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SETTING UP A SMALL BUSINESS – ORGANIZATIONAL DETAILS James H. Bownas, Esq. Zaino & Humphrey, LPA 5775 Perimeter Drive, Suite 275 Dublin, Ohio 43017-3223 (614) 799-2800 (Voice) (614) 799-1500 (Facsimile) email@example.com www.zandhlpa.com I. SETTING UP A SMALL BUSINESS – ORGANIZATIONAL DETAILS A. Limited Liability Considerations Clients who are organizing a new business usually want to insulate their personal assets from the claims of their business creditors. In many cases, unless the client will be truly a passive investor, the goal is not realistic under any format, because business creditors (at least the ones with potentially substantial claims) will not deal with the new entity absent the personal guarantees of the entrepreneurs, and frequently of their spouses, as well. Besides liabilities to which the owners may have to subject themselves contractually, they may be statutorily liable for certain obligations of their business, irrespective of the form it takes. Those obligations may include, but are not limited to: · federal, state and local payroll taxes withheld from the wages of employees but not paid over to the taxing authority; · Ohio sales tax, and most other taxes for which the vendor is the state's statutory collection agent, to the extent not paid over to the state; · in some circumstances, "Superfund" liability under CERCLA. Even in the absence of specific contractual or statutory liability, the entrepreneurs may become personally liable for their business entity's obligations if their participation warrants "piercing the veil" of the entity. Nevertheless, most clients will expect you to give serious consideration to their exposure to tort and contract liabilities arising in the business. The corporation (governed by Chapter 1701, ORC) has been the traditional vehicle for insulating personal assets, and there is no distinction between a C Corporation and an S Corporation in this respect. On the other hand, Ohio law requires certain formalities of corporations, including annual meetings of their shareholders and directors, and codes of regulations and bylaws typically adopted by Ohio corporations may require additional formalities. Failure of the clients to observe those formalities could increase the risk of the corporation being disregarded for liability purposes. Sometimes, for convenience in exercising management, the shareholders of an Ohio corporation will enter into a close corporation agreement, dispensing with some of the corporate formalities. Such an agreement merely dispenses with, and does not constitute a failure to observe, the statutory formalities, but it also creates one more set of procedural obligations which, if ignored, can be pointed to by business creditors as evidence that the owners, themselves, failed to treat the corporation as an independent entity. Limited partnerships (governed by Chapter 1782, ORC) have also been widely used to limit their owners' liability to the amount of capital invested in the business. Only the limited partners are protected, however; at least one individual or entity has to agree to be the general partner, and to bear unlimited liability for the partnership's debts. While the general partner can, itself, be an entity with liability insulation features, former law required the general partner to have more than a nominal amount of assets at risk in the partnership's business in order for the partnership to avoid being taxed as a corporation. With the adoption of the "check the box" regulations, that issue is no longer relevant, and it is possible, today, to structure a limited partnership in which no partner has any material exposure for business debts. A limited partner will, however, lose liability protection as to certain creditors if the partner's name is part of the limited partnership's name, or if the partner participates in the control of the partnership's business. While certain basic organizational decisions may be exercised without participating in control, it is clear that the limited partnership is not ideally suited for individuals who insist on both strict protection from business debts and a voice in managing operations. By statute, the mere fact that a limited partner is also a shareholder, officer or director of a corporate general partner (or holds comparable positions in a general partner that is a partnership, LLC, estate or trust) does not constitute participating in control, but it is by no means clear that this protection extends to a limited partner who, in addition to merely holding such a position, also engages in that capacity in the management of the limited partnership (and, of course, in the case of a limited partner who is also a partner in a general partnership that serves as a general partner of the limited partnership, the fact that he or she does not "participate in control" does absolutely nothing to mitigate her or his vicarious liability as a partner). Ironically, while corporate shareholders frequently have to contract away their liability protection in order to borrow working capital, real estate limited partnerships typically are able to contract for "exculpatory" or "non-recourse" mortgage financing for tax reasons, even though it may be unnecessary from the standpoint of limitation of liability. The limited liability company (governed by Chapter 1705, ORC) is the newest addition to the pantheon of entities to shield owners from business debts. As in the case of a corporation, the owners of an LLC are not personally liable for entity debts, except where there immunity has been contracted or legislated away. Although there