Start Your Own Corporation
Garrett Sutton
Start Your Own Corporation reveals the secrets the rich have used to limit their liability, protect their assets and minimize their taxes. Originally published as Own Your Own Corporation in the Rich Dad’s Advisor series, and one of the best selling books on the advantages of incorporating, Start Your Own Corporation has been updated and re-released to better assist entrepreneurs and investors with asset protection strategies. A companion book, Run Your Own Corporation, is being released to address the all too often asked question entrepreneurs have: I’ve set up my corporation, now what do I do?
Start Your Own Corporation offers advice on the right choice of entity, business tax deductions and building business credit. The book also discussed how to raise money for your company and how to be on the look out for corporate scam artists looking to separate money from your new business. As well, the key issue of maintaining the corporate veil is addressed to the reader’s great benefit.
Using illustrative stories and examples, Start Your Own Corporation is a clearly written and easy to understand guide into the whys and hows of corporate protection. As Robert Kiyosaki’s rich dad said: “If you are serious about being rich and keeping your wealth, understanding corporations and other legal structures is an important part of your ongoing financial education.”
Corporate Success
By Garrett Sutton
Cover Artist:
Christoph Koerblein
Published by BZK Press, LLC
This publication is designed to provide competent and reliable information regarding the subject matter covered. However, it is sold with the understanding that the author and publisher are not engaged in rendering legal, financial, or other professional advice. Laws and practices often vary from state to state and country to country and if legal or other expert assistance is required, the services of a professional should be sought. The author and publisher specifically disclaim any liability that is incurred from the use or application of the contents of this book.
Copyright © 2011 by Garrett Sutton. All rights reserved. Except as permitted under the U.S. Copyright Act of 1976, no part of this publication may be reproduced, distributed, or transmitted in any form or by any means or stored in a database or retrieval system, without the prior written permission of the publisher.
Smashwords Edition License Notes
This e-book is licensed for your personal enjoyment only. This e-book may not be resold or given away to other people. If you would like to share this book with other people, please purchase additional copies. If you’re reading this book and did not purchase it, or it was not purchased for your use only, then please return to Smashwords.com for your own copy. Thank you for respecting the hard work of this author.
ISBN: 978-1-937832-16-2
This publication is designed to educate and provide general information regarding the subject matter covered. However, laws and practices often vary from state to state and are subject to change. Because each factual situation is different, specific advice should be tailored to the particular circumstances. For this reason, the reader is advised to consult with his or her own advisor regarding that individual's specific situation.
The author has taken reasonable precautions in the preparation of this book and believes the facts presented in the book are accurate as of the date it was written. However, neither the author nor the publisher assume any responsibility for any errors or omissions. The author and publisher specifically disclaim any liability resulting from the use or application of the information contained in this book, and the information is not intended to serve as legal advice related to individual situations.
This book is dedicated to my wonderful wife, Jenny, and our terrific kids, Teddy, Emily, and Sarah. Thank you for your understanding as this book was being written.
I would like to acknowledge the assistance of Robert Kiyosaki and Mona Gambetta in the revision and updating of this book. Thank you.
Contents
Chapter Three: Corporation or LLC?
Chapter Four: Using Nevada and Wyoming Entities to Your Maximum Advantage
Chapter Five: How a Charging Order Works to Your Advantage
Chapter Six: Crossing State Lines
Chapter Seven: Professional Corporations
Chapter Nine: The Importance of Corporate Formalities
Chapter Ten: Business Tax Deductions
Chapter Eleven: Building Corporate Credit
Chapter Thirteen: Joint Ventures
Chapter Fourteen: Raising Money
Chapter Fifteen: Voting Trusts
Chapter Sixteen: Know Who Your Directors and Officers Are!
Chapter Seventeen: How to Use a Buy-Sell Agreement
Chapter Eighteen: Protecting You and Your Business
Chapter Nineteen: What Happens at the End
Chapter Twenty: Some Miscellaneous Traps and Thoughts
Chapter Twenty-One: Seven Steps to Achieve Limited Liability
Appendix 1: Form 2553 - Election by a Small Business Corporation
Appendix Two: Sub S Shareholder Agreement
Appendix Three: Form 1065 - U.S. Return of Partnership Income
Appendix Four:Subscription Agreement - Purchaser Suitability Questionnaire
When I was ten years old and in the fifth grade, I began to read about the great explorers, such as Columbus, Magellan, Cortez, daGama, Cook. I dreamed of someday traveling the world in a wooden ship, in search of treasures in unexplored lands. I read every book I could about their lives and adventures. In the fifth grade, I often had the highest scores on the tests and quizzes about the great explorers.
"You read about the explorers who were successful," said rich dad. "What about the explorers who failed?" Rich dad was helping me prepare for my final exam in the fifth grade.
"The ones who failed?" I asked.
"Yes, the ones who failed," said rich dad. "In school they teach you about the successful explorers or the famous explorers. There were many more explorers who were not successful and not famous whom we have never heard about, nor will we ever hear about them."
"Why is studying about the explorers who failed so important?" I asked.
"Because you need to know how the owners and the investors in those failed voyages protected themselves against the repercussions from such failures," said rich dad.
"Repercussions?" I asked. "What kind of repercussions?"
"Such things as the loss of life," said rich dad. "The owners and investors wanted to protect themselves and their fortunes from the families of the explorer and his crew in the event there was a loss of life on the voyage."
"You mean the men on the ship risked and sometimes lost their lives, and all the owners and investors on land wanted to do was protect themselves from losing money? That's one of the repercussions you're talking about?"
