Tag Archives | Entrepreneurs

Personal Liability – Piercing the Corporate Veil

One of the biggest advantages of running your business as a corporation, limited liability company or other corporate entity is that it provides limited liability to the owners.  Stated differently, the owners are shielded from personal liability.  However, you must be diligent in maintaining the corporate existence in order to enjoy such protection.

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One of the first things I tell business owners is not to treat the company as an extension of themselves.  At the top of my list is to avoid paying personal expenses from corporate accounts.  Do not write a corporate check to pay a personal expense, do not use a corporate credit card to buy your family’s groceries, do not use your corporate credit card to take your wife to the theater.  In addition, if the business owner has multiple businesses, I remind her to keep each corporate entity separate from the others.  Do not use one company’s check to pay another company’s expense and so on.  Comingling of assets can present similar problems as well.

Courts have regularly noted that if the business owner does not respect the corporate existence, an adversary will not be required to either.  In these instances, the adversary argues that the company is nothing more than the alter ego of its owners, and courts allow the adversarial party to “pierce the corporate veil” and seek to hold the business owners personally liable.

Respecting the corporate existence also includes keeping proper books and records, minutes of director and shareholder meetings, and having proper agreements in place, to name a
few.  Agreements should include those with outside companies, and especially those with the owners or related companies, if applicable.

The law goes far to protect business owners, but it has its limits.  It is incumbent upon you to protect yourself and your business.

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The Importance of a Business Plan

According to Dun & Bradstreet statistics, poor planning is the number one cause for the failure of a small business.  A business plan is both your company’s resume as well as its growth strategy.  Your business plan, especially for a start-up or early stage company, should outline the plans, strategies and goals for your business.

When writing your business plan, remember that you cannot foresee everything that will happen to your company, so be prepared to revise it as conditions change.  In addition, be realistic with your assumptions, take into consideration the difficulties in growing your business, take your competitors into consideration, and discuss the risks to your business.

Your business plan should be concise and easy to read and comprehend.  It should express the market opportunities for your business, and the strength and depth of your management team.

Keep in mind that youruntitled business plan serves three key functions, namely a planning tool for the growth of your business, a document to convey information to prospective investors, and a base to measure and monitor your company’s performance over time.

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What is a Partnership?

A general partnership consists of two or more partners.  There are no statutory formalities, however it is prudent to have a partnership agreement that sets forth the partners’ rights and obligtations.  A general partnership is thus easy to establish and can be  more informal than other business entities.

There is a huge downside to a general partneship; each partner may be liable for all of the partnership’s debts and liabilities.  This personal liability is the rationale behind a detailed partnership agreement.

A limited partnership, on the other hand, consists of one or more general partners and one or more limited partners.  The general partners typically make all of the business decisions, while the limited partners are typically passive investors.

Unlike a general partnership, a limited partnership requires an organizational document to be filed with the Secretary of State.  In addition, a limited partnership agreement should be drafted setting forth the rights and obligations of the general partner and the limited partners.  Typically only the general partners bear the liability for the partnership’s debts and liabilities, while the limited partners have limited exposure.

Limited partnerships have their place, and can be a good structure for certain enterprises, such as real estate holdings, venture capital funds and so on, but limited liability companies and corporations are typically better for operating a business.

Determining the correct structure for your enterprise is a critical first step and should not be decided lightly.

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What is an S Corporation?

An S corporation (sometimes referred to as an S Corp) is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.

To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits the financial liability for which you (the owner, or shareholder) are responsible.

What makes the S corp different from a traditional corporation (C corp) is that profits and losses can pass through to your personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. There is an important caveat, however: any shareholder who works for the company must pay him or herself reasonable compensation. Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as wages.

Before you form an S Corporation, determine if your business will qualify under the IRS stipulations, eg domestic corporation, no more than 100 shareholders, shareholders must be individuals, certain trusts, or estates, and a shareholder cannot be a partnership, corporation or non-resident alien..

To file as an S Corporation, you must first file as a corporation. After you are considered a corporation, all shareholders must sign and file Form 2553 to elect your corporation to become an S Corporation.

Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state and locality.

There is always the possibility of requesting S Corp status for a limited liability company, even a sole owner LLC. You’ll have to make a special election with the IRS to have the LLC taxed as an S corp using Form 2553. And you must file it before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect.

The LLC remains a limited liability company from a legal standpoint, but for tax purposes it’s treated as an S corp.

Most businesses need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit.

All states do not tax S corps equally.

Your corporation must file the Form 2553 to elect “S” status within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect.

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What is a Limited Liability Company?

Limited Liability Company

A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.

The “owners” of an LLC are referred to as “members.” Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs.

Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.

Forming an LLC

While each state has slight variations to forming an LLC, they all adhere to some general principles:

Choose a Business Name. There are 3 rules that your LLC name needs to follow: (1) it must be different from an existing LLC in your state, (2) it must indicate that it’s an LLC (such as “LLC” or Limited Company”) and (3) it must not include words restricted by your state (such as “bank” and “insurance”). Your business name is automatically registered with your state when you register your business, so you do not have to go through a separate process.

File the Articles of Organization. The “articles of organization” is a simple document that legitimizes your LLC and includes information like your business name, address, and the names of its members. For most states, you file with the Secretary of State. However, other states may require that you file with a different office such as the State Corporation Commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or the Division of Corporations & Commercial Code. Note: there may be an associated filing fee.

