The Sykes Law Office

Business Law 

Below you will find information about and definitions of some business services provided by The Sykes Law Office.

Please contact us if you need help with any of these areas of the law.

508-979-8070

Small Business Check-Up: Are You Operating Under The Right Legal Structure?

Find out if a sole proprietorship, partnership, LLC or corporation is, or still is, the right fit for your business.

1. Is your business engaged in risky activities?

Certain businesses -- a hazardous waste cleanup company or building demolition contractor, for example -- are inherently riskier than others. If your business engages in (or in the future will engage in) risky activities, that may be reason enough to convert your business to a corporation or LLC. That's because by incorporating or forming an LLC you get the protection of limited liability, meaning your personal assets are shielded from business-related debts and claims.

2. Do you own substantial personal assets?

If you have a significant amount of personal assets, that may also be reason enough to convert your business's legal structure to an LLC or corporation. Without the limited liability protection offered by these business forms, your personal assets will be at risk if your business can't pay off its debts or satisfy court judgments entered against it.

3. Will business insurance cover the risks of your business?

Your business may be able to protect itself against certain risks through insurance. For example, you can use an insurance policy to guard against work-related car accidents involving your employees. If it looks like the right business insurance policy will cover most of your business's risk, then converting to an LLC or corporation may not be warranted. Unless there are other compelling reasons to convert to and maintain an LLC or corporation, save yourself the expense and paperwork, and just stick with the status quo.

4. Do you want to sell stock to investors or issue employee stock options?

Both LLCs and corporations provide personal liability protection for their owners, but a key difference between the two business forms is the ability to issue stock. If you want to raise investment capital by selling stock -- or if you're looking to attract and retain key employees by issuing stock options -- you would have to first convert your business to a corporation. While it's true that LLCs can raise capital by selling membership interests, the process of doing this is more cumbersome than issuing stock, particularly if you expect to have multiple investors or want to raise money from the public.

Another benefit of issuing stock is the ability to make gifts of stock to family members as part of an estate plan. You can easily make gifts of corporate shares without giving up management control and, if you do it correctly, you can avoid paying a gift tax.

5. Is your business extremely profitable?

If so, you could save significant income tax dollars by converting your business to a corporation and keeping some of your profits in the corporation each year. The profits left behind (called the "retained earnings") would be taxed to the corporation at corporate income tax rates (15% on the first $50,000 of profit and 25% on the next $25,000 of profit), which are lower than most business owners' individual income tax rates. However, the tax savings alone -- probably a few thousand dollars -- may not be worth the hassle of converting to a corporation and filing a corporate tax return.

6. Does your business provide extensive fringe benefits to its owner-employees?

Another tax benefit of corporations is that they can deduct the full cost of fringe benefits (like health insurance and reimbursement of medical expenses) that are provided to employees (including owner-employees), and the employees and owner-employees don't have to pay any tax on the value of these benefits. Other types of business entities can also deduct the cost of many fringe benefits as a business expense, but the owner-employees who receive these benefits will ordinarily be taxed on their value.

7. Are you worried about retaining independent contractor status?

If you're an independent contractor and want to ensure the IRS or other government agency doesn't reclassify you as an employee, you may want to incorporate. Because reclassification is highly unlikely for incorporated independent contractors, your clients may also insist that you be incorporated before they hire you.

Starting Up Your Business

When you start a business, you must decide whether it will be a sole proprietorship, partnership, corporation, or limited liability company (LLC). Which of these forms is right for your business depends on the type of business you run, how many owners it has, and its financial situation. No one choice suits every business: Business owners have to pick the structure that best meets their needs. Several of the most important factors to consider include:

• the potential risks and liabilities of your business
• the formalities and expenses involved in establishing and maintaining the various business structures
• your income tax situation, and
• your investment needs.

Risks and Liabilities

In large part, the best ownership structure for your business depends on the type of services or products it will provide. If your business will engage in risky activities -- for example, trading stocks or repairing roofs -- you'll almost surely want to form a business entity that provides personal liability protection ("limited liability"), which shields your personal assets from business debts and claims. A corporation or a limited liability company (LLC) is probably the best choice for you.

Formalities and Expenses

Sole proprietorships and partnerships are easy to set up -- you don't have to file any special forms or pay any fees to start your business. Plus, you don't have to follow any special operating rules.

LLCs and corporations, on the other hand, are almost always more expensive to create and more difficult to maintain. To form an LLC or corporation, you must file a document with the state and pay a fee, which ranges from about $40 to $800, depending on the state where you form your business. In addition, owners of corporations and LLCs must elect officers (usually, a president, vice president, and secretary) to run the company. They also have to keep records of important business decisions and follow other formalities.

