Choosing a Legal Structure for your Veteran-Owned Business with Wes O’Donnell

Words by Wes O’Donnell.  Wes is a “serial entrepreneur” that has successfully started 3 veteran-owned companies.

“Timing, perseverance, and ten years of trying will eventually make you look like an overnight success.” —Biz Stone, Twitter co-founder

Step one of opening your veteran-owned business is choosing which legal structure to use for your company.  Let’s look at the differences between the three primary choices and you can see which one is the best fit for your future goals.  A lot of people are confused about the differences between business structures…  I was in the infantry and I like things simple, direct and to the point so that’s the way I like to explain things to other people; I’ll be as concise as possible for these definitions.

Sole Proprietorship

The sole proprietor is an unincorporated business with one owner who pays personal income tax on profits from the business. With almost no government regulation, they are the simplest business to start up or close down, making them popular among individual self-contractors or business owners.

Many sole proprietors do business under their own names because creating a separate business or trade name isn’t necessary.

There is no separate legal entity created by a sole proprietorship, unlike corporations and limited partnerships.  Consequently, the sole proprietor is not safe from liabilities incurred by the entity.  The debts of the sole proprietorship are also the debts of the owner.  Now this bit is crucial:  If your business has unpaid debts or gets sued, your personal property assets like your house, car, personal bank account are NOT protected, meaning that you could lose everything if something suitably catastrophic happens with your business.  It’s for this reason that I cannot recommend starting your company as a sole proprietorship.

 

The advantages of a sole proprietorship include:

• Owners can establish a sole proprietorship instantly, easily and inexpensively.
• Sole proprietorships carry little, if any, ongoing formalities.
• Owners may freely mix business or personal assets.  Your normal annual personal tax return will reflect             both you and profits or losses from your business

 

The disadvantages of a sole proprietorship include:

• Owners are subject to unlimited personal liability for the debts, losses and liabilities of the business.
• Owners cannot raise capital by selling an interest in the business.  (Conversely, an LLC or Corporation could sell stock, shares or interest in the company to raise money from investors)
• Sole proprietorships rarely survive the death or incapacity of their owners and so do not retain value.

 

If you’re a freelancer doing, for instance, writing or photography for money and you have NOT filed any paperwork to become an LLC or a corporation, then you’re already a Sole-Proprietor.  I don’t recommend running your business as a Sole-Proprietor.

A note on Legal Zoom:  I have used Legal Zoom on numerous occasions from opening all three of my companies to registering a DBA (Doing Business As) name to filing a trademark application.  I absolutely endorse them here for start-ups (and it should be noted that they are NOT paying me for that endorsement) because my dealings with them have been accurate, pain-free and most importantly, cost-effective.  Even my business lawyer that I hired stated that he can’t compete with Legal Zoom on price; they’re just too good at routine business stuff.  Having said that, if you need to litigate against someone infringing on your patent or trademark/ brand or any legal matter with any depth to it, you’ll want to find a dedicated business lawyer.

 

Limited Liability Company

A Limited Liability Company (LLC) is a hybrid business entity having certain characteristics of both a corporation and a partnership or sole proprietorship (depending on how many owners there are, more on single owner LLCs later). An LLC, although a business entity, is a type of unincorporated association and is not a corporation. The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass-through income taxation. It is often more flexible than a corporation, and it is well-suited for companies with a single owner.

  

Limited Personal Liability

Unlike a sole proprietorship, your personal assets are safe in the event of a catastrophic business failure.  For example, say I were to receive an investment of $100,000 from an angel investor granting him 20% equity stake in my company for 5 years, meaning that he gets 20% of my profits every year for 5 years for his investment.  If the company goes bankrupt, the investor or anyone else for that matter cannot come after my personal assets like my house or my car for LLC debts that were incurred because of the failure of the business.

LLC Taxation

If there is only one member in the company, the LLC is treated as a “disregarded entity” for tax purposes, and an individual owner would report the LLC’s income or loss on Schedule C of his or her individual tax return. Thus, income from the LLC is taxed at the individual tax rates.  If the owner is an individual, the activities of the LLC will generally be reflected on:

• Form 1040 Schedule C, Profit or Loss from Business (Sole Proprietorship)
• Form 1040 Schedule E, Supplemental Income or Loss
• Form 1040 Schedule F, Profit or Loss from Farming

An individual owner of a single-member LLC that operates a trade or business is subject to the tax on net earnings from self-employment in the same manner as a sole proprietorship.

For federal income tax purposes, a single-member LLC classified as a disregarded entity generally must use the owner’s social security number (SSN) or EIN for all information returns and reporting related to income tax.

So what’s an EIN and where do I get one?

Even though single-member LLCs are allowed to use their SSN to identify themselves to the IRS for tax purposes, it’s still a good idea to get an Employer Identification Number or EIN.  An EIN is basically a SSN for your company.  When MD-Advantages was still a single-member LLC, I was asked for my EIN from other companies that wanted to do business with me as well as the government when I was going through the process of getting certified as a Service Disabled Veteran Owned Small Business.  It’s extraordinarily easy to get one and costs nothing.  Go here to get one:  http://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/Apply-for-an-Employer-Identification-Number-(EIN)-Online

So let’s get “Official” here

I officially recommend using an LLC for your business purposes whether online or off.  It will provide you with all the legal protection that you need, it scales up easily when your company starts to grow and the tax law with its “pass-through taxation” is very simple.

