To Incorporate or Not to Incorporate

Our next few blog posts will be dedicated to legal and tax issues affecting startups.

NOTE: These posts are overviews and are not meant to replace a discussion with your attorney and/or tax counsel.

The first legal issue we will look at is the first issue a startup entrepreneur is likely to confront: what type of entity should you use to conduct your business?

These days, entrepreneurs commonly think of filing to form a corporation or a limited liability company (“LLC”). But in fact, there is no legal requirement to take any formal action to form a legal entity.

You can operate your business in your own name (a “sole proprietorship”) or with co-owners (a “partnership”) without filing to create any sort of formal entity. This saves on legal and filing fees, and can be a perfectly fine way to run your business, especially in the very beginning before your business is likely to have revenues or create significant liabilities.

In the case of a partnership, various state laws provide default provisions regarding ownership, allocation of profits, and management rights. If the agreement between the partners is silent on an issue, these laws are read into the agreement by a court. Otherwise, partners are free to agree to pretty much any arrangement that they wish. If you are the sole proprietor, you obviously don’t need any agreement.

Sole proprietorships and partnerships are “pass-through” entities for tax purposes. That means that these entities don’t pay taxes themselves. Rather, a partnership’s income or losses are deemed to pass through to the owner(s) who are responsible to report the income (or loss) on their personal taxes—regardless of what distributions the entity makes to its owner(s).

This pass-through feature of sole proprietorships and partnerships can be extremely beneficial for some businesses—especially where depreciation deductions are significant. An example is the ownership of real estate. For revenue producing property, the annual depreciation deductions can off-set a significant portion (if not all) of the annual cash flow from the property for tax purposes, reducing taxes in early years of ownership of a property and effectively increasing the property’s return of capital.

Although the deductions reduce the owners’ tax basis, and increase taxes at the time of sale of the property, those taxes typically qualify for lower capital gains tax rates, thus reducing the total amount of taxes paid, as well as well as deferring the time of their payment.

Unfortunately, sole proprietorships and partnerships have significant disadvantages to consider. The first and most obvious is pass-through liability—i.e., each owner has personal liability for all liabilities of the business. This can be an extremely daunting prospect in the face of any business, especially risky business, and business where accidents and damages to third parties are unforeseeable.

The problem of personal liability has led to the evolution, over the centuries, of a number of types of business entities, including corporations, limited partnerships, and more recently, limited-liability companies. In the next few posts we will discuss each of these types, several of their variations, and each of their advantages and disadvantages.

Thank you for reading this entry in our “Startup” blog post series. We will start in the next post with a discussion of corporations. If our posts are relevant to you, call our office at (866) 954-7687 or send email to info@warren.law.