For any business or professional practice to survive, it must continually focus on
4 elements: (1) its products or services; (2) the marketing and/or public relations function (your business will not survive if you are the best in the world but your phone never rings); (3) the often neglected, related administrative requirements of running your business (your business will fail if you are the best in the world, your phone is ringing off the hook but you don’t get your bills out or you don’t pay your withholding taxes); and (4) the ethical component which is essential, as demonstrated by the demise of Enron.
Any business person or professional needs to continually focus on and address each of the above four elements because neglecting any one will cause your business potential to suffer and can cause businesses ultimately to fail.
This article will briefly address some issues, typically handled by an attorney, in conjunction with your accountant, concerning the choice of the best form of entity to provide your business services.
The vast majority of businesses in the United States are operated as sole
proprietorships. The sole proprietorship is, of course, available as a form of business entity to businesses such as restaurants, contractors, and others, as well as professionals, including physicians and attorneys. In fact, many businesses operate successfully as sole proprietorships.
The sole proprietorship is the simplest and least structured form of entity with basically no differentiation between the proprietor and the business. I practiced law as a sole proprietor for about four years when I started my own business some time ago.
Most businesses can, through their choice of business entity, insulate their personal assets from their business assets. While insurance is still important, the choice of business entity may be more meaningful as a personal risk avoidance and asset preservation mechanism.
Professionals like doctors and attorneys cannot through their choice of business entity insulate themselves from their own professional malpractice. Accordingly, this risk must be addressed through other measures like insurance. Professionals can, however, insulate their personal assets from the professional malpractice of fellow professionals in their business. Accordingly, when one associates with other professionals in one’s business, the situation changes. While insurance is still important, the choice of business entity may be more meaningful as a personal risk avoidance and asset preservation mechanism.
Sole proprietors have few legal formation requirements, e.g., they are required by Virginia law to file fictitious name certificates if they trade under a name other than, or in addition to, their legal name, and most Virginia cities/counties require business licenses. Bookkeeping and accounting are simple and, of course, sole proprietorships pay taxes on their income at the individual tax rates and file Schedule C of individual IRS Form 1040.
Currently, individual tax rates can exceed corporate rates at certain levels, such as at the highest tax rates. However, the main disadvantage to being a sole proprietorship is probably still perceived to be the personal/unlimited liability of the sole proprietor for all debts and liabilities of the business.
As a sole proprietor, in signing a lease with a landlord, buying real estate from which to operate your business, signing an onerous contract with a third party, etc., there is no differentiation between the proprietor and the business. Accordingly, generally, creditors (including both trade and judgment creditors) can have full recourse to the sole proprietor’s personal assets.
S-Corps and LLCs
It is precisely because corporations and limited liability companies allow business owners to insulate their personal assets from the vagaries and risks of running a business that they have become so popular as a choice of entity. Generally, the company is the only entity responsible for business debts and liabilities unless the debts and liabilities have been guaranteed, in which case the guarantors are also liable.
Professional corporations or professional limited liability companies are an exception to the general rule because professionals cannot insulate themselves from their own professional malpractice to their clientele. However, personal assets of professionals can, of course, be protected in many other ways by choice of the corporate or limited liability company form of entity e.g., leases, onerous indemnification provisions in third party contracts, slip-and-falls, etc.
Both the S-Corp and the limited liability company allow for flow-through or conduit tax treatment and can avoid double taxation issues upon sales of businesses and upon distributions of profit from business operations. In certain circumstances, self-employment taxes may be reduced. Whether a new form of business entity provides asset preservation, administrative, tax and other benefits can be a complex analysis, which should be undertaken periodically by the business owner, in conjunction with their professional advisers, typically their attorneys and accountants.
Virginia law allows for the same person to serve as sole shareholder, sole director and sole officer in a corporation. Virginia law also allows for single-member limited liability companies. While there are more formalities associated with operating one’s own business as a corporation or a limited liability company than as a sole proprietorship, Virginia law has greatly reduced the inconvenience and hassle factor so that it should not present a major impediment in the decision of most business owners.
Limited liability companies and corporations can also be formed for minimal expense. For example, the filing fee for a limited liability company payable to the State Corporation Commission (the “SCC”) is $100 and for a corporation (assuming the usual 5,000 authorized shares) is $75. Typically, our firm charges only $300 in legal fees to organize an S-Corp or limited liability company. On this issue a word of caution: An accountant recently told a professional whom we ultimately assisted, just to go down to the SCC and fill in the SCC’s pre-printed form to organize his entity. Several issues/problems arise. For example, for professionals there are certain extra requirements to address in the Articles of Organization or Articles of Incorporation. Additionally, even for non-professionals, the pre-printed forms may not address other possible provisions which could have a significant effect on the entity, e.g., preemptive rights, indemnification provisions, etc. A mistake often made by persons forming their own corporations is assuming that receipt of the Certificate of Incorporation completes the organization of the corporation. Not so, the corporation has now been “incorporated” but further steps must be taken to complete the organization of the corporation. Virginia Code Section 13.1-623 describes how the organization of the corporation is completed. It is important that these remaining steps be taken to assure limited liability.
Of course, there are other entities available to businesses such as the limited liability partnership and business trust.
Several years ago, I presented a series of numerous articles, in much greater detail, to the Virginia Society of CPAs newsletter for publication. The scope of this article has been greatly reduced to cover what I consider the most salient choice of entity issues facing businesses. Accordingly, this column is intended for informational and educational purposes only and not as legal advice. Readers needing legal advice should retain competent legal counsel.
© 2003, John V. Robinson, P.C.