Which Legal Format Should You Use?

If you are really serious about building a business to last a lifetime, it needs to be built on a solid foundation, not the shifting sands of life.  In this episode, we begin that journey with the first pillar of your foundation: Why it is important to have a basic understanding of the available legal formats you have to choose from and which is better for each stage of building your business.

Transcript

Episode 5 - The First Pillar 
 

Welcome back. You know, life is full of opportunities. They come at us all the time, and yet most people don't even know it when they see them. And that's because they haven't educated themselves in the ways of the world. And this is particularly in the field of business, because business is not really one of the things that's taught anymore, as I've said before. And so today we're gonna start on that journey. We're gonna discuss the things that you need to know, the things you should ask yourself, and the things that are going to be relevant when those opportunities come across. 

Because Hopefully, if you're listening to this, you're one of those people that wants to be prepared. So let's get started. 

You are listening to the Mastering Business Basics Podcast, where we discuss how to build a solid foundation under your small business to improve your chances of success. And now here is your host, Roger Pearson. 

You know, one of the first things you need to know is legal formats. I mean, we've talked in previous episodes about your whys and what you like and what you don't like, and how to incorporate those. 

We've talked about your skillset and so forth, but the first thing that you really need to know once you decide all those things and decide if you really want to get into business is, you need to know about legal formats. 

Now, there's some basic ones in the United States like sole proprietorships. You got partnerships, you got S corporations, C corporations, LLCs. And most people have heard these terminologies, but they don't really know what they are and the repercussions of which one they choose. 

Now, of course, the most common one and the one that the majority of small businesses in this country actually are formatted under is the sole proprietorship. 

They're very easy, they're inexpensive. You don't have to file with the state, you don't have to file with the federal government. You can use your own social security number if you want, but I'd advise you get an EIN number for your business so you don't have to give out your social security number. 

And, it's a single owner, as it says sole proprietorship, and the owner has the full control of all aspects of the business from the type of work you do, the purchases are made and everything else. There's no separate annual tax return for your business. You just slap it on a Schedule C and add it to your 10 40 and off you go. 

So it's cheaper to actually run as far as the paperwork goes and easier. And you can hire employees the same as any other as your business grows and you can sell or transfer the business assets anytime you wish, if you've grown to that point. 

Now, one of the reasons sole proprietorships are even more important nowadays is because we have the gig economy. Of course, I'm referring to like all the ubers and Instacarts and all of those that are there. There's a lot of different things that can apply to that. All that part-time businesses are generally sole proprietorships because they don't need all the fancy legal structures that help protect taxes and other things. 

The disadvantages of sole proprietorship are the owner is liable for all the debts of the business. So you get yourself into debt, Hey, you're the one that's gotta come up the money to pay them off. This includes things like obligations or acts committed by employees. So you have to be very careful if you're hiring people what you are, because you can become complicit and liable for the things they do. 

The other disadvantage is the self-employment taxes. Now, this legal format and general partnerships pay the highest amount of taxes out of their pockets simply because they're responsible for a hundred percent of the self-employment taxes. And what a lot of people don't realize is that self-employment taxes are 15.3% of your net profit. 

And a lot of people, the first time they come and they do taxes with me, I mean, they're shocked. They're just shocked here. They thought they made some money and all the money get paid back to the government just because they owe between 25, 40% of their income in taxes and in high tax states is even worse. 

It could be up to 50% of your net income is just gonna go for federal and state taxes. It's, it's an incredible amount. So it's a big disadvantage to doing a sole proprietorship when you start making money, 

It's difficult to raise capital. You know, a lot of owners must obtain the loans based on their own credit reports and take the loans out in their own names to fund their business if that's the way they're gonna fund it. So that's kind of a drawback. 

And the other thing is if you should build up a business to where it's fairly profitable, where it's sellable. Then you can't just sell it as a whole. You have to sell each individual part. All your assets, your licenses and everything have to be transferred individually, which can be kind of a messy paperwork nightmare to do. So that's one of the downsides of it, also. 

But the nice thing about that is if you want to test out a business concept, that's probably the best way to do it. You know, before you go to the expense of filing corporate, or partnership returns and all of that, then try out the concept in a sole proprietorship because if it is become successful, you can always change your legal format at any time that it makes sense to your business. 

I don't think a lot of people even realize that. They think they just start out one thing or they go to another. And of course the other biggest problem is that a lot of people just listen to Uncle Joe and his opinion on things, even though he's never run a business in his life. 

They hear things on the internet, which is, well, there's good things on the internet and there's bad, but you should do your own research and not trust anybody on the internet, not even me. And so those are the things you have to consider. 

