Choice of a Business Entity Can Be a Problem

Starting a business is stressful. Licensing, banking, equipment, personnel and business office location are only a few of the details that must be addressed. Often overlooked is giving attention to the type of entity under which the business will be conducted. Yet, the type of entity has long reaching consequences that should be considered at the start. Although the business entity can be changed, it is better to get it right at the beginning.

A lot of start-up businesses originate as a one-person operation. A former employee branches  out to start a business in the former field of employment or sometimes a completely new endeavor. The easiest way to do that is just start offering service or product as an individual. Many of these folks do not even open a separate bank account. With or without a business bank account, this business form is a sole proprietorship.

The sole proprietor operates under his or her social security number although the proprietor might register a fictitious business name with the State. The sole proprietor is 100% responsible for business debt, liability and income. No filing with the State is required to create a sole proprietorship. It is simply an individual conducting business.

Things get more complicated when more than one person owns the business. The simplest form of multiple business ownership is a general partnership. These are often created by handshake deals under which the partners agree to share the expenses, labor and income. Partners can also agree in writing to terms governing the partnership including allocation of income and expense. The partners report income and losses on their individual tax returns in proportion to their interest in the partnership.

A big problem with informal partnership agreement is the partners can eventually argue who is supposed to do what. Those issues should be addressed in a more formal agreement.

Biggest drawback to a general partnership is liability. Each partner is 100% liable for all debts of the partnership, including and lawsuit against the partnership. If one partner makes a mistake, all are liable. 

Liability is what drives most business people to create a more formal entity with limited liability. That adds complication and possible confusion because there are many options available in Florida. 

Chartering a corporation was the original way to gain limited liability. A corporation has formal structure and is created by filing a charter with the State. Owners own shares of stock in the corporation and its operation as an entity is governed by statute and bylaws adopted by the shareholders. Since a corporation is created by charter with the State, it cannot be created orally or by handshake alone.

Shareholders generally have liability limited to their investment in the corporation which means what they pay for their stock and un-repaid loans to the corporation. A shareholder could have liability for personal wrongdoing such as fraud to third parties or if signing as a guarantor for corporate debt or performance. Liability is otherwise limited to their investment.

A drawback to corporate business form is the corporation gets taxed as a separate entity on profits of the business. When profits are later distributed as dividends to the shareholders, the shareholders are taxed on the distribution as income, resulting in double tax. That is really a burden to small business owners.

To remedy the tax problem, Congress added a special classification for small business corporations to the Internal Revenue Code in 1958. Subchapter S was added to that portion of the tax code addressing corporations. A subchapter S or S corporation is one which has no more than 100 shareholders, has no nonresident alien shareholder, with limited exception has no shareholder who is not an individual , has only one class of stock and that elects subchapter S treatment by filing with the IRS. Shareholders of a subchapter S corporation are taxed on the income of the corporation (even if it is not distributed to them) and the corporation does not pay income taxes. 

Subchapter S corporations quickly became the entity of choice for most small businesses. But, the relatively strict rules of a corporation often conflicted with the desire of the owners for a more partnership type structure. Desire and creativity spawned the limited liability company.

Wyoming adopted the first law allowing creation of a limited liability company in 1977 and Florida followed in 1982. The Wyoming law was the result of effort by the Hamilton Brothers Oil Company,  which wanted to operate business in the United States with limited liability and tax treatment similar to what it enjoyed in Panama.

A limited liability company can have one or more members, with no maximum. It combines the limited liability of corporations with the ability to elect tax treatment of a partnership (or S corporation). 

Non-resident aliens, corporations and other entities can be members of a limited liability company. The owners can adopt flexible allocation of capital ownership, sharing of income and other governance that would not be allowed in a corporation.

Limited liability companies have one additional benefit. In most states, the ownership of a member in a multi-member limited liability company cannot be taken by that member’s creditors. Creditors of a shareholder in a corporation can take the shareholder’s stock. 

One liability overlooked or ignored by many chartering a limited liability entity is what happens when there is dispute among the owners or one owner wants to sell. The cordial relationship at startup of a business can degenerate over time leading to infighting that also hurts the business. Selling ownership interest to a third party or even to one of the other owners can also disrupt what was once a good working arrangement.

A well drafted transfer agreement among owners can address procedure for transfer, death of an owner, buy out if disagreement and other issues before they arise. The agreement is a prenuptial for a possible future business divorce and is highly recommended even though everyone gets along so well at the beginning of a business.

Limited liability is a big deal in business. It can mean the difference between losing everything and only losing an investment when things go wrong. It is also a big deal to select the right entity and owner agreements for the limited liability. Poor choices at the start of business are often a time bomb for problems and expense later.