder                                           Member

What an Owner Owns                          Shares of Stock                                      Membership Interest      

What Document Creates the Entity        Articles of Incorporation                          Articles of Organization
                                                         (or, in some states, Certificate of
                                                         Incorporation or Charter)                       

What Document Spells Out Internal       Bylaws                                                  Operating Agreement
Operating Procedures                                                                                     

 

2.     Number of Owners

Nearly all states allow an LLC to be formed by just one person. (In Washington, D.C. and Massachusetts, however, you need two or more members to form an LLC.) This means that in most states, if you plan to be the sole owner of a business and you wish to limit your personal liability, you have a choice of forming a corporation or an LLC.

If your state still requires two or more members for a valid LLC, meeting that requirement should be no problem if you’re married: simply invite your spouse to be a member. If that’s not a possibility for you and you want limited personal liability for your one-person business, you’ll need to form a corporation. All states do allow one-person corporations.

3.     Tax Flexibility

If you create a single-member LLC, it will not be taxed as a separate entity, like a regular corporation, unless you elect to have it taxed in this manner. Normally, you won’t choose corporate-style taxation, preferring to have your single-member LLC report its profits (or losses) on Schedule C of your personal return, just as a sole proprietorship would.

 

Similarly, if you have an LLC with two or more members, it will be treated as a partnership for tax purposes, with each partner reporting and paying income tax on her share of LLC profits unless you elect to have the LLC taxed as a corporation. Again, you normally won’t elect to do this, preferring to have your multi-member LLC follow the partnership tax route. This means that the LLC will report its income (or loss) on Form 1065, an informational return that notifies the IRS of how much each member earned (or lost). Each member will then report his or her share of profits or losses on her personal Form 1040.

 

Occasionally, the members of an LLC will conclude that there’s an advantage to being taxed like a corporation, with two levels of tax—one at the business entity level (for company profits) and another at the owners’ personal income tax level (for salaries and dividends). LLCs that are taxed like corporations are able to split monies between business owners and the business itself, resulting in some situations in a significant overall tax saving.

 

If, after reviewing all the financial implications—and perhaps seeking the advice of a tax pro—you decide to elect corporation-style taxation, you’ll do this by filing IRS Form 8832, Entity Classification Election. Where the LLC has two or more members, they can all sign the form or authorize one member or manager to sign.

Electing to have your LLC taxed as a corporation can be advantageous if you want to receive tax-free fringe benefits from the business. If you follow the usual practice of having pass-through taxation for your LLC—meaning that the business isn’t taxed as a separate entity—then as a business owner you’ll be taxed on the value of the fringe benefits you receive from the LLC (unlike other employees). A different rule applies if you elect to have your LLC taxed as a corporation. In that situation, as long as you meet the IRS guidelines, you can receive fringe benefits as an owner-employee of the LLC and not have to pay tax on the value of those benefits.

4.     Flexible Management Structure

An LLC member may be an individual or a separate legal entity such as a partnership or corporation that has invested in the LLC. You and the other members jointly run the LLC unless you choose to have it run by a single member, an outside manager or a management group—which may consist of some members, some nonmembers or both. If you decide to form an LLC, I recommend that all the members sign an operating agreement that spells out how the business will be managed.

5.     Flexible Distribution of Profits and Losses

The members of an LLC can decide to split up the LLC profits and losses each will receive any way they want. Although it’s common to divide LLC profits according to the percentage of the business’s assets each member contributed, this isn’t legally required.

EXAMPLE: Jim, Janna, Jill and Jerry—certified personal trainers—form Fit for Life LLC to operate a family fitness center. Each contributes $25,000 to the enterprise. Because Jim, who has a strong business background, has put together the LLC, set up a bookkeeping system, arranged for a bank loan to purchase necessary equipment and negotiated a very favorable lease at a good location, the owners state in their operating agreement that for the first two years, Jim will receive 40% of the LLC’s profits and that Janna, Jill and Jerry will each receive 20%. After that, they’ll share profits equally.

By contrast, rules governing corporate profits and losses are considerably more restrictive. A regular corporation can’t allocate profits and losses to shareholders; instead, shareholders must receive dividends according to the number of shares they own—if they receive dividends at all. (But it is possible, although more cumbersome, to establish two or more classes of stock, each with different dividend rights.) Similarly, in an S corporation, profits and losses are attributed to the shareholders based on their shares: a shareholder who owns 25% of the shares in an S corporation ordinarily must be allocated 25% of profits and losses—no more and no less. Sometimes, however, corporations can get away from this strict formula by adjusting the salaries of shareholders who work in the business.

The easy flexibility allowed to LLCs in distributing profits and losses permits businesses to be creative and even make distributions to members who have contributed no cash.

EXAMPLE: Howard and Saul run a home repair business organized as an LLC. Howard puts up all the money to needed to buy a van, tools and supplies and to pay for advertising brochures and radio commercials. Saul, who has little cash but loads of experience in doing home repairs, will contribute future services to the LLC. Although the owners could agree to split profits and losses equally, they decide that Howard will get 60% for the first three years as a way of paying him back for taking the risk of putting up cash.

Copyright © 1999-2001 Nolo.com All Rights Reserved

 

Excerpted from the “Legal Guide for Starting and Running a Small Business”, by Fred S. Steingold