Rich dad nodded his head. He then began to tell me about the Dutch East India Company and the British East India Company, two of the more powerful and famous corporations behind some of those explorers. Some of these corporations even had their own navy and army to control access to their nation's overseas wealth. He told me how these corporations in many ways took over whole countries, such as New Zealand, Hawaii, Australia, Malaysia, Indonesia, South Africa, and other parts of the world. One of those countries was one day to become the United States of America. Rich dad pointed out to me that the flag of the United States was originally the flag of the British East India Company, reportedly modified by Betsy Ross. While England may have lost control over its colonies, the British East India Company simply changed its name—a simple d.b.a.—and kept on trading.
The more rich dad told me about the corporations behind these great explorers and how they shaped world history, the more interested I became in global business and doing business through a corporation. When I was sixteen, I began applying for a congressional appointment to the U.S. Merchant Marine Academy, the federal military school that trains young men to sail ships of the merchant marine. Kings Point, which the school is also known as, continues to train young people to replace the great seafaring explorers. Only two students from Hawaii are admitted to this little known federal academy each year, so I felt fortunate to be accepted after passing rigorous exams and interviews. At age eighteen, I began sailing as a student onboard ships carrying cargo along the same trade routes established by Ferdinand Magellan and Captain James Cook. I quickly realized that although the early explorers are gone, some of those corporations rich dad talked about still exist today, and the U.S. government funds the education of these corporations' leaders. I began to understand why rich dad told me years ago, "Don't just study the explorer and his ships, study the power of the corporations behind the explorer and his ships."
747 Replaces Cargo Ships
Today I travel by 747 rather than by cargo ship. Although my mode of transportation has changed, I have heeded rich dad's advice and learned my lessons well. Today I travel as a representative of several corporations—the difference is that I control those corporations rather than simply work for them.
As I stated in Rich Dad Poor Dad, my poor dad thought it was a good idea to be a good employee and climb the corporate ladder, while my rich dad said, "Don't climb the corporate ladder, why not own the corporate ladder?" Rich dad also said, "The problem with climbing the corporate ladder is that when you look up, you see somebody's big fat butt above you." On a more serious note, he said, "The two main reasons you need to Start Your Own Corporation are for protection against lawsuits and against excessive taxes, yet there are many other reasons and other strategies. The point is, if you are serious about being rich and keeping your wealth, understanding corporations and other legal structures is an important part of your ongoing financial education."
Introducing Garrett Sutton
I am pleased to introduce Garrett Sutton to you. Often in my classes, students ask me questions about corporations and legal structures. My standard reply is, "I did not go to law school and I am not an attorney, so I do not give advice on that subject. I suggest you do as I do: Find a good attorney and use him or her as your advisor on this very important subject." I am pleased to introduce to you my advisor in these matters, Garrett Sutton. He is a pleasure to work with, and he is more than a great advisor, he is a great teacher. As rich dad said to me years ago, "If you are serious about being rich and keeping your wealth, understanding corporations and other legal structures is an important part of your ongoing financial education."
Congratulations. You are about to undertake a powerful and enlightening journey. By reading this book you will learn quickly and easily the legal secrets and strategies that the rich have used to run their businesses, hold their real estate and protect their assets. In short order you will clearly understand exactly how certain entities—corporations, limited liability companies, and limited partnerships— can not only save you thousands and thousands of dollars in taxes but can also save your house and savings and family assets from the attacks of creditors. And because real estate is an important component of your wealth strategy we have included information on using good entities to protect your real estate holdings from attack.
These are the same lessons that Robert Kiyosaki's rich dad taught him. Own nothing and control everything. Use the techniques of the rich to improve your financial standing and protect your family. And above all, work smarter instead of harder.
This is the third edition of this book, and we have changed the title from “Own Your Own Corporation” to “Start Your Own Corporation.” In discussions with readers there is a great deal of interest in knowing what to do once your entity is formed. To that end, a companion book to this one will be available entitled “Run Your Own Corporation.” As well, we have updated “Start Your Own Corporation” to include new strategies for maximum results.
As such, by the time you finish this book you will have the legal savvy of an experienced entrepreneur and the knowledge necessary to immediately implement your own custom legal strategy.
Let's begin...
Welcome to the world of asset protection and entity formation! As you gain knowledge of the strategies and advantages (and you will in this book), you will come to appreciate your six main menu choices:
C corporation
S corporation
Limited Liability Company (LLC)
Limited Partnership (LP)
General Partnership
Sole Proprietorship
As legal business systems and traditions have developed over the last five hundred years, several structures for running a business have evolved. Each structure, or entity, has its own benefits and drawbacks, which we will explore.
First off: What does the word 'entity' mean? It refers to an organization (be it a business or government unit) which has a legal identity separate from its members. It is derived from the Latin word 'ens,' meaning an existing or real thing. So an entity is a real thing, distinguishable and apart from its owners. (Two of six choices aren't really real things, which, as we'll learn, is not a good thing.)
As a frame of reference for making your entity selection, it is important for you to clarify your strategy in this planning. The purpose of this chapter is for you to clearly understand and choose the best entity for your unique and specific purpose. To that end, the following checklist should be considered:
1. Protection of family assets and investments
2. Management control
3. Avoiding family disputes
4. Flexibility of decision making
5. Succession of children and other family members to management
6. The nature of the business to be operated
7. The nature of the asset to be held
8. The number of owners involved
9. Estate planning and gifting of assets
10. Who may legally obligate the business
11. Effect upon an owner's death or departure
12. The need for start-up funding and raising of capital
13. Taxation
14. Privacy of ownership
15. Consolidation of assets and investments
These and other issues will become apparent as we review your choices. And please note, your decision does not have to be made alone. It is recommended that these issues be discussed with your attorney, accountant, or other professional advisor. An individual well versed in these areas will provide excellent insight into which entity is right for you.
