B101.8 - Business Entities |
One of the hardest things in business is getting oriented out of the gates.
What is a business? Is it like a person? Is it a thing? It's not a plant, animal or mineral...
A business has a name that could just be your name or another name.
Ultimately, think of creating a business separate from yourself for two reasons.
Everyone thinks they get legal liability separation by setting up a company.
Your true protection from legal liability actually comes from insurance.
Read between the lines here. These are the cliff notes.
What is a business? Is it like a person? Is it a thing? It's not a plant, animal or mineral...
- A business is a "cognitive concept".
- It is a non-living entity that takes on traits and characteristics of a person, but without a heartbeat and without a conscience.
A business has a name that could just be your name or another name.
- A business has a born on date, although sometimes it's born without knowing it, and you decide later what that date kind of was.
- A business is identified by one of two numbers: A social security number OR a Federal Employer Identification Number. (in this sense you can see the parallel to human birth pretty easy)
- A business has legal requirements, like we all do.
- A business has financial requirements, like we all do.
- A business dies, just like us, too, although they can outlive a single human life or an entire generation or a few, and that's where some of them get scary.
- A business does NOT experience re-incarnation, although some get revived in weird ways later in history when new generations learn about cooler old businesses that died or were killed off for some reason.
Ultimately, think of creating a business separate from yourself for two reasons.
- Legal Separation -- A business entity, in theory, helps separate individual liability from that of the non-human corporation. A business entity helps parse and separate legal liability between the employees that make up the corporation, it's executives, the owners and the business entity itself, which can only be fined, and never punished physically, mentally or emotionally.
- Tax Treatment -- Various forms of corporate structures are handled different from a tax perspective. There are tax benefits to setting up a business as you make more money, but always remind yourself this is all a game. As there are benefits, there are more complexities, and those that live off of your pursuit of your dreams (like accountants, attorneys, and insurance agents) start making more money with each more complex step you take.
Everyone thinks they get legal liability separation by setting up a company.
- That is only true in theory.
- If you misbehave as a company owner, you can in fact be sued personally.
- When that is done, it's called "Piercing the corporate veil".
- It's not easy to do, but it is doable, and in smaller companies it's much easier to do than larger ones
Your true protection from legal liability actually comes from insurance.
- Often times, that's like sleeping with a den of snakes, BUT the entire concept of corporations is in fact built on some pretty sketchy and venomous ideas to start with, so get use to it as long as you see a benefit in having them somehow.
Read between the lines here. These are the cliff notes.
- Legal Liability -- As a small person in business, be far more conscious about legally protecting yourself with insurance as opposed to corporate structures. It's often times easier to be a sole proprietor or in a partnership with healthy insurance than it is to be a corporate owner, who also has similar or nearly identical insurance needs, but is then limited in other ways, like with financing options.
- Tax Liability and Benefits -- For small people the taxes are the same on an unincorporated entity and an incorporated entity until you start making more in the company than you need to pay out to yourself in the form of a paycheck for your basic needs.
- If you can write yourself a regular weekly or monthly check, subject to all federal, state, and social security taxes, that covers all your personal bills, and there is still additional money left from the net profit of your company for that same time period, you will want to consider incorporating as an LLC, LLP, S-Corp or C-Corp. By doign this, you can withdraw that money that is beyond your paycheck as an owner draw instead of a payroll expense, and by you do NOT pay 15% social security (aka self employment tax) on those additional withdrawals.
- Please note, you do NOT need to write yourself a normal weekly or monthly check UNTIL SUCH TIME you want to start benefiting by NOT paying social security on all of your withdrawls from the company. This is not intuitive for most. Reread it and keep it simple until you are making good money in your business (so much so, that you can live off a regular paycheck and there is money left over each pay period that is yours to keep to, but still in the company).
Big Business (Corporations) vs Small Business (not Corporations)
There is only one type of "Big Business". It's called a "Corporation".
A corporation has a clear born on date. A corporation has one or multiple parents. Unlike humans, where two parents are required to create a human, a business can have one to hundreds or thousands of parents and the parents don't all have to have an equal stake in the creative process.
To allocate ownership to the parents, an arbitrary amount of "stock" is created. It might be 10 shares. It might be 100 shares. It might be 1000 shares. It might be 5000 shares. It might be 5 million shares. This is a game. The creators of a business can create any amount of shares they want to start the game.
