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When thinking about all you need to do to start your new business, researching the proper business entity might not be at the top of your list, but it should be. Lori Ann Fox, government relations and regional attorney at CT Corporation, details why it is vital for new businesses to establish a formal entity. Fox explains the different types of entities and how to choose the right fit for your business. She also details how the different entities could impact your tax bill and what sort of compliance is necessary long after you open your doors.
Greg: Hi I’m Greg Corombos and our guest this week is Lori Ann Fox. She is Government Relations and Regional Attorney at CT. Our topic today is “Choosing a Business Entity and Why You Need To Do It” and making sure you choose the right one. Lori Ann, thank you for being with us.
Lori: Thanks for having me here today, Greg.
Greg: So when starting a small business why is it important to choose a business entity?
Lori: One of the reasons it’s so important is how you’re going to present the entity to the world, so to customers and the public in general. It’s also going to dictate how you’ll interact with federal, state and other local agencies, and possibly even international agencies.
Greg: When is the right time to dig into this?
Lori: My belief is as soon as you decide you want to start a new business, or you even start thinking about what type of business entity is going to be best because often it will be guided by the business and financial plans over a 5-, 10-, 15- or 20-year span.
Greg: What are the most common business entity types?
Lori: We have a number of them today. We have corporations which probably everybody has heard of. We have limited liability companies, and then we have partnerships. For partnerships we have a number of those that are an option. You have a general partnership, limited partnership, limited liability partnership, and in some states you even have a limited liability limited partnership. And of course there is also the business trust.
Greg: Are any more popular than the others?
Lori: Yes. So corporations and LLCs, limited liability companies are the two most popular entity types for business today. Now that’s in general, and there are some specialty areas where a limited partnership may be preferred or liabilty partnership. However corporations and LLCs are the two most popular.
Greg: Why are they the most popular?
Lori: They have a number of similarities, and do have some differences as well. Part of it is corporations have been around in the U.S. for 100 years at this point. Limited liability companies are a younger entity type, and they became popular in the early 90s once tax treatment was determined, but they do have some good pieces to both of them.
Greg: What are the most common similarities?
Lori: The great thing about both entity types is they give owners—either the shareholders for a corporation or members of an LLC—limited liability, meaning the corporation is going to be responsible for its own debt not the owners. So that’s really a key piece there for both, and so it’s a great similarity. They also have some similar tax treatment options. And I say options because there are options.
Greg: What are the tax treatment options?
Lori: For a corporation we have a default under a new code which most people call a C corporation, and it’s really easy for people to say can you form a C Corp? I giggle because you don’t form a C Corp, you form a corporation because the states don’t distinguish on the tax treatment when talking about forming the entity. But the Internal Revenue Service does care, so Treasury cares. So you have your C Corp which is a default for a corporation.You also have an option for pass-through taxation, which is called an S corporation, and for that you’ll make a special filing opting into it, and it has to be unanimous. At that point you’ll file an informational return each year for the entity, but the income, losses, deductions and everything else passes straight to the owners and shareholders, personal tax returns at that point. Now if the owner is an entity it would be the entity tax return, and if it was an individual like me or you, it would be a 1040.
With the LLC we have default taxation which if you only have one member, the IRS is going to disregard you as an entity and tax you like a sole proprietorship meaning pass-through taxation to your 1040. If you have two or more members, then the default is partnership taxation under the Internal Revenue Codes of Chapter K. However you have the option as an LLC to elect to be a C or S Corp.
Greg: A lot of very helpful tax information there. We talked about similarities Lori Ann. How about the differences between those two?
Lori: I think a lot of the differences come down to how you interact with the entity, and how it’s more formalized. So for a corporation about 40 states have adopted the Model Business Act which tells you what to do. It says you must do A, B and C and so it’s easy to follow in that context.
On the LLC it’s more default statutes. So they say, okay, here’s the standards, here’s the parameters in which you can work, and then it allows you to make more decisions on your own. It offers things…for example, here is a great one. For corporations the decisions are always going to be made by a board of directors unless you have a statutory closed corporation which not all states have, but at that point you can dispense with the board and shareholders can make the decisions. Otherwise, shareholders elect board members, and board members make the decisions and officers carry them out.
With the LLC you have options. The default for an LLC is the members or owners are going to manage it, but you can elect to have managers manage the entity for you. So you really have more flexibility there, and it tends to be less of a formal entity.
Greg: So we get to the bottom line Lori Ann, how do you decide on the right business entity type for you?
Lori: I really think it comes down to what your business is. Think about it in terms of what is the type of business you’re going to be in? What are the factors going into your business plan? Are you planning to grow in ten years to have ten employees, but really they’re not all going to be employees you’re going to have some independent contractors? Are you going to have salaries?
Or are you going to blow the business up and in ten years you’ll have 100, 200 actual employees where you’ll have withholdings and paying taxes, and so there are a lot of different pieces in there. My belief is often it comes down to the financial side. You also want to take into account the financial needs of the owners as well because there is a big difference between being taxed as a C corporation which has a lot of different pieces that you’d use under the Internal Revenue Code versus pass-through taxation which will have different pieces you’d use. Of course there is still a difference between a partnership or sole proprietorship taxation versus an S Corp taxation.