If you're starting your business on a shoestring, it might make the sense to form the simplest type of business -- a sole proprietorship (for one-owner businesses) or a partnership (for businesses with more than one owner). Unless yours will be a particularly risky business, the limited personal liability provided by an LLC or a corporation may not be worth the cost and paperwork required to create and run one.

Income Taxes

Owners of sole proprietorships, partnerships, and LLCs all pay taxes on business profits in the same way. These three business types are "pass-through" tax entities, which means that all of the profits and losses pass through the business to the owners, who report their share of the profits (or deduct their share of the losses) on their personal income tax returns. Therefore, sole proprietors, partners, and LLC owners can count on about the same amount of tax complexity, paperwork, and costs.

Owners of these unincorporated businesses must pay income taxes on all net profits of the business, regardless of how much they actually take out of the business each year. Even if all of the profits are kept in the business checking account to meet upcoming business expenses, the owners must report their share of these profits as income on their tax returns.

In contrast, the owners of a corporation do not report their shares of corporate profits on their personal tax returns. The owners pay taxes only on profits they actually receive in the form of salaries, bonuses, and dividends.

The corporation itself pays taxes, at special corporate tax rates, on any profits that are left in the company from year to year (called "retained earnings"). Corporations also have to pay taxes on dividends paid out to shareholders, but this rarely affects small corporations, which seldom pay dividends.

This separate level of taxation adds a layer of complexity to filing and paying taxes, but it can be a benefit to some businesses. Owners of a corporation don't have to pay personal income taxes on profits they don't receive. And, because corporations enjoy a lower tax rate than most individuals for the first $50,000 to $75,000 of corporate income, a corporation and its owners may actual have a lower combined tax bill than the owners of an unincorporated business that earns the same amount of profit.

Investment Needs

Unlike other business forms, the corporate structure allows a business to sell ownership shares in the company through its stock offerings. This makes it easier to attract investment capital and to hire and retain key employees by issuing employee stock options.

But for businesses that don't need to issue stock options and will never "go public," forming a corporation probably isn't worth the added expense. If it's limited liability that you want, an LLC provides the same protection as a corporation, but the simplicity and flexibility of LLCs offer a clear advantage over corporations. 

Changing Your Mind

Your initial choice of a business structure isn't set in stone. You can start out as sole proprietorship or partnership and later, if your business grows or the risk of personal liability increases, you can convert your business to an LLC or a corporation.

Corporations vs. Limited Liability Companies (LLC)

Let's assume that you've concluded it would be advantageous to operate your small business through an entity that limits the personal liability of all the owners -- even if following this strategy involves a bit more paperwork, complexity and possible expense. You have two main choices -- either the tried and true corporation or the new and streamlined limited liability company (LLC). Which is better? There's no answer to this question that applies to every business. Nevertheless, some general principles may be helpful.

When an LLC May Make Sense

For the majority of small businesses, the relative simplicity and flexibility of the LLC makes it the better choice. This is especially true if your business will hold property, such as real estate, that's likely to increase in value. That's because regular corporations (sometimes called C corporations) and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, LLC owners (called members) avoid this double taxation because the business's tax liabilities are passed through to them; the LLC itself does not pay a tax on its income.

Here are the main features of an LLC:

Limited Personal Liability

Like shareholders of a corporation, all LLC owners are protected from personal liability for business debts and claims. This means that if the business itself can't pay a creditor -- such as a supplier, a lender, or a landlord -- the creditor cannot legally come after an LLC member's house, car, or other personal possessions. Because only LLC assets are used to pay off business debts, LLC owners stand to lose only the money that they've invested in the LLC. This feature is often called "limited liability."

Exceptions to Limited Liability

While LLC owners enjoy limited personal liability for many of their business transactions, this protection is not absolute. This drawback is not unique to LLCs, however -- the same exceptions apply to corporations. An LLC owner can be held personally liable if he or she:

• personally and directly injures someone
• personally guarantees a bank loan or a business debt on which the LLC defaults
• fails to deposit taxes withheld from employees' wages
• intentionally does something fraudulent, illegal, or reckless that causes harm to the company or to someone else, or
• treats the LLC as an extension of his or her personal affairs, rather than as a separate legal entity.

This last exception is the most important. If owners don't treat the LLC as a separate business, a court might decide that the LLC doesn't really exist and find that its owners are really doing business as individuals who are personally liable for their acts. To keep this from happening, make sure you and your co-owners:

• Act fairly and legally. Do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders.
• Fund your LLC adequately. Invest enough cash in the business so that your LLC can meet foreseeable expenses and liabilities.
• Keep LLC and personal business separate. Get a federal employer identification number, open up a business-only checking account, and keep your personal finances out of your LLC accounting books.
• Create an operating agreement. Having a formal written operating agreement lends credibility to your LLC's separate existence.
  