Create an Operating Agreement. Most states do not require operating agreements. However, an operating agreement is highly recommended for multi-member LLCs because it structures your LLC’s finances and organization, and provides rules and regulations for smooth operation. The operating agreement usually includes percentage of interests, allocation of profits and losses, members’ rights and responsibilities and other provisions.

Obtain Licenses and Permits. Once your business is registered, you must obtain other necessary business licenses and permits. Regulations vary by industry, state and locality.

LLC Taxes

In the eyes of the federal government, an LLC is not a separate tax entity, so the business itself is not taxed. Instead, all federal income taxes are passed on to the LLC’s members and are paid through their personal income tax. While the federal government does not tax income on an LLC, some states do.

Since the federal government does not recognize LLC as a business entity for taxation purposes, all LLCs must file a corporation, partnership, or sole proprietorship tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law. For guidelines about how to classify an LLC, visit IRS.gov.

LLCs that are not automatically classified as a corporation can choose their business entity classification. To elect a classification, an LLC must file Form 8832. This form is also used if an LLC wishes to change its classification status. Read more about filing as a corporation or partnership and filing as a single member LLC at IRS.gov.

You should file the following tax forms depending on your classification:

  • Single Member LLC. A single-member LLC files Form 1040 Schedule C like a sole proprietor.
  • Filing as a Partnership. An LLC filing as a partnership requies the members to file a Form 1065 partnership tax return like owners in a traditional partnership.
  • LLC filing as a Corporation. An LLC designated as a corporation files Form 1120, the corporation income tax return.

Combining the Benefits of an LLC with an S-Corp

There is always the possibility of requesting S-Corp status for your LLC.  You’ll have to make a special election with the IRS to have the LLC taxed as an S-Corp using Form 2553. You must file prior to the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. For more information about S-Corp status, visit IRS.gov or read Should My Company be an LLC, an S-Corp or Both?

The LLC remains a limited liability company from a legal standpoint, but for tax purposes it can be treated as an S-Corp. Be sure to contact the state’s income tax agency where you plan to file your election form. Ask about the tax requirements and if they recognize elections of other entities (such as the S-Corp).

Advantages of an LLC

  • Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members’ personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means “limited” liability – members are not necessarily shielded from wrongful acts, including those of their employees.
  • Less Recordkeeping. An LLC’s operational ease is one of its greatest advantages. Compared to an S-Corporation, there is less registration paperwork and there are lower start-up costs.
  • Sharing of Profits. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity. Consequently, it’s up to the members themselves to decide who has earned what percentage of the profits or losses.

Disadvantages of an LLC

  • Limited Life. In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways. However, you can include provisions in your operating agreement to prolong the life of the LLC if a member decides to leave the business.
  • Self-Employment Taxes. Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.
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Contracts and Small Business

We recognize that many small business owners often operate with various informal agreements.  However, we want to ensure you recognize that it is frequently important to formalize an agreement with a legal contract.  For example, any agreement upon which you rely that can affect the future of your business is important enough that it should be formalized.

Among other things, contracts allow both parties to clearly define their obligations and expectations to and from one another, establish (and potentially limit) their liability, set forth payment terms, and allow each party to understand its responsibilities.

A legally valid contract has four basic components:

  1. A meeting of the minds.  Both parties understand and agree to the essential elements of the arrangement.
  2. Consideration.  Something of value must be exchanged by each of the parties.  This can be in the form of money, goods, or even a promise to do something.
  3. An agreement to enter into the contract.  A written contract signed by both parties satisfies this requirement.  (Oral agreements can also be valid in certain circumstances.)
  4. Legal competence.  Each party must have the capacity to enter into the agreement, meaning each must be of sound mind, and neither can be a minor.

While most contracts address specific items, such as payment terms, timing issues, and the exact subject of the agreement, the  above four components are a critical starting point.  Remember, if it’s important enough to cause you to wonder, it’s probably important enough to formalize the agreement.

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Business Plan Basics

Taking the time to put together a solid business plan that includes your plans, strategies and goals for your business can make the difference between the success or failure of your company.  In fact, according to Dun & Bradstreet statistics, poor planning is the number one cause for failure of small businesses.

Your business plan should give a meaningful description of your business.  Think of it as a tool to help grow your company, and to monitor your company’s performance over time.  In addition, investors will typically want to review your business plan to determine whether to invest in your company.

Don’t worry that you can’t foresee every twist or turn your business will take, and be prepared to modify your business plan as you go along.  Do, however, be realistic in the assumptions you make while drafting your business plan.  Your business plan conveys a lot about both you and your business, so make sure you approve of the message it sends.

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Piercing The Corporate Veil

One of the most attractive features of a corporate structure is limiting the personal liabity of the company’s shareholders (or members in a limited liability company).  But simply incorporating your business is not enough; it does not automatically protect you from your company’s creditors.

Generally a corporation’s creditors can’t sue its shareholders for their personal assets (limitied liability). However, in certain instances courts will allow the creditors to pierce the corporate veil and do exactly that.  For example, courts sometimes allow piercing the corporate veil in instances of fraud or similar wrongdoing, not allowing the shareholder to hide behind a false or flimsy corporate veil.

It is important to adhere to corporate formalities, and treat the corporation as a separate entity.  (You and the corporation are NOT one and the same.)  Properly document transactions between the corporation and its shareholders, officers and directors, and make sure the transactions are fair and reasonable and in accordance with applicable corporate law.

Though piercing the corporate veil is not terribly common, it is important to protect yourself against even the possibility of losing your limited liability.

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