Let's pick 100 shares to make this simple. If we start with 100 shares, each share is worth 1% of the company. Owners buy the initial shares at whatever value they say they are worth (it's all just a game). Only a total of 100% of the shares can be sold, and the ownership is dictated as a percent of who bought what.
This is slightly oversimplified but you get the gist.
The reason you form a company instead of just working as a team of individuals is for individual Legal Liability Protection. There is no other reason, first and foremost. As crazy as it sounds, individuals working within a corporation can commit crimes, and the bulk of the heat will first fall on the corporation, which has no heartbeat. It's really quite a crazy system actually.
Corporations use to be taxed at far higher rates than individuals. Much of that was to pay the government to act as a commercial rule maker and referee, and to pay the Government to keep them in check when they stepped out of bounds. Many things are upside down now.
Many people have heard this idea that corporations are subject to "double taxation". That's a myth.
Corporations get taxed on their net income. After that, dividends may be paid out to share holders (financial owners that may or may not really have any say in the business, they are often much more like gamblers betting on a secondary racetrack than any concept of owner you are thinking about now). If dividends are paid out, those are subject to individual taxes. This idea that the company gets taxed and then the share holders get taxed is where the idea of double taxation comes from.
Corporations require paper work as well as legal and accounting services to operate. They are a more complex game structure than is needed for many commercial endeavors, thus some smaller "cognitive entities" exist for smaller business ventures, which are for smaller, simpler game players.
A corporation has a clear born on date. A corporation has one or multiple parents. Unlike humans, where two parents are required to create a human, a business can have one to hundreds or thousands of parents and the parents don't all have to have an equal stake in the creative process.
To allocate ownership to the parents, an arbitrary amount of "stock" is created. It might be 10 shares. It might be 100 shares. It might be 1000 shares. It might be 5000 shares. It might be 5 million shares. This is a game. The creators of a business can create any amount of shares they want to start the game.
Let's pick 100 shares to make this simple. If we start with 100 shares, each share is worth 1% of the company. Owners buy the initial shares at whatever value they say they are worth (it's all just a game). Only a total of 100% of the shares can be sold, and the ownership is dictated as a percent of who bought what.
This is slightly oversimplified but you get the gist.
The reason you form a company instead of just working as a team of individuals is for individual Legal Liability Protection. There is no other reason, first and foremost. As crazy as it sounds, individuals working within a corporation can commit crimes, and the bulk of the heat will first fall on the corporation, which has no heartbeat. It's really quite a crazy system actually.
Corporations use to be taxed at far higher rates than individuals. Much of that was to pay the government to act as a commercial rule maker and referee, and to pay the Government to keep them in check when they stepped out of bounds. Many things are upside down now.
Many people have heard this idea that corporations are subject to "double taxation". That's a myth.
Corporations get taxed on their net income. After that, dividends may be paid out to share holders (financial owners that may or may not really have any say in the business, they are often much more like gamblers betting on a secondary racetrack than any concept of owner you are thinking about now). If dividends are paid out, those are subject to individual taxes. This idea that the company gets taxed and then the share holders get taxed is where the idea of double taxation comes from.
- You can add the two taxes together to find out total tax on a corporate earnings.
- It's not double taxation, it's just a higher tax rate than either rate stated individually.
Corporations require paper work as well as legal and accounting services to operate. They are a more complex game structure than is needed for many commercial endeavors, thus some smaller "cognitive entities" exist for smaller business ventures, which are for smaller, simpler game players.
Small Business Entities
In the United States, there are 5 Business Entities you should educate yourself on. All of the entities below are referred to as "pass through tax entities". Taxes for all money made in the business each year are assessed based on the individual owners tax bracket. This compares to that corporate tax rate combined with a dividend rate of a corporation above. And note, it doesn't matter if money is paid out of a corporation to an owner or not, all income for the year is taxed at the individual rate(s) of the owners on each of their tax returns, even if it is not withdrawn from the company.