appears to be no case authorizing the piercing of an LLC's veil under the limited liability company statute of any of the states, it is reasonable to anticipate that the Supreme Court of Ohio will eventually apply the same tests for LLC's that it does for corporations. Sole proprietors and general partners (Chapter 1775) are personally liable, with few exceptions, for all of the business debts of their enterprises. Some of the more esoteric entities, including limited partnership associations (Chapter 1783), professional associations (Chapter 1785), business trusts (Chapter 1746) and real estate investment trusts (Chapter 1747) all provide for limited liability comparable to corporations and limited liability companies in one form or another. Registered limited liability partnerships (authorization is sprinkled throughout Chapter 1775) do not limit a partner's liability for business debts, but do protect a partner against vicarious liability for the professional malpractice of other partners, employees or agents. B. Management Considerations The ease and flexibility with which an entity's business may be operated is a significant factor to take into account in deciding on the form in which to do business. In some cases, a lawyer's prior experience with the ability of a particular client to attend to details may rule out some of the more complex options. A sole proprietorship is the simplest form of business. No special formalities are prescribed by law, although it may be necessary to remind the new sole proprietor of the need to obtain occupational licenses, to establish various employment-related accounts if the enterprise will employ others, to obtain a vendor's license if it will make taxable sales and to register any trade or fictitious name used in the business. Single-member limited liability companies, permitted in Ohio for the past year, are not far behind sole proprietorships. A simple registration, typically one page, and the appointment of a statutory agent, are required to form the entity. Under the "check the box" regulations, a single-member LLC does not even obtain a separate tax identification number, but uses that of its sole member. No operating agreement is required, if the member is willing to adopt the default features of Chapter 1705. On the other hand, if a single-member LLC does want to deviate from the statute, it must do so in writing. Multiple-member LLC's are similarly easy to organize, but are required to obtain a tax identification number from the Internal Revenue Service. Not only may it dispense with an operating agreement altogether, if it wants to depart from the statutory default provisions a multiple-member LLC may have an oral operating agreement (whether is wise to do so is a different issue than whether it is permissible to do so). Multiple-member LLC's may be more complex to operate simply by virtue of the fact that there will be more cooks sticking their fingers into the broth than in a single-member LLC. In order to regulate their procedural wishes and to limit the exercise of authority by members, a multiple-member LLC may be more likely to require or desire an operating agreement. Depending on the number of members, and on their personal management styles, it may be appropriate to appoint one or more managers to operate an LLC, rather than leaving it to the members. Many LLC's even choose to create offices, similar to those in traditional corporations, and to fill them with individuals who are charged with running the day to day operations of the business like in a manner comparable to their corporate counterparts. Since there is no substantial body of common law or tradition surrounding LLC's, however, the details of any such structure should be spelled out in an operating agreement. The management of an LLC does not, for example, automatically benefit from the Business Judgment Rule, the Corporate Opportunity Doctrine, or any of the other judicial gloss applicable to corporations. Unlike corporations, Ohio law has no requirement that either the members or the managers of LLC's have periodic meetings, keep minutes or otherwise deliberate as a body. Notwithstanding this freedom from detail, lawyers frequently draft operating agreements for their LLC clients that require meetings, votes, minutes, quora, proxies, agendae and worse, apparently in an attempt to emulate the orderliness to which a corporate minute book may aspire (but rarely attain). Sometimes, the relationship of the members is such that strict procedural rules are appropriate in an LLC, but when you see a single-member LLC with a requirement for quarterly meetings of its members, it's pretty obvious that the attorney who formed that entity pulled a form off the printer without giving any individual attention to the circumstances. The leisure time of LLC members is invaded not only by the actions of their own attorneys, but of those representing financial institutions, as well. It is literally impossible for even a single-member LLC to borrow money from an Ohio bank without adopting and certifying resolutions in which the member attests that she duly met with herself and authorized herself to enter into the transaction. General partnerships are easy to form in Ohio, requiring no filing at all except a fictitious name certificate filed with the Recorder of the county in which the partnership has its principal place of business and of each county in which the partnership owns real estate. A partnership must obtain a federal tax identification number. Similar to the situation with multiple-member LLC's, the management complexity for partnerships stems from the fact that each partner, when