SEELEY LEGAL SERVICES P.A., 3416 University Ave SE, Suite 200, Minneapolis, MN 55414 (612) 379-2440 seeleylegal@hotmail.com

COMMON LEGAL ISSUES FACING PARENTS WITH MINOR CHILDREN AND BUSINESS PERSONS by William Seeley, Attorney

II.   HOW TO START UP A NEW BUSINESS:  There are two common ways you can start up a new business:

1.  Sole proprietorship:   For example, if you wanted to start a business out of your home creating and servicing web sites, you can do it without registering with either the local, state or federal government.  For tax purposes, you would use Schedule C on the Federal Income Tax returns to itemize your expenses and revenues, thus showing your taxable net profits.  Any net income to yourself would be treated as taxable wages, for which you would have to pay estimated federal and state withholding taxes every quarter along with 15.3% social security/Medicare tax (known as “FICA”).  When you prepared your taxes you would get half of your FICA taxes back as a tax credit.

Deductible business expenses would include such items as your computer (providing that you used it exclusively for business purposes); marketing expenses; travel expenses to/from customer work sites; postage; business publications; supplies and even the percentage of your home rent or expenses for a home that you own that is EXCLUSIVELY USED FOR OPERATING YOUR BUSINESS.  If you were audited by the IRS and the Agent asked you:  “In the room you use for your business, do you ever read Chinese newspapers and novels when relaxing during the day?”  If you said, “Oh, sure, it’s a quiet room and I need to get away from the TV and my screaming kids, so I read novels and listen to soft music every evening.”  Guess what:  The IRS would disallow the 15% of total living space that you claimed as a deduction.  On the other hand, if you rent an office outside of your home, the IRS would rarely question your rent expense, even if you did play computer games and read novels for a few hours a day at your office. 

In my opinion the biggest risk of a sole proprietorship that liability for faulty work that you do for others.  Supposing that Poland Spring pays you $5,000 in advance to create a web site to promote its new apple scented water.  You sign a contract with Poland Spring in which you promise complete and set up a functioning interactive web site within 30 days of signing contract.  The contract includes the following clause:

“The parties agree that this is a time of the essence contract.  If Creative Web Designers (the name of your business) fails the complete the contract on time it agrees to pay Poland Spring $50,000 in liquidated damages.” 

Due to your other work and family commitments, it takes you 60 days to get the web site up and running.  Meanwhile your customer’s competitor launches a similar new product 31 days after you sign the contract.  Poland Spring sends you a demand letter asking you to pay them $50,000.  Even if your business only has $5,000 cash on hand, Poland Spring can get a judgment against you personally and collect any personal assets that you own. 

2.  Incorporate as C corporation, S corporation or Limited Liability Co. (LLC)      

Has you paid an attorney to incorporate your business, once of the benefits it that only assets owned by the corporation can be attached by creditors.  Thus in the example above, if the corporation only had $5,000 in cash on hand, and computer equipment and office supplies worth another $2,000, that all the judgment creditor (see example above) could get.  Of course, a judgment is good for 10 years.  Thus if the corporation earned more in subsequent years, the creditor could attach those assets.  But if your small business had a judgment against it for $50,000, the owner would probably pay off other suppliers and pay themselves a bonus and then pay any remaining funds to an attorney to dissolve the corporation.   You could start up a new corporation and go back into business again. 

BUT TO GET THE LIMITED LIABILITY PROTECTION OF CORPORATION, YOU MUST OPERATE AS A CORPORATION.  By this I mean that you should: 

·        Hire an attorney to prepare and file your Articles of Incorporation with the Secretary of State in the state where you want to operate;

·        Pay for your attorney to prepare By Laws, Minutes of your First Meeting and Share certificates (for C and S Corporation).

·        Open a corporate bank account;

·        Also sign contracts as the officer of the corporation.  Thus in the example above with the Poland Springs web design contract, if you simply signed the contract as Xiao Liu, even though you have a corporation, you have signed the contract in your individual capacity – not as an officer of the corporation.  You should sign it as:     Xiao Liu, President (or other title) of  Creative Web Designers, Inc. 

·        When the corporation takes major actions, such as leasing business space, entering into significant contracts or selling corporate assets, you should always hire your business attorney to draft minutes of the Board of Directors of the corporation approving this action. 

BASIC DIFFERENCES BETWEEN C CORP, S CORP AND LLC: 

C CORPORATION: 

1. You can have as many shareholders as you want. 
2. The corporation can issue different types of stock, such as preferred, common, voting and non-voting stock.
3. Shareholders can be U.S. citizens, foreign residents and other corporations.
4. Excess income is paid to shareholders in the form of dividends, which is taxable income at both the federal and state level.
5. The corporation pays tax on its net income.
6. The corporation can pay the entire cost of health insurance for all officers and employees, which is a tax deductible expense.
7. The corporation is perpetual – no time limit on its existence.

