Management Strategies: A Question of Liability
Which kind of entity should you be?
Your “big idea” is proving viable, and you are trying to decide the format in which to establish a for-profit business. Will it be a sole proprietorship, a partnership, a corporation or a limited liability corporation?
There are three basic elements that answer to that question.
The world of business liability breaks down roughly into two halves: unlimited and limited liability.
Unlimited liability means that you could lose pretty much everything you own owing to a loss suffered by the business. Sole proprietorships and general partnerships fall into this category. Owners may mitigate the risk with insurance, personal asset protection and by refraining from signing personal guarantees for loans or leases.
Limited liability means that the most you can usually lose is the amount of your investment in the company. Examples are corporations and limited liability companies. Bear in mind that a limited liability entity can be stripped of protection if owners use the company as a personal piggy bank or for fraudulent or illegal purposes.
Here, we are talking about a world of three parts.
One is individual taxation, which applies to sole proprietorships. In essence, all tax outcomes relate personally to an owner and are attended to directly on the owner’s tax return and paid accordingly.
Then there is pass-through treatment, which applies to all partnership forms. Tax outcomes essentially pass through the entity and are attended to by the owners on their tax returns. For pass-through entities, it is not just that tax activities are invisible to the companies; rather, those companies report tax-related activities to the owners and the IRS for final disposition and payment by the owners on their tax returns. As a result, there is only one level of tax return at the owner level.
Finally, there is dual taxation treatment, which applies to “C” corporations. These are corporations that do not take an “S” election, and “C” double-taxation is, accordingly, the default federal tax format for corporations. In essence, a “C Corp” pays income tax, itself, and then the owners pay a second level of income tax on their dividend distributions.
The brief discussion above does not touch upon the related topics of state and local taxes that may include occupation/business taxes, income taxes, sales taxes and employment taxes, among the menu of taxes levied on business entities.
All artificial business entities are creatures of statute, meaning that their formation, structure and operations emerge from a state’s code of laws.
In Florida, this code is found in Chapter XXXVI, “Business Organizations.”
These statutes describe the regulations for creating a business entity and the regulator, which in Florida is the Division of Corporations in the Department of State.
Bascially, each artificial entity has to: File a constituting document, such as articles of incorporation for a corporation or articles of organization for an LLC, with the state regulator.
Create “rules of the game,” such as a partnership agreement, bylaws for a corporation or an operating agreement for an LLC, which it keeps with its operating documents.
Then, the company has to actually observe the terms of the statutes and its constituting document and rules of the game.
For example, it may have to notice and convene annual and periodic owner or directors meetings and keep records of its actions.
And later file annual business reports and tax returns. The consequences of not doing those core activities can include the piercing of the limited liability veil.
In the end, take in input from your attorney and accountant, and also from your insurance agent and commercial banker, and make informed decisions concerning those fundamental questions: Shall I form a business entity? And, if so, which one?
Philip N. Kabler is an incubator resource person at the Santa Fe College Center for Innovation and Economic Development and has taught courses at the University of Florida Levin College of Law and at the University of Florida Warrington College of Business. He is a member of the Florida Bar’s professional ethics committee.