acting in the apparent scope of the partnership's business, is the legal agent of the partnership and of each other partner, authorized to bind each of them, personally, to contractual obligations. Accordingly, a fair amount of attention may be devoted to an agreement among the partners restricting their authority. Many partnerships operate for years, however, with no written partnership agreement at all. Registered limited liability partnerships are, by definition, required to register, although compliance is relatively simple. Otherwise, their operations are no different from those of other partnerships. A limited partnership is formed only upon filing a qualifying certificate, the preparation of which is certainly not oppressive, but the importance of which cannot be overstated. An entity that tries, but fails, to become a limited partnership, is probably a general partnership, with the consequent personal liability of each owner. Either "substantial compliance" with the formation requirements or an erroneous but "good faith" belief that one is a limited partner will protect limited liability, but a complete failure to file the certificate places the owners in jeopardy. A limited partnership is managed by its general partner(s), which may make its management very simple or very complex, depending on whether the general partner is an individual, a group of unrelated corporations, or something in between. From the view of one who wishes to be a limited partner, management is not complicated at all, because he or she cannot participate in it. The statute requires the consent of limited partners for certain material organizational decisions, and limited partnership agreements typically provide additional democracy rights contractually. Corporations are the most cumbersome of the mainline business entities to form and operate. Their articles of incorporation are a matter of public record which must be amended upon the occurrence of basic organizational changes, and they typically adopt written codes of regulations and bylaws which further regulate the conduct of their business. Extensive statutory provisions regarding the respective rights and obligations of shareholders, officers and directors are supplemented with common law doctrines. A corporation whose shares are not registered with the United States Securities and Exchange Commission or on a stock exchange may adopt a close corporation agreement, by which the operations of the corporation may be streamlined. A close corporation agreement may not, however, dispense with any filings required to be made with the Ohio Secretary of State nor with the provisions of specified statutory provisions. An S Corporation does not differ significantly from a C Corporation with respect to management issues, except that, by definition, it must elect S Corporation status by filing its election with the Internal Revenue Service, and that its reporting to shareholders is complicated by its passthrough nature for federal income tax purposes. While Ohio professionals may now associate in any business form, professional associations are essentially special corporations formed for the exclusive purpose of performing professional services pursuant to a license, certificate or other legal authorization and regulated by Title 47, ORC. Its formation and operation procedures are the same as for corporations, with the addition of an annual filing requirement with the Secretary of State, listing the names and addresses of each of its shareholders, and certifying that each of them is appropriately licensed. Limited partnership associations and REIT's are special purpose entities with some elaborate operational requirements. REIT's must also satisfy extensive federal income tax qualifications in order to obtain and retain their status. C. Capital Contribution Considerations A client can make capital contributions to any form of business entity with equal facility. The treatment of capital contributions and the ability to withdraw them, however, can vary dramatically. Except for purposes of internal bookkeeping, the concept of capital contributions in a sole proprietorship is irrelevant. Cash from any source may be injected into the business and withdrawn from the business as often as desired, all without tax consequences, other than those attributable to the source of the cash in the first place. Since sole proprietors are personally liable for all their business debts, in effect unlimited capital contributions are mandatory at all times. Loans are indistinguishable from capital contributions when made by sole proprietors to their business. By definition, capital contributions cannot be made effectively by non-owners, but loans can be structured to simulate most forms of equity investment in other types of organizations. In the absence of a contrary provision in an operating agreement, capital contributions to an LLC automatically determine the allocation of profits among members. To a single- member LLC, this feature is not relevant, because the sole member is entitled to all the profits in any event. For a multiple-member LLC, however, except in the relatively rare case of a capital-intensive business with unlimited capacity to absorb additional funds, this is probably not a feature that the members would favor, and an operating agreement with different provisions for the effect of capital contributions is probably called for. In other respects, LLC's exhibit essentially the same characteristics as other entities with respect to capital contributions: · single member LLC's (unless they have "checked the box" to be taxed as corporations) are identical to sole