Forming an LLC

While each state has slight variations to forming an LLC, they all adhere to some general principles:

Choose a Business Name

There are 3 rules that your LLC name needs to follow:

·         it must be different from an existing LLC in your state

·         it must indicate that it’s an LLC (such as “LLC” or Limited Company”)

·         it must not include words restricted by your state (such as “bank” and “insurance”). Your business name is automatically registered with your state when you register your business, so you do not have to go through a separate process

File the Articles of Organization

The “articles of organization” is a simple document that legitimizes your LLC and includes information like your business name, address, and the names of its members. For most states, you file with the Secretary of State.  However, other states may require that you file with a different office such as the State Corporation Commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or the Division of Corporations & Commercial Code. Note: there may be an associated filing fee.

 

Create an Operating Agreement

Most states do not require operating agreements. However, an operating agreement is highly recommended for multi-member LLCs because it structures your LLC’s finances and organization, and provides rules and regulations for smooth operation. The operating agreement usually includes percentage of interests, allocation of profits and losses, member’s rights and responsibilities and other provisions.

Obtain Licenses and Permits

Once your business is registered, you must obtain business licenses and permits.  Regulations vary by industry, state and locality. We’ll go over Federal, State and Local Start-Up Requirements for business licenses in a future post.

Announce Your Business

Some states, including Arizona and New York, require the extra step of publishing a statement in your local newspaper about your LLC formation. Check with your state’s business filing office for requirements in your area.

Cost

This is the part where I recommend Legal Zoom to do the heavy lifting of the LLC creation.

Legal Zoom charges $99 plus your state’s filing fee.

But there are a couple of things to watch out for:

1. The process takes approximately 8 weeks, but this is normal no matter who you use.
2. Legal Zoom will try and talk you into using one of their “Registered Agents” (Required) for your business.  A registered agent accepts “service of process” documents such as subpoenas or complaints.  They often also receive state tax notices.  They will also assist you with serving these types of legal documents on other people or businesses.  They want $159/ year.  Your choice if you just want them to handle the headache, but you can nominate your own registered agent.
3. If you elect to try Legal Zoom’s Free 30-day trial of Business Advantage Pro, a service that gives you access to lawyers at a discount and some other minor, arbitrary legal services, then when your 30-day trial expires they will charge you $29.99 every month thereafter.  I didn’t read the fine print and one day, while looking at my expenses, I realized that this was coming out and cancelled the service.  I lost $60 by letting this go for two months.  Recommend you opt-out.

Here’s a list of the state filing fees for LLC creation as of 2015:

Alabama              $177	Alaska                 $250	Arizona                 $85
Arkansas               $45	California              $85	Colorado               $50
Connecticut         $275	Delaware             $140	D.C.                     $220
Florida                 $155	Georgia               $100	Hawaii                   $50
Idaho                   $100	Illinois                 $612	Indiana                  $87
Iowa                      $50	Kansas                 $165	Kentucky               $40
Louisiana            $100	Maine                  $175	Maryland             $197
Massachusetts     $520	Michigan               $50	Minnesota           $180
Mississippi            $50	Missouri                $50	Montana                $70
Nebraska             $105	Nevada                  $75	New Mexico       $150
New Hampshire  $100	New Jersey          $175	North Dakota      $135
New York           $210	North Carolina    $125	Oregon                $100
Ohio                    $125	Oklahoma           $100	South Carolina    $110
Pennsylvania       $125	Rhode Island       $156	Texas                   $301
South Dakota      $150	Tennessee           $300	Virginia               $100
Utah                      $76	Vermont              $100	Wisconsin           $130
Washington         $230	West Virginia      $115
Wyoming            $100

 

Go here for current Legal Zoom pricing as well as current state filing fees:  http://www.legalzoom.com/limited-liability-company/limited-liability-company-pricing.html

 

S-Corporation

While I don’t recommend starting a company as an S-Corp, as an entrepreneur you should plan for growth.  So let’s do a fly-by:

An S corp is a corporation with the Subchapter S designation from the IRS.  To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered.  According to the IRS, S corporations are “considered by law to be a unique entity, separate and apart from those who own it.”  This limits the financial liability for which you (the owner, or “shareholder”) are responsible. Nevertheless, liability protection is limited – S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident.

What makes the S corp different from a traditional corporation (C corp) is that profits and losses can pass through to the your personal tax return. Consequently, the business is not taxed itself.  Only the shareholders are taxed.  There is an important caveat, however: any shareholder who works for the company must pay him or herself “reasonable compensation.”  Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as “wages.”

But just so that we do our due dilligence:

 

Advantages of an S Corporation According to SBA.gov

• Tax Savings. One of the best features of the S Corp is the tax savings for you and your business.  While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax.  The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.
• Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses.  Nevertheless, if such an employee owns 2% or more shares, then benefits like health and life insurance are deemed taxable income.
• Independent Life.  An S corp designation also allows a business to have an independent life, separate from its shareholders.  If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed.  Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.

Disadvantages of an S Corporation According to SBA.gov

• Stricter Operational Processes.  As a separate structure, S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.
• Shareholder Compensation Requirements.  A shareholder must receive reasonable compensation.  The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages.  You could pay a higher employment tax because of an audit with these results.