By reading this book you will be better able to work with your professional advisors. They won't have to spend time explaining all of the tax issues and limitations of liability strategies to you. By reading this book you will have a leg up. When you meet with your advisors you won't be stepping up to the plate for the first time. Instead, you'll be at second base, ready to score. (Fear not, our first sports analogy is also our last one.)
It is important to know that in entity selection one size does not fit all. If your attorney or accountant suggests only one entity, a general partnership for example, for each and every business venture you have him or her review, you will want to question why they believe one entity fits all situations. Or you may want to seek out a new professional advisor.
We will discuss which entities work well in various business and asset holding scenarios. But before doing so, we must point out which entities do not work well in any situation. For as important as knowing which entity to use for running your business, protecting your assets, and limiting your liability is knowing which entity NOT to use.
Bad Entities
Sole proprietorships
General partnerships
In my legal practice I represent various businesses, from small and basic to large and complicated. I enjoy helping entrepreneurs and business owners make money, provide for their families and employees, and secure a stable future.
I cannot do my job if a client insists on using a bad entity. Sole proprietorships and general partnerships provide no asset protection. Remember the Latin word 'ens?' It means an existing or real thing. These bad entities are not separate legal 'things.' You haven't registered them with your state. Instead, they are just you, doing business without any protection. One lawsuit against your business, and your house, savings, and personal assets can all be lost. Our first case is illustrative.
Case No. 1: Johnny
Johnny was a plumber. He had been at it for five years and was starting to succeed. His customers were satisfied with his work and the word of mouth for Johnny's Ace Plumbing was good.
While Johnny was a good plumber, he felt intimidated by legal matters. Lawyers and accountants were supposed to be smart, so the work they did must be difficult. When Johnny was a young boy his father had been unfairly treated by a lawyer. He remembered it to this day, and wanted nothing to do with them.
So instead of consulting with a professional on how best to conduct his business, Johnny let his part-time bookkeeper select an entity off the menu. The results were disastrous.
Johnny's part-time bookkeeper knew only that forming a corporation required filing special documents with the state but did not know how to file them. He knew that a corporation needed to file a separate tax return but was not sure of the ins and outs of preparing one. And so he suggested Johnny use a sole proprietorship because he knew how to handle one and always suggested one for his clients. One size fits all.
The problem was that a sole proprietorship provides absolutely no asset protection. By operating as a sole proprietorship Johnny has unlimited liability for the debts, claims, and obligations of the business. This unlimited liability meant that his house and savings and personal assets were exposed to the claims of others.
Of course, as in all horror stories, a demon entered Johnny's business. He had hired Damien as an employee to assist with his growing workload. Damien seemed like a decent guy and appeared to know the plumbing business. Johnny did not bother to do a background check on Damien. Johnny was new to the business world and not aware of the need to do so.
After one week on the job, Damien assaulted one of Johnny's customers while they were alone in her house. Without going into the sordid details, this woman was so severely traumatized by what Damien did to her in her own home that she and her family had to move away.
Within three weeks of the incident Johnny's business was sued. Because Johnny was a sole proprietor, this meant that he, and not the business itself, as with a corporation, was sued and had to defend himself.
The lawyers suing for the woman did the background check of Damien that Johnny did not do. Damien was a recently released ex-convict with a history of sexual assaults. Johnny did not have the insurance to cover such a claim. The case went forward. The lawyers argued to a jury that Johnny's business was irresponsible for failing to check up on Damien and was responsible for the consequences. They presented to the jury what was true—a business is vicariously liable, or responsible, for the acts of its employees. The jury was horrified by the whole case and awarded damages of $10 million.
Johnny was wiped out. As a sole proprietor he was completely and personally responsible for every claim the business incurred. And he had attorneys with a one-third contingent interest in the collection of $10 million after him.
Johnny lost his house, his savings, and his family. The stress of it all resulted in his wife divorcing him, obtaining custody of the children, and moving away. Johnny declared bankruptcy. He ended up a broken man despising lawyers and our legal system all the more.
The irony, of course, is that by consulting with a lawyer and using the legal system to his advantage, Johnny could have prevented the disastrous consequences that resulted from relying on a part-time bookkeeper with a one-size-fits-all mentality for entity selection.
Other Sole Proprietorship Disadvantages
As if personal liability was not bad enough, there are several other disadvantages to using a sole proprietorship:
Owners. There can only be one owner of a sole proprietorship. If you later want to bring on owners you will have to switch to another business entity.
Sale. It is hard to sell a sole proprietorship since its value is based on the owner and not the business.
Death. When a sole proprietor dies, the sole proprietorship terminates. The sole proprietor's successors can only sell assets, not the business as a going concern.
Audit Risk. Because sole proprietors report their business profits and losses to the IRS on Schedule C, there is a much higher risk of IRS audit. Schedule C returns are audited at a five times greater rate than corporate tax returns.
A competent lawyer would have told Johnny that there were risks-known and unknown—in running any business. To protect yourself from such risks you need to limit your liability by establishing a corporation or other good entity.
A good entity is one that shields and protects your personal assets from business risk. A bad entity is one that provides you no protection whatsoever. By using a good entity Johnny could have used the legal system—which has evolved to encourage business activity and limit the liability of risk takers—to his advantage.