proprietorships, except that the member has limited liability, and so future capital contributions are optional · Multiple-member LLC's (unless they have "checked the box" to be taxed as corporations) are identical to partnerships, except that the members have limited liability, and so future capital contributions are optional (except to the extent the members have agreed otherwise in an operating agreement) · Single-member and multiple-member LLC's that have elected to be taxed as corporations are identical to corporations In the absence of a contrary provision in a partnership agreement, partnership profits are allocated equally (i.e., per capita) among the partners, irrespective of capital contributions. While partners have unlimited liability for partnership business debts, and, therefore, are required to make unlimited future capital contributions, they are also entitled to interest on unscheduled advances until they are repaid. Additional capital contributions may be obtained from existing partners or in consideration for admitting new partners, but an amendment to the partnership agreement will probably become necessary in either event, unless these events were specifically anticipated at the time the original agreement was drafted. For partnership accounting purposes, capital contributions may be withdrawn by a partner only after payment of all partnership obligations. For tax purposes, distributions to partners are not characterized as distributions of profits or return of capital. Distributions may be made either in cash or in other property, with tax consequences as follows: · distributions of property are generally not a taxable event, but the property will take a carryover tax basis equal to the lesser of the partnership's tax basis in the property and the partner's tax basis in his or her partnership interest (neither basis can ever be less than zero), and any subsequent disposition of the property will generate gain or loss by relation to that carryover basis · distributions of "hot assets" (unrealized receivables and substantially appreciated inventory items), unless made proportionately to all partners, do constitute taxable events · distributions of cash are not taxable events, but reduce partners' tax basis in their partnership interests, until basis has been reduced to zero; thereafter, any further distributions are taxed as if they represented gain upon sale of the partnership interest · partnership debts are treated for tax purposes as if they were capital contributions made proportionately by each of the partners (i.e., they increase each partner's basis in her or his partnership interest) and reductions to partnership debts are treated as if they were distributions made in cash proportionately to each of the partners (i.e., they reduce each partner's basis in his or her partnership interest until it reaches zero, and then generate gain) Partners may make loans, as opposed to capital contributions, to their partnerships, and the repayment of such loans, with or without interest, will not be treated as distributions. Limited partnerships have the same characteristics as general partnerships, except that: · since limited partners are not personally liable for partnership debts, unlimited future capital contributions are required only from the general partner(s), unless there is a contractual requirement to the contrary in the limited partnership agreement · since limited partners are not personally liable for partnership debts, such debts are not treated as capital contributions by limited partners (i.e., they affect the basis of only the general partner(s)) except in the case of debts for which no partner is personally liable (i.e., exculpatory or non-recourse indebtedness) Shareholders in a C Corporation are not personally liable for corporate debts, and so future capital contributions are optional for the shareholders, in the absence of an agreement otherwise among shareholders. Shareholders may make loans, in lieu of capital contributions, to their corporations, and repayments of principal will be received by the shareholders free from tax consequences. Since returns of capital contribution do not receive tax-free treatment, the Internal Revenue Service has adopted regulations pursuant to which it attempts to distinguish between bona fide debt and disguised equity. Subsequent capital contributions can be made readily, either by contribution from existing shareholders, by the issuance of additional shares to existing shareholders or by the issuance of additional shares to new shareholders. Corporations are not required to designate a "stated capital" for their issued and outstanding shares, except in the case of preferred classes. To the extent they do designate a stated capital, however, corporations may not make distributions that would impair the stated capital. Distributions to shareholders other than in complete liquidation of their shares are dividends, taxed as ordinary income to the shareholder. Distributions which are in complete liquidation result in gain or less relative to the shareholder's tax basis in the shares. S Corporations have the same characteristics as C Corporations with respect to obligations for future capital contributions, the ability to make loans and additional capital contributions (except that S Corporations may have a maximum of 75 shareholders, the nature of which is limited, which restricts, to some extent, the ability to raise additional capital from new shareholders) and statutory restrictions upon distributions to shareholders. The tax consequences of returns on, and returns of, capital, are dramatically different for S