Sole Proprietor -- A sole proprietor is someone in business because they say they are in business. No formal paper work is required. Someone who sets up a lemonade stand in their front yard becomes a sole proprietor as soon as they sell their first drink. If the drink is tainted and kills someone, that dead person's relatives can sue for more than just the lemonade stand and it's proceeds (a civil law action). Furthermore, the cops on behalf of the Attorney General of a state can come after the purveyor and/or his or her parents directly for manslaughter or murder (a criminal law act). As far as taxes go, the sole proprietor fills out a schedule C tax form as part of their normal 1040 return to report business income and expenses. All net income is taxed at a personal level and all is subject to 15% social security, medicare tax combination. To protect one's assets from lawsuit, a sole proprietor can buy business insurance, which in many ways, gets them as much legal protection as a small company entity would. If the sole proprietor wants to go by a catchy name other than their own, they can do that without doing anything, but it's best to register the name they want with a state entity. This registration is often called a trade-name registration or a fictitious name registration and it's cheap. The Sole Proprietor will be doing business under their social security number.
Sole Proprietor -- A sole proprietor is someone in business because they say they are in business. No formal paper work is required. Someone who sets up a lemonade stand in their front yard becomes a sole proprietor as soon as they sell their first drink. If the drink is tainted and kills someone, that dead person's relatives can sue for more than just the lemonade stand and it's proceeds (a civil law action). Furthermore, the cops on behalf of the Attorney General of a state can come after the purveyor and/or his or her parents directly for manslaughter or murder (a criminal law act). As far as taxes go, the sole proprietor fills out a schedule C tax form as part of their normal 1040 return to report business income and expenses. All net income is taxed at a personal level and all is subject to 15% social security, medicare tax combination. To protect one's assets from lawsuit, a sole proprietor can buy business insurance, which in many ways, gets them as much legal protection as a small company entity would. If the sole proprietor wants to go by a catchy name other than their own, they can do that without doing anything, but it's best to register the name they want with a state entity. This registration is often called a trade-name registration or a fictitious name registration and it's cheap. The Sole Proprietor will be doing business under their social security number.
Partnership -- A partnership is identical to a Sole Proprietorship, but it involves more than one person. All partners have equal stake in the profits and losses, and all partners could be held separately or collectively liable for legal matters. Buy insurance to protect against legal issues. Schedule C is filled out for the business and a Schedule K-1 is used to parse up partial business profits or losses for tax on personal returns and it has to be parsed as a percent of one owner divided by the total number of owners. You can't assign more or less money to one partner. The legal way around that is to pay out money in the form of consulting to a partner to account for uneven payments to partners. It's all a game and as long as the IRS isn't cheated of tax proceeds (and they don't come after you for that), you are generally good to go.
Limited Liability Company -- A Limited Liability Company ( LLC ) is the simplest of small business corporate structures. An LLC can often be setup with a single piece of paper that gets filed in a state office. An LLC will need a name that is not registered to anyone else in the state. An LLC will need one of two numbers associated with it. It will either need your Social Security Number (it's a mini me that is kind of separate, but not really) or it will need a Federal Employer Identification Number (FEIN). An FEIN is only needed if / when you start to have w2 employees or if you have an excise tax liability. A limited liability company can have one or multiple owners. Owners are refered to as members and those that run it are "managing members". If it's an LLC of one, it's called a "sole member LLC" and you are the "managing member".
All members have an equal share in the company. Owners can make different amounts by paying each out as consultants or employees with different wages. All money left over after those expenses would get allocated as profits or losses equally and there is no way to deviate from that (other than paying out individuals prior to reporting time as employees or consultants).
Originally, LLC's were NOT allowed to have employees (it's all a game). They allowed that later in the game. Your tax person only needs to file a form to allow you to do that.
All members have an equal share in the company. Owners can make different amounts by paying each out as consultants or employees with different wages. All money left over after those expenses would get allocated as profits or losses equally and there is no way to deviate from that (other than paying out individuals prior to reporting time as employees or consultants).
Originally, LLC's were NOT allowed to have employees (it's all a game). They allowed that later in the game. Your tax person only needs to file a form to allow you to do that.
- If you have employees, the tax advisor will need to file a form that "modifies" the entity for tax purposes to be treated like an S Corporation or a C corporation
- With the modified status, you can pay yourself a reasonable wage via a payroll system as an employee. Then you can pay out the rest of your profits as a corporate distribution (instead of payroll), with the later being free from the 15% self employment tax that would apply otherwise. (This is all a game. Just a game, like monopoly, but with a lot more rules.)