Additional Protection: Business Insurance

A good liability insurance policy can shield your personal assets when limited liability protection does not. For instance, if you are a massage therapist and you accidentally injure a client's back, your liability insurance policy should cover you. Insurance can also protect your personal assets in the event that your limited liability status is ignored by a court.

In addition to protecting your personal assets in such situations, insurance can protect the LLC's assets from lawsuits and claims. But your LLC won't be protected if it doesn't pay its bills: Commercial insurance usually does not protect personal or corporate assets from unpaid business debts, whether or not they're personally guaranteed.

LLC Taxes

Unlike a corporation, an LLC is not considered separate from its owners for tax purposes. Instead, it is what the IRS calls a "pass-through entity," like a partnership or sole proprietorship. This means that business income passes through the business to the LLC members, who report their share of profits -- or losses -- on their individual income tax returns. Each LLC member must make quarterly estimated tax payments to the IRS.

While an LLC itself doesn't pay taxes, co-owned LLCs must file Form 1065, an informational return, with the IRS each year. This form, which partnerships also have to file, sets out each LLC member's share of the LLC's profits (or losses), which the IRS reviews to make sure LLC members are correctly reporting their income.

LLC Management

The owners of most small LLCs participate equally in the management of their business. This arrangement is called "member management."

There is an alternative management structure -- somewhat awkwardly called "manager management" -- in which you designate one or more owners (or even an outsider) to take responsibility for managing the LLC. The non-managing owners (sometimes family members who have invested in the company) simply sit back and share in LLC profits.

In a manager-managed LLC, only the named managers get to vote on management decisions and act as agents of the LLC. Choosing manager management sometimes makes sense, but it might require you to deal with state and federal laws regulating the sale of securities.

Forming an LLC

To create an LLC in Massachusetts, you file a "certificate of organization" (in some states called  "articles of organization" or "certificate of formation") with the LLC division of your state government. This office is often in the same department as the corporations division, which is usually part of the secretary of state's office. Filing fees range from about $100 to $800. Now, in every state, you can form an LLC with just one person.

Many states supply a blank one-page form for the articles of organization, on which you need only specify a few basic details about your LLC, such as its name and address, and contact information for a person involved with the LLC (usually called a "registered agent") who will receive legal papers on its behalf. Some states also require you to list the names and addresses of the LLC members.

In addition to filing articles of organization, you must create a written LLC operating agreement. You don't have to file your operating agreement with the state, but that doesn't mean you can get by without one. The operating agreement is a crucial document because it sets out the LLC members' rights and responsibilities, their percentage interests in the business, and their share of the profits.

Ending an LLC

Under the laws of many states, unless your operating agreement says otherwise, when one member wants to leave the LLC, the company dissolves. In that case, the LLC members must fulfill any remaining business obligations, pay off all debts, divide any assets and profits among themselves, and then decide whether they want to start a new LLC to continue the business with the remaining members.

When a Corporation May Make Sense

An LLC isn't always the best choice, however. Occasionally, other factors will be present that may tip the balance toward a corporation. Such factors include the following:

• You expect to have multiple investors in your business or to raise money from the public. While an LLC works fine when you have just a few investors -- especially those who will be active in the day-to-day operations of the business -- it may get more awkward when the number of investors increases. For example, you'll likely run into resistance from potential investors if you can't offer them the corporate stock certificates that they consider tangible evidence of their partial ownership of the business. Rather than wasting your time trying to overcome this resistance, it's probably better to structure your business as a corporation.
• You'd like to provide extensive fringe benefits to owners. Often, when you form a corporation, you expect to be both a shareholder (owner) and an employee. The corporation can, for example, hire you to serve as its chief executive officer, pay you a tax-deductible salary, and provide fringe benefits as well. These benefits can include the payment of health insurance premiums and direct reimbursement of medical expenses.

The corporation can deduct the cost of these benefits and they are not treated as taxable income to the employees, which can be an attractive feature of doing business through a regular corporation. With an LLC, you can only deduct a portion of medical insurance premium payments, and other fringe benefits provided to members do not receive as favorable tax treatment.

• You want to entice or keep key employees by offering stock options and stock bonus incentives. Simply put, LLCs don't have stock; corporations do. While it's possible to reward an employee by offering a membership interest in an LLC, the process is awkward and likely to be less attractive to employees. Therefore, if you plan to offer ownership in your business as an employee incentive, it makes sense to incorporate rather than form an LLC.