Corporations, however. Distributions in complete liquidation of a shareholder's stock will give rise to gain on the sale of the stock. Other distributions to shareholders are not taxable as dividends unless they are deemed to be made out of "accumulated earnings and profits". The amount of a distribution is the sum of the cash distributed and the fair market value of other property distributed. To the extent of each shareholder's basis in her or his S Corporation stock, distributions are received tax-free, but reduce such basis. After a shareholder's basis is reduced to zero, additional distributions will give rise to gain. If distributions are deemed to be made out of accumulated earnings profits (primarily earnings and profits from prior years in which the corporation was a C Corporation), then they will be treated as if made in the following order: · first, tax free distributions, to the extent of undistributed S Corporation earnings and profits (subject to miscellaneous adjustments) · then, taxed as a dividend, to the extent of accumulated C Corporation earnings and profits (subject to miscellaneous adjustments) · then, tax free to the extent of the shareholder's remaining tax basis in S Corporation stock · and finally taxable as gain with respect to the stock D. Ownership Considerations A sole proprietorship is singularly devoid of complicating factors with regard to operations, but also restricted with regard to flexibility in making dispositions and succession transfers. While a sole proprietor may contract to sell his or her business assets, or provide for their disposition testamentarily, there is no way to involve other owners, whether key employees, family members or prospective purchasers, without converting to another form of business organization. Sale or testamentary disposition of the business can only be made on an asset-by-asset basis. Vehicles and other titled assets will have to be retitled. Real estate owned by a sole proprietor is subject to the dower rights of her or his spouse. Charitable and other donative dispositions are practically impossible, except to the extent of gifts of cash after it has been earned in the business. There is no provision under Ohio law that would permit a sole proprietor to merge or consolidate with any other type of entity in a tax-free exchange. A sole proprietor could, however, make a contribution of his or her business assets to a partnership, limited partnership or LLC in a tax-free transaction. The sole proprietor could also make a tax-free contribution to the capital of a C Corporation or an S Corporation under §351 of the Internal Revenue Code, provided that she or he remained in control of the corporation long enough thereafter to satisfy the continuity of ownership requirements of that section. Partnerships are slightly more complicated and slightly more flexible from an ownership standpoint. They provide at least the prospect that a disabled, retiring or deceased partner may have a market for his or her interest, in the person of the remaining partner(s). Partnerships are also vehicles for spreading mortality risks, for example, by the purchase of insurance on the lives of partners in order to liquidate the interest of a deceased partner. Partnership interests can be conveyed -- by sale, by gift, by testamentary disposition -- without unbundling all of the underlying assets, but, in light of the mutual agency relationship among partners, it is seldom desirable for interests to be freely transferable. Absent a specific provision in a partnership agreement, a partner may not withdraw and substitute an assignee as a partner without the unanimous consent of the remaining partner(s). As several of the international accounting firms have demonstrated, there is practically no limit on the ability of a partnership to add members, provided contractual provisions are in place to make operating control manageable. Assets held by a partnership are not subject to the claims of its partners' creditors or spouses. While a creditor can obtain a charging order against a partner's interest in the partnership, the creditor cannot attach partnership assets, directly. Any type of entity -- C Corporations, S Corporations, LLC's or other partnerships -- in addition to individuals, may be a partner in an Ohio partnership. Ohio partnerships are not permitted by law to merge with any other type of entity, however the same effect may be obtained in certain transactions. If all the interests in a partnership are transferred to the same individual, corporation, LLC or separate partnership, for example, the partnership will cease to exist by operation of state law, and the assignee of the partnership interests will succeed to the ownership of partnership assets. Technically, however, this causes a termination of the partnership, and not a merger into another entity, with consequent loss of continuity that could affect the status of contractual or regulatory rights. Limited partnerships are nearly identical to general partnerships, except that there is no mutual agency relationship among limited partners. Accordingly, restrictions upon transfers of limited partnership interest may be less of a concern than in the case of general partnership interests. In fact, since the elimination in 1997 of the "transferability of interests" test formerly used by the Internal Revenue Service to classify organizations as partnerships or corporations for federal income tax purposes, restrictions contained in existing limited partnership agreements may be unnecessarily extensive. Limited partnerships are frequently used in estate plans to begin the transfer of family assets to