Limited Liability Partnership -- A Limited Liability Partnership is most like an LLC but slightly different. Members are typically licensed professionals (lawyers, doctors, accountants, etc) all of the same kind, and by default, the LLP provides a little more separation of responsibility between the partners. Ask your tax and/or legal advisory for more details or self-educate online. In such case, each is going to be carrying their own professional insurance coverage which is going to protect them first and foremost, and any suing party would likely have little standing suing the entire partnership, altough I can assure you, you will be sold insurance to cover that too...
S-Corporation - An S-Corporation is a "Small" Corporation or a "Sub" Corporation. This was designed to reduce the paper work and complexity of a corporation. This entity was the one you would pick if you were going to have employees. As a reminder, this entity is a "pass through" tax entity compared to it's full parent, the "C Corporation". Picking an S-Corp structure over and LLC when you had employees use to be a big deal when the game was more strict. Now, it just doesn't matter and the LLC is generally simpler.
There are two noteworthy differences between an S-Corp and LLC.
There are two noteworthy differences between an S-Corp and LLC.
- An S-Corp has shares like the C-Corp. Thus, ownership can be split up unevenly easier without the need to write consulting checks. This does come with more paper work, and a few more required corporate meetings that few people actually have each year, even though they are supposed to.
- An S-Corp has the ability to offer corporate benefits like 401-k programs. It's my understanding an LLC can not, but maybe with that tax status form it an do this too? You can setup 401-k programs for self invested management as opposed to aligning with investment companies putting money into the ponzi scheme called Wall Street. This means you could infact create a 401-k account and invest those funds in real estate. This all gets complex, and real estate investing is a train wreck right now, but food for thought. {I need to verify if you can do this from an LLC or not}
State of Incorporation?
Everyone use to rave about setting up a company in Delaware because there was no corporate tax. If you are setting up a small company, that's irrelevant, because you are setting up a pass through tax entity, so just set it up in your state of residence.
Maryland use to have no annual fee for companies. They were low cost to setup (under $100 as I recall) and then it cost nothing each year to maintain. Then they created a $300/year annual registration/renewal fee. What for? Because they can...
In theory, there are states that have no annual fees. However, you will need to have a resident agent in that state and a mailing address. Companies will rent you a mail box and act as your resident agent. That might be $15/month or something like that. Also, the accountant in your state may have an extra form to fill out at tax time which adds to that. Check your state before incorporating else where in a way that just complicates thins for no real benefit.
Maryland use to have no annual fee for companies. They were low cost to setup (under $100 as I recall) and then it cost nothing each year to maintain. Then they created a $300/year annual registration/renewal fee. What for? Because they can...
In theory, there are states that have no annual fees. However, you will need to have a resident agent in that state and a mailing address. Companies will rent you a mail box and act as your resident agent. That might be $15/month or something like that. Also, the accountant in your state may have an extra form to fill out at tax time which adds to that. Check your state before incorporating else where in a way that just complicates thins for no real benefit.
Help Incorporating and the SECRECY of it all...
Many accountants will offer services to help you incorporate. They simply fill out the forms for you and file them
Many attorneys will offers services to help you incorporate. They simply fill out the forms for you and file them
Many third party companies will offer services to help you incorporate. They simply fill out the forms for you and file them.
Or you can do it yourself, just read up a little.
NOTE: Your insurance policy is going to protect you the most from lawsuits not a proper or improper company setup.
NOTE: Only a single name is required on a company incorporation document. It can be a member or a resident agent, which can be an accountant, an attorney or any third party willing to receive mail for you. This is where the corporate secrecy process starts for those who play darker games.
Many attorneys will offers services to help you incorporate. They simply fill out the forms for you and file them
Many third party companies will offer services to help you incorporate. They simply fill out the forms for you and file them.
Or you can do it yourself, just read up a little.
NOTE: Your insurance policy is going to protect you the most from lawsuits not a proper or improper company setup.
NOTE: Only a single name is required on a company incorporation document. It can be a member or a resident agent, which can be an accountant, an attorney or any third party willing to receive mail for you. This is where the corporate secrecy process starts for those who play darker games.