It’s a matter of the income, losses, and deductions and how it all works tougher. So my belief tends to figure out your finances, figure out your business plan, and know where you want to be going and plan for that long term.
Greg: So once you made this important decision what are the next steps following that decision?
Lori: Well it may be something when you first decide on the business you start thinking about because names are a huge issue. It’s not just what name you’re going to put on the business, but how you’re going to present the business to the world and everybody, your customers and clients whoever you’re going to be interacting with. Shockingly names can be a little more of a challenge then you would think.
Years ago when I was in private practice I had clients and I’d tell them give me three names. They go three? Yeah give me three names because we have to find out if it’s available. So always be thinking about the name and whether it’s available. I highly recommend if you think of a name that might be good, start looking at things like whether it’s available as a domain name on WHOIS [whois.icann.org], look at if there is a trademark on it on the USPTO site, and then you’ll get down to the state records.
Once you have your name, and sorted out name availability, which you can get help with, then we’re going to file articles of formation, organization or corporation. It depends on the type of entity, and also the state—they’ll interchange the wording for those sometimes.
If it’s a corporation it might be articles of incorporation. If it’s an LLC it’s often articles of formation, though some states have started to standardize and have gone to articles of organization.
Then after you get your articles on file to let the public know you’re doing business as this business entity type, then you’re going to start wanting to work on your internal governing documents.
Greg: What are those? What’s an internal governing document?
Lori: It sounds really formal doesn’t it? Kind of scary, but don’t worry about it, it’s easy. For a corporation, an internal governing document—think of it in terms of bylaws. So bylaws are the who, what, when, where and often the why and the how of how the business is going to conduct itself to the world, internally or with its shareholders. You may also have something like a shareholder agreement depending on the sophistication of the business.
For an LLC it’s often called an LLC or an operating agreement. That will cover a lot of the same things your bylaws are going to cover, but then it’s going to cover more because remember earlier I said LLCs are a lot of default statutes? Well that’s what happens, and so now you get to opt in or out so if you like them you can live by them. But if you don’t like them, or need to tweak something for your particular business, or it doesn’t quite suit your needs, you’re going to have a more sophisticated business then what the default statutes allow for, this is where you’re going to put it.
Again, it’s how you’re going to do business and who’s going to make decisions, and how they’re going to be carried out.
Greg: How does that differ from a corporation?
Lori: Remember, a corporation has the board of directors that are elected by the shareholders, and you’re going to have things in the bylaws like how many board of directors are you going to have. Is it going to be three, five or seven? What kind of a term? Are they going to have a one year term or is it going to be a staggered term? So there are a lot of pieces you’re going to have to determine for both.
Greg: What else do you need besides this to get your business started?
Lori: Those are really the biggest ones to get your business started, but you do have ongoing requirements as well. So once you get it filed, you also have to think about what else do I need to do? You need to think in terms of am I in a regulated industry? If so, is it regulated by a federal, state or local agency?
Greg: Talk about that a bit more. What’s a regulated business?
Lori: An easy example would be insurance, and that is highly regulated typically by a Department of Insurance or a Commissioner of Insurance in a state. But you also have less formal sounding things for businesses. For example, let’s say that you’re going to start a local brewery and you might have brewery manufacturing licensing or distribution or sellers permit issues, and so you want to know where those apply. You may also have city ordinances you need to comply with.
Or let’s say you’re starting a construction company, and so you may be on file with the state, but then you may also have to get permissions or licenses from a county or even a city as you’re going into a job.
Greg: Final question Lori Ann before we let you go. Once you have your business on file with the state, is there anything you need to do to maintain that business entity?
Lori: There are, and we were just talking about all the pieces we have to go through just to get on record, and let the public know this is what we’re doing out there in the world. Then you have to keep the state updated because that’s how the public will know you’re still doing this. So you’re going to have to do things like file an annual or biennial report and that’s typically just letting us say we’re still in business and these are, for example, on a corporation that might be directors, on an LLC it might be managers, and we’re still at this address, and this is still our registered agent…that’s another you have to do, you have to maintain your registered agent for service of process for the corporation and LLC.
What that means, because a lot of people don’t understand that one, is you have a designated registered agent to receive and forward service of process. Now we all…we never get sued, that’s not our goal when we go into business. So think beyond lawsuits because the resident agent often times is set as the address to send notifications. For example, we just said the annual or biennial report depending on the state’s requirements, well the state may be sending that notification or a reminder to the resident agent address because the concept is that you’re keeping your address updated at all times with the registered agent, even if you’re not filing some kind of update with the state.
Then you also have to think about taxes. You have the franchise tax, and some state’s call them margin tax, which is basically a privilege to do business tax. In addition to that many states and, of course, federal government has income taxes for entities, and so you have to make sure you’re keeping up with those filings as well.
And if anything changes you’re going to want to notify the state so they have up-to-date records for the public to contact you and understand what’s going on.
Greg: So much good advice and Lori Ann we thank you for your time today we much appreciate it.
Lori: Thank you Greg.
Greg: Lori Ann Fox, Government Relations and Regional Attorney at CT Corporation. I’m Greg Corombos and for more information on this topic visit the website or call the number on your screen.
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