younger generations during the lifetime of the older generations, because limited partner interests can be gifted to family members without surrendering management control. Under Ohio law, limited partnerships are permitted to merge with or into domestic and foreign corporations, LLC's and limited partnerships, as well as with or into other foreign entities which are permitted by the laws of their domiciliary state to participate in such a merger. Limited liability companies exhibit many of the characteristics of partnerships or of corporations, depending upon the extent to which their operating agreements (if any) move them from membership-managed to manager-managed models. C Corporations are very flexible vehicles primarily due to their commercial acceptance, and not because of any legal requirements. E. Taxation Considerations Typically, the tax consequences of selecting one form of business entity over another are second in importance only to the ability to limit personal liability. Sole proprietors are taxed directly on the income and gains of their businesses, and may deduct personally the deductions and losses of their businesses. Depending on the size and nature of their business, they may be on either the cash or the accrual method of accounting for tax purposes, but they are taxed on net income irrespective of the receipt of any cash or other property. If the sole proprietorship must make principal payments on loans or other nondeductible payments, the sole proprietor may be subjected to tax on "phantom income". The sole proprietor reports business income and expenses on Schedule C to her or his Form 1040, and pays self-employment taxes on the net income. Sole proprietors may have draws, but they do not pay themselves wages or salaries. They are not required to withhold taxes from the sole proprietor and do not issue a Form W-2 or Form 1099 to him or her. The sole proprietor is, however, required to make quarterly estimates and deposits of income tax liability and must issue W-2's and/or 1099's to other parties who receive compensation. An individual who forms a single-member LLC is taxed in exactly the same way as a sole proprietor. The existence of the LLC is disregarded for federal income tax purposes and the sole proprietor reports the LLC's income and expenses directly on his or her Schedule C. A sole proprietor or a single-member LLC may adopt a Keogh Plan or, if there are employees other than the sole owner, a Simplified Employee Pension plan (SEP). With extremely limited exceptions (including for purposes of the Columbus municipal income tax) partnerships are not taxpayers. The partnership and its partners are taxed in essentially the same fashion as a sole proprietorship and its sole proprietor, with some modifications to reflect the need for allocation among the several partners. All of a partnership's items of income, gain, loss, deduction and credit for federal income tax purposes are allocated pro rata to its partners, retaining the same character in the partners' hands as they had in the partnership's hands. Thus, the partnership is a "passthrough" entity for tax purposes. A partnership agreement that provides for allocations other than on a per capita basis will be honored for federal income tax purposes, but if the agreement allocates economic items (i.e., distributions of cash and other assets) in different proportions than it allocates tax items, a complex series of adjustments must be made pursuant to the Regulations under Internal Revenue Code §704(b), and the allocations in the partnership agreement will be disregarded in favor of the "true" proportionate interest of each partner in the partnership if the tax allocations do not ultimately embody "economic substance". Partners are taxed on their respective shares of partnership income regardless of whether distributions are made to partners, and so the prospect of phantom income is present. The partnership files a Form 1065 with the Internal Revenue Service, attaching a Schedule K-1 for each of its partners, reporting the partners' respective shares of each partnership tax item. Partners who are individuals report their K-1 items on Schedule E to their Form 1040. A partnership may pay draws, or even "guaranteed payments" in the nature of salary to its partners, but it cannot, technically, pay them wages or salaries. It does not issue W-2's or 1099's to its partners with respect to distributions of profits, but it does issue them to non- partner employees and vendors and it could, for example, issue a 1099 to a partner who provides a product or service outside the scope of the partners participation in the partnership business. A partnership may adopt a Keogh Plan or SEP for all its partners and employees. A partnership may form a single-member LLC, and if it does, the LLC will be disregarded and its income and expenses will be reported directly on the face of the partnership's Form 1065. A limited partnership is taxed in exactly the same manner as a general partnership. The only distinguishing characteristic is that, in light of the limited liability of limited partners, there is a greater likelihood that net losses of a limited partnership will not be deductible by the limited partners on their individual tax returns, because they may lack sufficient tax basis or "amount at risk" with respect to the limited partnership. A limited partnership may be the sole member of an LLC. A multiple-member LLC is taxed exactly as if it were a partnership, unless it "checks the box" to be taxed as a corporation. A C Corporation, unlike the passthrough entities under comparison, is a taxpayer in its own right. The