A general partnership is also a bad entity. In fact it is twice as bad as a sole proprietorship because you have twice the personal exposure: personal liability for your acts and your partners' acts.
This will be illustrated in Case No. 2 ahead.
Whenever two or more persons agree to share profits and losses a partnership has been formed. Even if you never sign a partnership agreement, state law provides that under such circumstances you have formed a general partnership.
A written partnership agreement is not required by law. A handshake is acceptable for formation. In the event you do not sign a formal document, you will be subject to your state's applicable partnership law. This may not be to your advantage, since such general rules rarely satisfy specific situations. As an example, most states provide that profits and losses are to be divided equally among the partners. If your oral understanding is that you are to receive 75 percent of the profits, state law and your handshake will not help you. Instead, against your wishes, state law may have you sharing 50-50. You are better advised to prepare a written agreement addressing your rights and rewards. But again, you are better off not using a general partnership in the first place.
Unlike a sole proprietorship, in which only one individual may participate, by definition, a general partnership must consist of two or more people. You cannot have a one-person partnership. On the other hand, you may have as many partners as you want in a general partnership. This may sound like a blessing but it is actually a curse.
The greatest drawback of a general partnership is that each partner is liable for the debts and obligations incurred by all the other general partners. While you may trust the one general partner you have not to improperly obligate the partnership, the more general partners you bring aboard the greater risk you run that someone will create serious problems.
And remember, just as with a sole proprietorship, your personal assets are at risk in a general partnership. Your house and your life savings can be lost through the actions of your partner. While you may have had nothing to do with the decision that was made and you may have been five thousand miles away when it was made and you may have voiced your opposition to it when you found out it was made, you are still personally responsible for it as a general partner.
As such, a general partnership is much riskier than a sole proprietorship. In a sole proprietorship, only the proprietor can bind the business. In a general partnership, any general partner—no matter how wise or, unfortunately, how ignorant—may obligate the business. By contrast, limited liability companies, limited partnerships, and corporations offer much greater protection. All of them offer owners limited personal liability for business debts and the acts of others.
It should be noted that because of these unlimited risks the last thing you want to do is become a general partner of an enterprise in which you do not have day-to-day management control. If you do not thoroughly know what is going on in the company you should not put your future on the line as a general partner.
Case No. 2: Louise
Louise had worked for someone else all her life. For the last ten years she had worked in the gift section of a large department store. She did not like the floor manager insisting she do things a certain way when she knew her way would generate more sales for the company. It was all petty politics. She looked forward to the day when she could open her own business and make her own decisions.
Then one day, Maxine came to work at the department store. The two of them hit it off immediately. Maxine had a certain style and attitude that appealed to Louise. They had similar interests, the same feel for what the customers wanted, and the same desire to escape working for a faceless corporation filled with narrow-minded managers who stifled their every idea for improvement. Soon they were talking about opening their own gift boutique.
Louise had managed to save $10,000 to pursue her dream. Maxine did not have any money to contribute, but convinced Louise that she would contribute her first $5,000 in profits back into the business.
Louise was not aware that agreeing to form a partnership with Maxine without getting a written agreement as to distributions meant that they were automatically 50-50 partners. While Louise put up all the money and Maxine orally agreed to put her profits back later, the law treated them as each owning 50 percent of their new business, L&M Gifts.
In nine businesses out of ten there are problems when only one partner puts up all the money. L&M Gifts was no exception.
Maxine wanted the store to have the right atmosphere. She decided on leasing a storefront in a nice area and obligated the partnership to a three-year lease at an above-market rate. She decided on stylish tenant improvements to achieve the right look for her dream store. She then obligated the partnership to buy a large quantity of gifts in order to stock the store.
Before L&M Gifts opened its doors the partnership had obligated itself to spend $12,000 on improvements. They were also obligated to pay $1,500 per month in rent for the next three years. Louise was not aware of these transactions. However, as general partner, Maxine could obligate the partnership without informing or getting the approval of her other partner.
Louise wanted to announce their grand opening by placing an ad in the newspaper. Because they were a new business, the paper wanted a check up front. When Louise went to write a check it hit her. They were out of money. Maxine had spent Louise's entire $10,000, and then some, to open the store.
When Louise confronted Maxine with this Maxine was unconcerned. She asked Louise if she could put up any more cash. But Louise did not have any more money. Her life savings, her dream of her own business and control of her future, was the $10,000 that Maxine had already spent.
Maxine said she did not have a credit card but asked if Louise had or could get a credit card to help them get over this hump. Maxine said that if they could just get the doors open together they would be rolling in profits. It was with this comment that Louise realized that she was putting up all the money and taking all the risk so that Maxine could share in all the profits.
Louise was shaken by this realization but remained composed. She said she did not have a credit card nor did she have good enough credit to get one.
At this, Maxine flew off the handle. She said that she had invested all her ideas of style and atmosphere into the business. All Louise had to do was put up the money. She was furious that her creative vision for L&M Gifts was to be dimmed by Louise's refusal to put in more money.
Louise was stunned by her partner's reaction. She had put her life savings into the business. Maxine, without telling her, had squandered it. And now Maxine was angry that she could not put in more.
As one would expect, things soured very quickly between the two. As soon as Maxine learned that no more money was forthcoming, she reignited a relationship with an old boyfriend who lived two thousand miles away. She picked up and left town within forty-eight hours. No one heard from her again.
