How to Set Up Your Business

How to Set Up Your BusinessThere are a number of ways to set up your business. These include:

  • Sole Proprietorship
  • General Partnership
  • C Corporation
  • Subchapter - S Corporation
  • Limited Liability Company

There are pros and cons to each form. When considering which is best suited to your situation, you need to keep in mind how each of these forms of doing business will affect your liability and taxable income.

Let me review briefly each of the above forms of business noted above.

Sole Proprietorship

This is the most basic way of doing business. You don't need to take any formal action to create it, although you may need to register your business name with the State of Missouri if the business name is other than your surname. You may have to obtain municipal or state licenses if the nature of the business or where it is being operated makes this necessary.

You are personally liable for every business debt. That means all of your assets, personal and business, are at risk. You report business profits or losses on an individual income tax return by filling out Schedule C. Net profit is taxed at personal income tax rates. You cannot deduct losses but can carry them forward to the next tax year to be applied to any net profit that year.

If you become disabled or die, your business is part of your "estate". Without proper planning, it goes through probate - a guardianship, in the event of your disability or a decedent's estate, in the event of your death.

General Partnership

General PartnershipThis is created by an agreement setting forth the respective ownership interests of the partners, the extent of each partner's investment in the business, the rights and obligations of each partner and what happens if a partner dies or becomes disabled.

You should be very aware of potential liabilities with a general partnership. Each partner is personally liable for all of the business liabilities of the partnership. Each partner's personal assets are potentially at risk. If a bill isn't paid, you can be forced to pay the entire amount if your partners are unable to pay their respective shares. Tax wise, total profit and losses are calculated for the business and then each partner files an individual income tax return which includes the amount of his respective tax liability share.

Although people doing business together often consider themselves as "partners", they would be well advised to consider another form of doing business, such as a limited liability company (LLC), in order to minimize liability exposure. Doing business together with just a "handshake" may create a general partnership with its resultant liability and tax exposure.

C Corporation

A corporation is an entity that is separate and distinct from you as an individual. To incorporate, you must file articles of incorporation, create corporate bylaws and follow state requirements for reporting certain information. Stock must be issued, even if you are the sole shareholder.

Under normal circumstances a corporate owner's liability is limited to funds invested in the stock. Stockholders cannot be held personally liable for corporate actions, and creditors are limited to corporate assets when seeking to collect monies owned. However, if you don't conduct your business according to state law and your own bylaws, you may lose your right to limited liability and expose your own personal assets to creditor collection.

The business must report income on a corporate tax return, separate from your own (shareholder) return. Shareholders will be taxed for dividends received and any salaries paid from the corporation will be taxed at individual rates. Thus there can be a tax at the corporate level as well as the individual level.

People usually choose to incorporate to obtain liability protection - to separate their personal assets from exposure to creditors of the business. Liability protection can also be found in a limited liability company (LLC) or a subchapter - S corporation. For Start-up businesses these latter forms of doing business are more often used as they have less formalities and better bottom line tax wise.

Subchapter - S Corporation

General Partnership A subchapter S corporation offers the same limited liability protection as a C corporation. A stockholder's liability is limited to the assets of the corporation, as long as the corporation "behaved like a corporation" (followed its own bylaws and state laws) and the stockholder did not pledge any personal assets as collateral for any corporate loan.

A subchapter - S corporation is formed by filing articles of incorporation, creating bylaws and by making an election with the IRS to be taxed as a subchapter - S corporation. This essentially means that the profits of the business pass through the corporation and are reportable and taxed on an individual's personal return. They are not taxed at the corporate level.

A subchapter - S corporation cannot have more than 100 shareholders, all of whom must be United States citizens or residents. There can be only one class of stock. Like a C corporation, a subchapter - S corporation continues in existence until formally shut down. If a shareholder of the corporation dies, his or her stock passes to his or her named beneficiaries or heirs, who then own those shares of the business. Owners of subchapter - S corporations, C corporations, limited liability companies (LLCs) and partnerships are well advised to have, in writing, an agreement directing what happens to their ownership interest in the event of their death or disability. Such agreements are often referred to as buy/sell agreements.

Limited Liability Company (LLC)

As the name implies, a limited liability company has the limited liability feature of a corporation. Liability is limited to the assets of the LLC. Members cannot be held personally liable for debts unless they have signed a personal guarantee. Event the, a creditor may be limited to a judicial remedy known as a "charging order". If a creditor obtains a charging order, the creditor is limited to the rights of an assignee of a membership interest in the LLC. Although a creditor is entitled to receive a proportionate distribution when a distribution is made from the LLC, the creditor has no voting rights and thus cannot force a distribution, liquidate the LLC or otherwise manage the business. If elected to be treated as a "pass through" entity, profits and losses are reported on a personal, rather than corporate, return.

This flexible form of doing business is created by filing articles of organization with the State of Missouri. Thereafter, an operating agreement is created which defines the rights and liabilities of the members of the LLC and how the LLC operates. Certificates of ownership are issued.

LLCs are quite popular in Missouri due to their flexibility in designing management structure and profits distribution. Depending on the size and the internal operational guidelines established in the operating agreement, an LLC can involve less ongoing paperwork than a corporation.

Key Documents

Deferred Compensation or Bonus Plan

A business needs to hold on to key employees; the real producers. A Deferred Compensation or Bonus Plan designed to reward key employees who meet certain performance targets can do just that. As an example, an agreement using gradual vesting schedules makes it difficult for key employees to leave the business and forfeit certain benefits.
Apart from the documents involved in organizational set-up, business owners should consider a Non-Compete and Confidentiality Agreement, a Buy-Sell Agreement and perhaps a Deferred Compensation or Bonus Plan for key employees.

Non-Compete and Confidentiality Agreement

Few events can sap the value of a small business like a key employee leaving the business and starting a similar business, especially if that employee leaves with key information such as trade secrets, confidential information or customer lists. Business owners should consider requiring an employee to sign a Non-Compete and Confidentiality Agreement to prevent this from happening.

Buy-Sell Agreement

A Buy-Sell Agreement is a contractual agreement between the owners of a business that controls what happens to the ownership of the business after a triggering event such as the death of an owner. A Buy-Sell Agreement offers three key benefits:
  • It provides a ready market for the departing (or deceased) owner’s interest in the business. As an example, the agreement might provide at the death of an owner that the business or other owners buy the decedent’s interest.
  • It sets a price for an owner’s interest in the business. This can be a predetermined and agreed-upon business value or a method of arriving at the value.
  • It provides for stable business continuity by avoiding unnecessary disagreements.
Deferred Compensation or Bonus Plan A business needs to hold on to key employees; the real producers. A Deferred Compensation or Bonus Plan designed to reward key employees who meet certain performance targets can do just that. As an example, an agreement using gradual vesting schedules makes it difficult for key employees to leave the business and forfeit certain benefits.

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