corporation files a Form 1120 with the Internal Revenue Service, on which it reports its income and deductible expenses and calculates its tax liability on its net income. To the extent it pays dividends to its shareholders, it gets no deduction for them, while the shareholders must include them in their own taxable income. Accordingly, C Corporations are "double taxation" entities. Shareholders who are individuals report their dividend income on Schedule B to their Form 1040. A C Corporation may employ shareholders, in which case it may pay them wages or a salary. It will withhold payroll taxes from the compensation of shareholder-employees, issue W-2's, and otherwise treat them in all respects as common law employees. Because a C Corporation is able to deduct compensation it pays to shareholders, whereas dividends are non-deductible, the Internal Revenue Service has adopted regulations pursuant to which it attempts to distinguish between bona fide compensation and disguised dividends. A C Corporation is permitted to deduct compensation only to the extent it is "reasonable" in amount under all the circumstances. A corporation issues Form 1099-DIV with respect to dividends paid to its shareholders. A C Corporation may adopt any of the ERISA-qualified employee retirement plans, including pension and profit sharing plans, 401(k) plans and ESOP's. Corporations may also adopt a variety of employee plans providing health and other benefits to employees (including to shareholder-employees) with the expense of the plan deductible to the corporation and the value of the benefits excluded from the income of the employees. A corporation may form a single-member LLC, in which event the LLC will be disregarded as an entity separate from the corporation. The LLC's income and expenses will be reported directly on the corporation's Form 1120. Under the "check the box" regulations, any partnership, limited partnership or LLC (including, but not limited to a single-member LLC) may elect to be taxed as if it were a corporation, while retaining all the non-tax characteristics assigned to it by state law. S Corporations are frequently described as being "corporations that are taxed just like partnerships", but that description is appropriate only with a number of exceptions and caveats. An S Corporation is a passthrough entity, and (except in certain extremely limited circumstances) not a taxpayer, itself. It reports all of its income and expenses to the Internal Revenue Service on Form 1120-S, along with individual Schedules K-1 for each of its shareholders, allocating their individual shares of its tax items in proportion to their respective ownership of stock. S Corporation shareholders do not, however, get tax basis in their stock for debts of the corporation, as general partners do in a partnership. Accordingly, S Corporation shareholders may benefit far less from tax losses sustained by their corporation than would general partners in a partnership with the same loss scenario. S Corporation shareholders do, however, acquire tax basis for loans they make to the corporation. While this feature may permit shareholders to deduct additional tax losses personally, it is not triggered by the shareholder's guarantee of a loan made directly to the corporation; to get the benefit of the additional basis, the shareholder must be the lender (although the shareholder could, for example, borrow funds from a bank and re-lend them to the corporation, perhaps with a corporate guarantee, instead of having the loan come directly from the bank to the S Corporation with a shareholder guarantee). Distributions to a shareholder who has made a loan to an S Corporation, whether intended as distributions of profits or as repayments of principal, will first reduce the basis in the shareholder's loan to zero, and then reduce the shareholder's basis in S Corporation stock. S Corporation's may employee shareholders and pay them W-2 or even 1099 compensation. In contrast to the incentive for C Corporations to pay excessive compensation to shareholder-employees in order, in effect, to "deduct dividends", S Corporations are motivated to minimize the compensation they pay to shareholders. This is so because if, for example, no compensation is paid to shareholder-employees, a shareholder will be taxed on the corporation's earnings, but not on distributions of profits, whereas if she or he receives compensation for employment by the corporation, his or her taxable income will be the same amount but employment taxes will have been incurred, in addition. Accordingly, the Internal Revenue Service has adopted regulations pursuant to which it attempts to identify "inadequate" compensation to S Corporation shareholder-employees. S Corporations may adopt the same ERISA-qualified retirement plans and benefit plans as C Corporations, but employees who are 2% or more shareholders in an S Corporation are limited in their ability to benefit from the resulting income exclusion. Since 1997, ESOP's have been permitted to own S Corporation stock without incurring "unrelated business taxable income". An S Corporation may be the sole member of an LLC, in which case the LLC existence as an entity separate from the corporation will be disregarded. Since 1977, S Corporations have also been permitted to be the sole shareholder in a "Qualified Subchapter S Subsidiary", as well as to own stock in C Corporation subsidiaries. F. "Check the Box" After years of wrangling with taxpayers over whether a particular entity had more "corporate characteristics" than "non-corporate characteristics", the Internal Revenue Service bagged the whole issue in 1997, and adopted