Louise was left with all the bills. Because Maxine had obligated the partnership, even though Louise had no knowledge of such obligations, Louise as the remaining general partner was personally responsible.
The landlord, the contractor who did the tenant improvements, and the suppliers of the inventory all sued Louise. While Maxine was equally responsible (if not more so) for these debts, the creditors did not even bother to pursue her. She had no money and she was on the other side of the country. Why would someone spend the time and money to chase her? The sole burden of the partnership's debts fell upon Louise.
With her life savings gone and her vision of her own business dashed, Louise unhappily went back to work at the department store.
As Case No. 2 illustrates, with a general partnership you have double the exposure of a sole proprietorship. Not only you—but your partner—can put your personal assets at risk. All of the risk and double (or triple or more depending on the number of general partners you have) the exposure is not a good way to do business.
As our first two cases point out, it is important to select the correct entity at the start. (And, please note, not all of our stories will be so dire. It is just that right now we are dealing with bad entities.)
Other General Partnership Disadvantages
As if all of the risk and double the exposure were not bad enough, there are other disadvantages to operating as a general partnership:
Termination. A partnership terminates when one partner dies, leaves, or goes bankrupt. You may be surprised by some unexpected event.
Sale. Most sophisticated buyers do not want the risk of being in a general partnership. This will hinder the ability to sell your interest in a general partnership.
Self-employment taxes. We will be discussing those darn Social Security and Medicare taxes throughout this book. Please note here that all general partners (even those not considered employees of the partnership) must pay self-employment taxes on their share of partnership income. Several good entities ahead offer ways to reduce such taxes.
Rich Dad Tips
The longer you operate as a sole proprietorship or general partnership the longer you are going to be personally responsible for every bad thing that can happen in your business.
If you are currently operating as a sole proprietorship or general partnership, see a professional or visit http://www.corporatedirect.com about switching to a good entity.
If you are considering getting into a business, do not start out on the wrong foot by using a bad entity.
Chapter Two: Good Entities
Entities are good when they are legally separate from their owners. Corporations, LLCs and LPs require filing with a state government to obtain that separate identity. Sole proprietorships and general partnerships are bad because no such filing is reuired and thus there is no separateness to protect you.
To succeed in business, to protect your assets, and to limit your liability, you will want to select from one of the good entities, structures that are truly separate legal beings. They are:
C corporations
S corporations
Limited liability companies (LLCs)
Limited partnerships (LPs)
Each one of the above entities has its own advantages and specific uses. Each one is utilized by the rich and the knowledgeable in their business and personal financial affairs. And, depending on your state's fees, each one can be formed for $800 or less so that you can achieve the same benefits and protections that sophisticated business people have enjoyed for centuries. But beware of promoters claiming they can incorporate you for $99 or less. We will discuss the consequences of using such services in Chapter 18.
Before we discuss the relative strengths of corporations, LLCs, and LPs, it is important to know the language of each. While their basic structure is similar, the terms for each structural facet are different. Here then is the language for the good entities.
Corporations
The best place to start the discussion of good entities is with corporations. They have evolved over the last five hundred years to become the most commonly used entity for conducting business.
As Robert Kiyosaki learned during his study of admiralty law, corporations came into common usage in the 1500s to protect investors in maritime ventures. Prior to the popular use of corporations, investors would come together as a partnership, outfit a ship, and send it out for trading purposes. If the ship was lost at sea, the investors could not only lose everything but also be personally sued by various creditors. Of course, this exposure deterred people from risk taking and discouraged economic activity. Seeing this, the English Crown and courts allowed for the charter of corporations whereby risks and liabilities could be limited to the corporation itself.
The shareholders, the investors in the corporation, were liable only to the extent of their contribution to the business. This was a significant development in world economic history.
Case No. 3: The English Rose/Sir Richard Starkey
In the late 1500s maritime activity was increasing. The New World beckoned with the promise of riches and opportunity. The then small segment of Europeans with money were investing in sailing ships to pursue trading opportunities. If your ship could make it across the Atlantic with supplies, sell them or trade them for commodities, and return with a valuable cargo, you could make a fortune. This scenario was the origin of the phrase: "When my ship comes in."
During this time, two groups of London promoters were soliciting investors to outfit a ship and send it to the Caribbean in search of trading opportunities. A ship known as the Royale Returne had just recently arrived at the London docks and its investors had reaped profits of 1,000 percent. Investors were excited by these opportunities. The first group was outfitting a ship known as the English Flyer. The promoters brought investors in as general partners, offering 10 percent of the profits in exchange for £250. In Elizabethan England, as today, there was no special requirement to get permission to operate as a general partnership.
Two British gentlemen, Sir Richard Starkey and Master John Fowles, were potential investors. Master John Fowles was astounded by the profits the Royale Returne had generated for its investors. He wanted to invest in the very next ship set to sail. It didn't matter that the English Flyer was a partnership. The personal liability of a general partnership did not trouble him—not when huge profits were in sight. Fowles invested £250 in the English Flyer as soon as he could.
The second group of promoters was outfitting the English Rose. They wanted the limited liability of a new entity called a corporation. The problem was that, like today, it cost extra money to form and you had to wait for the Crown to give you a charter. But the second group of promoters was more careful than the first. They did not want to put themselves or their investors at risk in case the ship never returned. Sir Richard Starkey, being prudent and cautious, chose to invest in the English Rose. He knew there was risk in venturing across the Atlantic. He wanted to limit his exposure to just £250.