When an S Corporation May Make Sense

Many entrepreneurs have two goals when choosing a structure for their business: protecting their personal assets from business claims (limited liability) and having business profits taxed on their individual tax returns. Not long ago, an S corporation was the only choice for these business owners. In recent years, however, S corporations have been largely replaced by limited liability companies (LLCs). Still, some businesses can benefit by organizing as S corporations.

What Is an S Corporation?

An S corporation is a regular corporation that has elected "S corporation" tax status. Forming an S corporation lets you enjoy the limited liability of a corporate shareholder but pay income taxes as if you were a sole proprietor or a partner.

In a regular corporation (also known as a C corporation), the company itself is taxed on business profits. The owners pay individual income tax only on money they receive from the corporation as salary, bonuses, or dividends.

By contrast, in an S corporation, all business profits "pass through" to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships, and LLCs). The S corporation itself does not pay any income tax, although an S corporation with more than one owner must file an informational tax return, like a partnership or LLC, to report each shareholder's portion of the corporate income.

Most states follow the federal pattern when taxing S corporations: They don't impose a corporate tax, choosing instead to tax the business's profits on the shareholders' personal tax returns. About half a dozen states, however, tax an S corporation like a regular corporation. The tax division of your state treasury department can tell you how S corporations are taxed in your state.

Should You Elect S Corporation Status?

Operating as an S corporation may be wise for several reasons:

• Forming an S corporation generally allows you to pass business losses through to your personal income tax return, where you can use it to offset any income that you (and your spouse, if you're married) have from other sources.
• When you sell your S corporation, your taxable gain on the sale of the business can be less than it would have been had you operated the business as a regular corporation.
• S corporation shareholders are not subject to self-employment taxes (active LLC owners are). These taxes, which add up to more than 15% of your income, are used to pay your Social Security and Medicare taxes.

Aside from the benefits, S corporations impose strict requirements. Here are the main rules:

• Each S corporation shareholder must be a U.S. citizen or resident.
• S corporations may not have more than 100 shareholders.
• S corporation profits and losses may be allocated only in proportion to each shareholder's interest in the business.
• An S corporation shareholder may not deduct corporate losses that exceed his or her "basis" in corporate stock -- which equals the amount of the shareholder's investment in the company plus or minus a few adjustments.
• S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.

Fortunately, a decision to elect to be an S corporation isn't permanent. If your business later becomes more profitable and you find there are tax advantages to being a regular corporation, you can drop your S corporation status after a certain amount of time.

How to Elect S-Corporation Status

To create an S corporation, you must first create a regular corporation by filing articles of incorporation with your secretary of state's office or your state's corporations division. Then, to be treated as an S corporation, all shareholders must sign and file IRS Form 2553.

S-Corporation Alternatives

Tax Issues For S-Corps and LLCs

Self-employment taxes can tip the balance toward S corporations, since LLC owners may pay more. What are self-employment taxes? Well, you know that taxes are withheld from employees' paychecks. Employers must withhold 7.65% of the first $94,200 of an employee's pay for Social Security and Medicare taxes, and 1.45% of earnings above that amount for Medicare taxes alone. The employer adds an equal amount and sends these funds to the IRS. (The total sent to the IRS is 15.3% on the first $94,200 of wages and 2.9% on anything above that.) You may not be aware that the IRS collects a similar 15.3% tax on the first $94,200 earned by a self-employed person and a 2.9% tax on earnings above that amount. This is the self-employment tax.

For an S corporation, the rules on the self-employment tax are well established: as an S corporation shareholder, you pay the self-employment tax on money you receive as compensation for services, but not on profits that automatically pass through to you as a shareholder. For example, if your share of S corporation income is $100,000 and you perform services for the corporation reasonably worth $65,000, you will owe the 15.3% self-employment tax on the $65,000 but not on the remaining $35,000.

By contrast, the self-employment tax may be imposed on an LLC owner's entire share of LLC profits. However, the rules for members of an LLC are murky.

Proposed IRS regulations (which Congress has placed on indefinite hold) would impose the self-employment tax on an LLC owner's entire share of LLC profits in any of the following situations:

• The LLC owner participates in the business for more than 500 hours during the LLC's tax year.
• The LLC provides professional services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting (no matter how many hours the owner works).
• The LLC owner is empowered to sign contracts on behalf of the LLC.

Until the IRS clarifies the rules on self-employment tax for members of an LLC, you should assume that 100% of an LLC member's earnings will be subject to the tax.

Therefore, an S corporation shareholder may pay less self-employment tax than an LLC member with similar income. You'll need to decide if this potential tax saving is enough to offset such LLC advantages as less formal record keeping and flexibility in management structure and in the method of distributing profits and losses.