Regulations §301.7701, the so-called "check the box" regulations. Under these regulations, certain business entities are classified automatically as corporations. Other business entities ("eligible entities") may choose how they are classified for federal tax purposes. An eligible entity with at least two members can choose to be classified as either a corporation or a partnership. Likewise, an eligible entity with only one member can choose to be classified as a corporation or to be disregarded as an entity separate from its owner (e.g., treated as a sole proprietorship, as a corporate division or as a d/b/a). Eligible entities who wish to elect corporate-type taxation must complete and file Form 8832. Eligible entities who wish to elect partnership-type taxation are not required to take any action. Note that an eligible entity could elect corporate-type taxation, and then make an S election, effectively ending up as a passthrough entity. The following types of business entities can never be eligible entities, and are always required to be classified as corporations: a "statutory corporation", as defined an insurance company a state bank insured under the Federal Deposit Insurance Act an entity wholly owned by a state or its political subdivision a business entity that is taxable as a corporation under a provision of the Internal Revenue Code other than §7701(a)(3) with certain exceptions, any foreign business entity listed in Regulations §301.7701-2(b)(8) The foregoing "automatic corporations" are not eligible to file Form 8832. All other entities are eligible entities. If a domestic eligible entity does nothing, it will automatically be classified as a partnership, if it has two or more members, and will automatically be disregarded as an entity separate from its owner, if it has only one owner. If a foreign eligible entity does nothing, it will automatically be classified as a partnership if it has two or more members and at least one member does not have limited liability, will automatically be classified as a corporation if all its members have limited liability, and will automatically be disregarded as an entity separate from its owner if it has only one owner, without limited liability. G. Formation Issues 1. Sole proprietorship: · No formation requirements; normal compliance with licensing and employment account (if applicable) requirements 2. General partnership: · No formation requirements beyond the statutory definition; normal compliance with licensing and employment account (if applicable) requirements · Unless partnership name contains the names of all partners, files certificate of partnership with Recorder of county in which it has its principal place of business and of each county in which it owns real estate, listing name and residence address of all partners [Note - although certificate is a statutory requirement, the only consequence of noncompliance is that certificate must be filed before partnership can take title to real estate and, theoretically, before it can commence a legal action] · Written partnership agreement is not required, but extremely desirable 3. Limited partnership: · Files a certificate of limited partnership with Secretary of State, setting forth partnership's name, address of its principal place of business, name and address of agent for service of process, name and address of each general partner and any other matters general partners determine [Note - As of July 1, 1994 this certificate replaces the fictitious name certificate required under prior law]. · Name must include one of the following: "Limited Partnership," "L.P.," "Limited" or "Ltd." and must not include the name of a limited partner unless it is also the name of a general partner or the business of the limited partnership had been carried on under that name before the admission of that limited partner · Written limited partnership agreement is not required, but extremely desirable 4. Limited liability company: · Files articles of organization with Secretary of State, setting forth its name, duration (perpetual, if not specified), address for requesting information, and any other provisions the members elect · Name must include on e of the following: "limited liability company," "LLC," "L.L.C.," "limited," "ltd." or "ltd" · Files appointment of a statutory agent for service of process, with acceptance of appointment by the agent · Written operating agreement is not required, however single-member LLC's may not deviate from statutory default provisions without a written agreement and it is extremely desirable for multiple-member LLC's 5. C Corporation: · Files articles of incorporation with Secretary of State, setting forth its name, principal office in Ohio, purpose for which formed (which may include "to engage in any lawful act or activity for which corporations may be formed under this chapter"), authorized number of shares and (if applicable) par value per share, express terms (if any) of shares, classes (if any) of shares, initial stated capital (if any) and any additional provision permitted · Files appointment of a statutory agent for service of process, with acceptance of appointment by the agent · Close corporation agreement, buy-sell agreement and other documentation are not required, but extremely desirable in multiple- shareholder corporations 6. S Corporation: · Same as for a C Corporation, to begin its legal existence · Files Form 2553, Election by a Small Business Corporation, with its Internal Revenue Service Center before the 16th day of the third month of the taxable year for which the election is to be effective.
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