As it turned out, the English Rose and the English Flyer left London for the Caribbean at about the same time. As they set sail the risks to the investors in each enterprise were as follows:
As luck would have it, the English Flyer was lost near the Bermuda Triangle. The promoters had leased the ship, provided their own captain, and were now responsible to the owners for its loss. The promoters and 90 percent of the general partners did not have as much money as Master John Fowles did. As we learned in Louise's case, and as has been the case for centuries, creditors will go after the easiest target with the deepest pockets. And so Master John Fowles, only a 10 percent general partner, was sued and held responsible for the entire loss of the English Flyer. He learned the hard way what happens when your ship does not come in, and you are responsible for it.
As Sir Richard Starkey's luck would have it, the English Rose did well on each side of the Atlantic and provided a huge return to its investors. Unlike Master John Fowles, Sir Richard Starkey was willing to lose £250 and no more. By using a corporation instead of a partnership he was able to establish his downside risk, while allowing for his upside advantage to be unlimited.
Sir Richard Starkey and other knowledgeable and sophisticated investors have used corporations, and other good entities, to limit their liability for centuries.
Forming a corporation is simple. Essentially, you file a document that creates an independent legal entity with a life of its own. It has its own name, business purpose, and tax identity with the IRS. As such, it—the corporation—is responsible for the activities of the business. In this way, the owners, or shareholders, are protected. The owners' liability is limited to the monies they used to start the corporation, not all of their other personal assets. If an entity is to be sued it is the corporation, not the individuals behind this legal entity.
A corporation is organized by one or more shareholders. Depending upon each state's law, it may allow one person to serve as all officers and directors. In certain states, to protect the owners' privacy, nominee officers and directors may be utilized. A corporation's first filing, the articles of incorporation, is signed by the incorporator. The incorporator may be any individual involved in the company, including, frequently, the company's attorney.
The articles of incorporation set out the company's name, the initial board of directors, the authorized number of shares, and other major items. Because it is a matter of public record, specific, detailed, or confidential information about the corporation should not be included in the articles of incorporation. The corporation is governed by rules found in its bylaws. Its decisions are recorded in meeting minutes, which are kept in the corporate minute book.
When the corporation is formed, the shareholders take over the company from the incorporator. The shareholders elect the directors to oversee the company. The directors in turn appoint the officers to carry out day-to-day management.
The shareholders, directors, and officers of the company must remember to follow corporate formalities. They must treat the corporation as a separate and independent legal entity, which includes holding regularly scheduled meetings, conducting banking through a separate corporate bank account, filing a separate corporate tax return, and filing corporate papers with the state on a timely basis.
Failure to follow such formalities may allow a creditor to disregard officers, directors, and shareholders. This is known as “piercing the corporate veil” – a legal maneuver in which the creditor tries to establish that the corporation failed to operate as a separate and distinct entity; if this is the case, then the veil of corporate protection is pierced and the individuals involved are held personally liable. (And I know that piercing the veil is successful in almost half of all cases!) Adhering to corporate formalities is not at all difficult or particularly time-consuming. In fact, if you have your attorney handle the corporate filings and preparation of annual minutes and direct your accountant to prepare the corporate tax return, you should spend no extra time at it with only a very slight increase in cost. The point is that if you spend the extra money to form a corporation in order to gain limited liability it makes sense to spend the extra, and minimal, time and money to ensure that protection is achieved.
One disadvantage of utilizing a regular (or C) corporation to do business is that its earnings may be taxed twice. This generally happens at the end of the corporation's fiscal year. If the corporation earns a profit it pays a tax on the gain. If it then decides to pay a dividend to its shareholders, the shareholders are taxed once again. To avoid the double tax of a C corporation, most C corporation owners make sure there are no profits at the end of the year. Instead, they use all the write-offs allowed to reduce their net income.
The potential for double taxation does not occur with the other good entities, a limited liability company or a limited partnership. In those entities profits and losses flow through the entity directly to the owner. Thus, there is no entity tax but instead there is a tax obligation on your individual return. Depending on your situation, an LLC or LP with flow-through taxation may be to your advantage or disadvantage. Again, one size does not fit all.
It should be noted here that a corporation with flow-through taxation features does exist. The Subchapter S corporation (also known as the S corporation or S corp), named after the IRS code section allowing it, is a flow-through corporate entity. By filing Form 2553, "Election by a Small Business Corporation," the corporation is not treated as a distinct entity for tax purposes. A copy of Form 2553 is found in the Appendix.
With the timely filing of Form 2553, profits and losses flow through to the shareholders as in a partnership.
While a Subchapter S corporation is the entity of choice for certain small businesses, it does have some limits. It can only have one hundred or fewer shareholders. All shareholders must be American citizens or resident aliens, who are foreign citizens working and paying taxes in America. Individuals may list their revocable living trust as a shareholder. That said, corporations, limited partnerships, limited liability companies, and other entities, including certain trusts, may not be S corporation shareholders. A Subchapter S corporation may have only one class of stock.
In fact, it was the above-named limitations that led in part to the creation of the limited liability company. Because many shareholders wanted the protection of a corporation with flow-through taxation but could not live within the shareholder limitations of a Subchapter S corporation, the limited liability company was authorized.
The Subchapter S corporation requires the filing of Form 2553 by the 15th day or the third month of its tax year for the flow-through tax election to become effective. A limited liability company or limited partnership receives this treatment without the necessity of such a filing.
Another issue with the Subchapter S corporation is that flow-through taxation can be lost when one shareholder sells his stock to a nonpermitted owner, such as a foreign individual or trust. By so terminating the Subchapter S election, the business is then taxed as a C corporation and the company cannot reelect S status for a period of five years. (In the Appendix is a form that Sub S Shareholders can sign stating that they won’t transfer their shares to a non-permitted shareholder). If you are worried about losing your S corporation status and flow through taxation, the problem can be eliminated by using a limited liability company.