S CORPORATION:

1. You can only have up to 75 shareholders.
2. Can only issue one type of stock (but can have different voting rights within that class).
3. All shareholders must be U.S. citizens or residents.  (Other corporations cannot be shareholders.)
4. The income of the corporation is taxed as a partnership; e.g., all net income at the end of its tax year is taxed to each of its shareholders in proportion to their percent of ownership in the corporation.  Thus if the corporation has net income of $100,000 and you are a 10% owner, you will get a K-1 statement showing that you have earned $10,000 in taxable income – even if the corporation does not pay out all of the net income to its shareholders.
5. The corporation files a tax return, but in Minnesota is only subject to a $100 tax.
6. The corporation can pay its employees in BOTH WAGES AND BONUSES.  The BONUS income is not subject to FICA tax.  Thus you can save 7.65% of any bonus income, compared with a C Corporation or LLC.  The WAGE income is subject to federal and state withholding.
7. The corporation can pay the entire cost of health insurance for all officers and employees, but only payments to employees of 2% or less of the corporate issued and outstanding stock is fully a tax deductible expense; for employees owning more than 2% of the corporate stock, only 50% of the health insurance expense is a deductible corporate expense.
8. The corporation MUST assess net income in proportion to the % of ownership of each shareholder.
9. The corporation is perpetual – no time limit on its existence.
10. If the corporation goes broke and out of business, you can deduct your basis in paying for its stock as an ORDINARY INCOME LOSS (Whereas in a C corporation your loss must be used to offset a capital gain; however an unused loss can be carried over to future tax years.)

LIMITED LIABILITY COMPANY (LLC):

1. You can have an unlimited number of MEMBERS.  Members are not issued stock, but rather the Minutes of the corporation show that members own a certain number of UNITS in the corporation.  The corporation can issue UNIT certificates, but it doesn’t have to.  Actually a privately owned C or S corporation is not required to issue share certificates, but it is good corporate policy to do so.

2. The corporation can issue different types of stock, such as preferred, common, voting and non-voting stock.
3. Shareholders can be U.S. citizens, foreign residents and other corporations.
4. The income of the corporation is taxed as a partnership; e.g., all net income at the end of its tax year is taxed to each of its shareholders on the basis of the year-end or other bonuses distributed to members by the BOARD OF GOVERNERS OR UNIT MEMBERS.  Note:  This is a difference between the LLC and S Corp, because an S corporation MUST report year end taxable net income to its members in proportion to their percent of ownership in the corporation, which is reported to them and the IRS on K-1 forms.  This allows the LLC to allocate a larger bonus to officers or employees who may have a small amount of ownership of corporate UNITS, but who may spend more time on the affairs of the corporation, or make a more important contribution to the success of a corporation.  
5. The corporation can pay its employees in BOTH WAGES AND BONUSES.  However in an LLC 100% of the BONUS income is subject to FICA tax, but the UNIT HOLDER can get a 7.65% (or 50% credit on the 15.3% paid by the corporation) when they file their individual tax returns.  This is a significant tax advantage that the S corporation has that the LLC does not have under current federal tax law.   For example, if you were a 50% owner of an S Corporation and earned $50,000 in wages and were paid $50,000 in bonus income, you would save 15.3% of $50,000 BONUS INCOME, or $7,650 in social security and Medicare taxes that you DO NOT HAVE TO PAY.  But if you got a $50,000 bonus in an LLC, after completing your taxes you would only get a savings of $3,825, or half of the bonus income that is not subject to  social security and Medicare taxes.    
6. Duration of the LLC is perpetual.   

SUMMARY OF DIFFERENT INCORPORATION CHOICES: 

Which type of corporation (C corp., S corp. or LLC) is the best choice for your business, depends of the financial situation of your investors, whether they are American citizens or residents; whether they are domestic or foreign corporations; and how many investors you want.  If you are starting a husband/wife corporation, usually an S corporation is the best choice, unless you want the corporation to pay for your health insurance expenses, which are only fully deductible in a C corporation.  But remember, one of the big tax advantages of an S corporation is that you will save 15.3% of ALL BONUS INCOME.  There is no IRS formula for the percentage of net income that is to be paid in wages or bonuses in an S corporation.  The tax code merely states that you should be paid a “reasonable wage” for the type of work/services that you perform.  Thus if you were a private airplane pilot, if you paid yourself $30,000 in wages and $200,000 in bonuses, the IRS would probably object.  (Also remember that only up to your first $90,000 in wages is subject to social security tax, but all of your wages is subject to Medicare tax.)  But if your business were a home based web design company with no employees, if you paid yourself $30,000 in wages and $60,000 in bonuses, the IRS might not object.  The best rule of thumb is the 50/50 FORMULA.  Pay yourself 50% in wages and 50% in bonuses.

If you want foreign investors, then you should either be a C corporation or LLC.

If you want a corporation that can pay large bonuses to a manager who has little money to invest, but who is willing to contribute large amounts of time and skill to the success of the corporation, then the LLC is probably the best choice. 

There are competing factors, and you have to consider the pros and cons of each.     We have not discussed non-profit corporations, partnerships and limited partnerships, which are other ways to organize a business, but there is not enough time to discuss these types of organizations in this presentation.  

FOR A COMPLETE COPY OF THIS PRESENTATION:

click the link Estate and Business Planning   

(Copyright William S. Seeley 2006)

Copyright 2003-2006 Seeley Legal Services, P.A.

Web Site Designed by VB Solutions, Inc.