Still, there are plenty of good reasons to use an S corporation, including the minimization of self-employment taxes, as we will explore in Chapter 4.
Both C and S corporations require that stock be issued to their shareholders. While limited liability companies may issue membership interests and limited partnerships may issue partnership interests, they do not feature the same transferability and liquidity (or ease of selling) of corporate shares. Neither limited liability companies nor limited partnerships have the ability to offer an ownership incentive akin to stock options. Neither entity should be considered a viable candidate for a public offering. If stock incentives and public tradability of shares are your objective, you must eventually become a C corporation.
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If you think you may want to go public at some point in the future but want initial losses to flow through, consider starting with an S corporation or a limited liability company.
You can always convert to a C corporation at a later date, after you have taken advantage of flowing through losses.
Limited Liability Companies
The limited liability company is a good entity to use in certain situations. Because it provides the limited liability protection of a corporation and the flow-through taxation of a partnership, some have referred to the LLC as an incorporated partnership.
There are two more features that make the LLC unique:
Flexible management structure
Flexible allocation of profit and loss
These features will be illustrated in our next case.
Case No. 4: Thelma/Millennium Salsa
Thelma was looking to start a salsa business with two partners, Pepe and Hans. They had taken the beneficial step of preparing a business plan. They analyzed the market and their competition. They calculated their expenses, projected conservative revenues, and figured that Millennium Salsa could break even in two years.
The problem was that each partner had his or her own agenda that was difficult to reconcile. They had agreed that for their efforts each was to receive a one-third interest in Millennium Salsa. But beyond that it was looking doubtful that they could structure the business in such a way that it would work. Pepe was putting in $200,000 of start-up money to get the business going. He wanted no part of managing the business but wanted, first, to use any losses to offset other income; and, second, that all of the first profits be paid directly to him until he was paid back $300,000, or one and one half times what he had invested. Hans, on the other hand, was putting his salsa recipe into the company. It was a well-known and world-famous recipe renowned for its freshness and long shelf life, but beyond that, Hans's contribution to the company would be limited. He had offered to work for the company, but for Thelma and Pepe, who both knew of Hans's odd work habits and culinary eccentricities, that was more of a threat than a promise.
Thelma was going to work in the business. Her contribution was to spend the next two years—or however long it took—working for a very low wage to make a go of it. She had learned from her cousin Louise that a general partnership was a bad entity to use. The last thing Thelma wanted was for Hans to be out obligating their business to another bizarre food project like the edible mold fiasco.
The management of the business, and keeping Hans out of it, was one issue. But an even bigger issue was how to satisfy Pepe's demands for all the losses to flow through to him and the first $300,000 in profits to go to him.
Thelma knew that in a Subchapter S corporation when profits and losses flowed through the entity, they flowed rigidly according to the shareholder's ownership percentage. If you owned 50 percent, then 50 percent flowed through to you. In the case of Millennium Salsa, each person would have a one-third interest in whatever entity was to be used. But they needed to initially distribute more than one third to Pepe.
How could they satisfy Pepe's demands? Thelma knew she had to figure out some way to get it done or Pepe would not agree to the project.
Thelma went to her part-time bookkeeper, who told her she had to use an S corporation. Thelma was told that Pepe's demands could not be met and that the only way to handle the corporate structure was to allocate profits and losses on a one-third basis to each Millennium Salsa shareholder. The bookkeeper said she used an S corporation for every such situation and that most of her clients were satisfied.
Thelma then sought the advice of a local attorney who specialized in business formation and structure. It was during her initial consultation that Thelma became aware of the limited liability company. She learned that special allocations according to partnership formulas could be made to accommodate Pepe's conditions. She learned that a flexible LLC management structure could be implemented so that neither Pepe nor Hans would be involved as decision makers.
The attorney charted for her the difference between the rigidity of an S corporation and the flexibility of an LLC when it came to distributions:
In Millennium Salsa, Inc. the flow-through distributions have to be made according to each shareholder's percentage ownership. Because Pepe owns one third there is no way to allocate him 100 percent of either profits or losses. He is stuck with what flows through to him strictly according to his ownership interest. However, Thelma liked what could be accomplished with an LLC:
In the LLC scenario, Pepe's goals are achieved. He is able to take the first losses and receive the first $300,000 in profits. It should be noted that special allocations such as this must be based on legitimate economic circumstances as opposed to simply shifting tax obligations from one taxpayer to another. For more information, see Garrett Sutton's How to Use Limited Liability Companies and Limited Partnerships. The attorney informed Thelma she needed to work with a tax professional so that Millennium Salsa's objectives were properly documented and carried out.
The attorney also noted that money flowing through the LLC to Thelma, as an employee, was subject to self-employment taxes of 15.3 percent to the
statutory salary maximum of now above $100,000 and 2.9 percent over that salary amount for the Medicare portion. Because Pepe and Hans were not employees but rather investors, their flow-through of monies, as of this writing, was not subject to self-employment tax. It was noted that an S corporation, where self-employment taxes were only paid on monies deemed to be salaries, and profits above that were not taxed as self-employment income, might be an option for Thelma's distributions. But again, the attorney noted the flexible distributions Pepe wanted could not be achieved in an S corporation. One entity did not fit all situations.
Thelma also learned that the management structure of an LLC was different, and much more flexible, than that of a corporation. A corporation had directors elected by shareholders, officers elected by directors, and employees hired by officers. By contrast, an LLC could be managed by all its members, which are akin to shareholders in a corporation, or be managed by just some of its members or by a nonmember. The first was called a member-managed LLC, the second a manager-managed LLC. Because Pepe wanted no management responsibility and neither Thelma nor Pepe wanted Hans anywhere near management authority, it was decided that Thelma would be the sole manager of a manager-managed LLC. As manager she had complete authority for the company's affairs. In corporate terms, she was the board of directors, the president, secretary, treasurer, and all vice presidents of Millennium Salsa. And all her business card had to say was "Manager, Millennium Salsa, LLC."
Pepe liked the plan that Thelma brought back from the attorney's office. He funded the project and they were in business.
The LLC was designed to overcome the problems corporations faced in attempting to avoid double taxation. In the process, as we have seen, some unique and useful features were created as additional benefits to the entity. The main features are as follows:
LIMITED LIABILITY PROTECTION
In an LLC, like a corporation, the owners do not face personal liability for business debts or for legal claims made against the company. In this day and age when litigation can unexpectedly wipe out a lifetime of savings, limited liability protection is of paramount importance.
The LLC, as well as the LP, offers even greater protections through the changing order procedure. This will be further discussed in Chapter 5.
It is important to note that in an LLC, as with a corporation, you may become personally liable for certain debts of the company if you sign a personal guarantee. As an example, most landlords will require the owners or officers of a new business to personally guarantee that the lease payments will be made. If the business goes under, the landlord has the right to seek monthly payments against the individual guarantors until the premises are leased to a new tenant. Likewise, loans backed by the Small Business Administration will require a personal guarantee. The SBA's representative will state that they will only loan to those persons committed enough to put their own assets at risk. In truth, as with any bank, they want as much security as they can get. Such personal guarantees are standard business requirements that will not change.
The important point to remember is that you are not going to sign a personal guarantee for each and every vendor agreement and customer transaction you enter. And in these matters, you will be protected through the proper use of an LLC. To obtain such protection it is important to sign any agreement as an officer of the LLC. By signing an agreement "Joe Doe" without adding "Manager, XYZ, LLC" you can become personally liable. The world must be put on notice that you are operating as an independent entity. To that end, it is important to include LLC—or Inc. if you use a corporation, or LP for a limited partnership—on all your stationery, checks, invoices, promotional literature, and especially written agreements.
UNLIMITED OWNERSHIP
One of the reasons people have a problem utilizing the S corporation is the limits on owners. An S corporation can only have one hundred or fewer shareholders. As well, some foreign citizens and certain entities are prohibited from becoming shareholders of an S corporation.
The LLC offers the flexibility of allowing for one member to an unlimited number of members, each of whom may be a foreign citizen, spendthrift trust, or corporate entity. And unlike an S corporation, you won't have to worry about losing your flow-through taxation in the event one shareholder sells their shares to a prohibited shareholder.
FLEXIBLE MANAGEMENT
LLCs offer two very flexible and workable means of management. First, they can be managed by all of their members, which is known as member-managed. Or they can be managed by just one or some of their members or by an outside nonmember, which is called manager-managed.
It is very easy to designate whether the LLC is to be member- or manager-managed. In some states, the articles of organization filed with the state must set out how the LLC is to be managed. In other jurisdictions, management is detailed in the operating agreement. If the members of an LLC want to change from manager-managed to member-managed, or vice versa, it can be accomplished by a vote of the members.
In most cases, the LLC will be managed by the members. In a small, growing company, each owner will want to have an active say in how the business is operated. Member management is a direct and simple way to accomplish this.
It should be noted that in a corporation there are several layers of management supervision. The officers—president, secretary, treasurer, and vice presidents—handle the day-to-day affairs. They are appointed by the board of directors, which oversees the larger, strategic issues of the corporation. The directors are elected by the shareholders. By contrast, in a member-managed LLC, the members are the shareholders, directors, and officers all at once.
In some cases, manager management is appropriate for conducting the business of the LLC. The following situations may call for manager management:
1. One or several LLC members are only interested in investing in the business and want no part of management decision making.
2. A family member has gifted membership interests to his children but does not want them or consider them ready to take part in management decisions.
3. A nonmember has lent money to the LLC and wants a say in how the funds are spent. The solution is to adopt manager management and make him a manager.
4. A group of members come together and invest in a business. They feel it is prudent to hire a professional outside manager to run the business and give him management authority.
As with a corporation, it is advisable to keep minutes of the meetings held by those making management decisions. While some states do not require annual or other meetings of an LLC, the better practice is to document such meetings on a consistent basis in order to avoid miscommunication, claims of mismanagement, or attempts to assert personal liability. It should be noted that in Germany, where the first LLC format was adopted over one hundred years ago as the GmBH, a failure to prepare annual minutes can lead to piercing of the LLC veil. One can assume that states throughout the United States will adopt such a requirement in the future. (Colorado already has.) The safer practice is to prepare annual minutes for your LLC as you do for your corporation.
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While all fifty states have adopted LLCs, so far only two Canadian provinces—Alberta and Nova Scotia—have provided for them. Investors in Canada frequently use a limited partnership instead of a ULC (Unlimited Liability Company), as LLCs are known in Canada. Canadians also tend to use a U.S. limited partnership when investing in the U.S. as LPs match up better for Canadian taxation.
DISTRIBUTION OF LLC PROFITS AND LOSSES/SPECIAL ALLOCATIONS