The second legal format is partnerships. Now, why would you want to even bother with partnerships? You're not going into a partnership. But the thing about it is that, like I said, opportunities come through every day. So what if somebody comes up to you and said, I have this great idea and, uh, I just, I don't have all the talents I need, but you do. I've got the money. I don't have the talent, but I want to go into partnership and let's see if we can do something. 

Well, that sounds great, but do you know the advantages, the disadvantages of partnerships. To get into it properly so you don't end up losing your shirt. And that's why it's important to know those things, even though it's not in your realm of thinking at the moment. You don't know life, what life's going to throw at you. You have to be ready. You have to know at least the general concepts, and this is what I'm trying to get around, the general concepts. 

Now, believe it or not, there are five different types of partnerships depending on what state you live in. All states have what's known as a general partnership. Now, general partnership is when all of the partners actively work the business and they're relatively easy to start. 

I mean, most states you have to go register your partnership. Not all states do require that though. There's no limit on the number of partners you can have. If you need a another skill set for a partnership that you're in, go out and find somebody that's good at it and say, Hey, would you like to join our partnership? 

Or would you like to buy into our partnership? However you wanna structure it. A partnership can be used to hold investments in other businesses even, or consolidate multiple businesses into one legal format. The great thing about partnerships, you'll find that, most law firms and most of the medical firms are all partnerships. 

And that's because it is the most flexible format there is. I mean, for instance, let me give you an example here. Say, one person has the money and the other person has the skills. Well, obviously both are not gonna equally work the business. So maybe the person giving the money needs a little more incentive to let go of that money. So you could set up the partnership to say, alright. The partner that gives the money gets 80% of the profits until such time as he's got his money back. And then after that everything is split 50 50. 

I mean, you can set up whatever way you want in a partnership to make it fair to everybody. That flexibility is why all the legal and medical organizations in this country are usually partnerships. 

The other thing is they're a pass through entity, so the taxes are not paid at the partnership level. They're paid on your personal return. So if your personal rates are lower than somebody else's, that's fine. You're not penalized, because somebody else makes more money from whatever investments and everything they have. You're not penalized for the entire partnership making a lot of money. If you, if you have a lower income, you're gonna be paying taxes on your share of that partnership at a lower tax rate. So that's kind of cool. 

And partnerships also get favorable tax treatment if they're ever liquidated and they have no double taxation like you're gonna find in a C corporation, which we'll talk about in a minute. 

Now, I said there was like five different types of partnerships. I'll get into all those in a minute, but what are some of the downsides of a partnership? Well, they require a separate tax return. Okay. And by default they have unlimited liability for all the partners. Now, what that means, unless it's an LLC, and we'll talk about that too, but they have unlimited liability for all partners, and that means that if one partner defaults on something, all the other partners are responsible for and they can go after whichever partner has the money to pay the bill if the partnership is sued. So that's kind of a downside. So you have to protect yourself against that. There's ways to do that. 

It's difficult to dissolve or change ownership without a lot of planning. So you have to do a lot of planning for that because there's specific rules when it comes to this on how a partner can leave, how the assets are handled, and so forth and so on. It's very complicated and I would really, if you ever get in that situation, get some help doing it. Get somebody professional to do this for you, because it is a difficult thing to do. 

So it also requires a lot more paperwork because you have to track the basis of each partner. Basis is how much skin you have in the game, how much money you've put into the partnership, for instance, or what your share of the partnership is. Now that's a little more complicated. I'm not gonna get into that at the moment. You just have to realize these are the things you have to do if you're gonna look at the cons of being in a partnership. 

Now, the partners pay tax on the income the year it's earned, not when it's distributed to them. So a partnership can earn a hundred and a hundred thousand dollars a year, but only pay you half of that. 

Well, you have to pay the taxes on the entire a hundred thousand, even if you don't receive the entire a hundred thousand. Your partnership may hold back some money for some investments in the next year. Well, that's fine, but it's a pay as you go system when it comes to taxes. You have to pay it all this year, even if you didn't get it this year, you know? 

And then of course, the individual's share, just like a sole proprietor share, you have to pay the 15.3% associated Social Security and Medicare tax on the amount of money that you made. And like the sole proprietorship, it cannot be sold as a whole. All the assets, license, and everything else must be transferred individually. But you should be aware of this. 

The other thing you should really be aware of if you ever go into a partnership is that you need a partnership agreement. Now, I always think of a partnership agreement like a prenuptial. It says exactly, number one, how you're gonna allocate the profits. 

But number two, what's gonna happen if a person leaves, the partnership. You may put a clause in there, okay? Instead of selling it to an outside person, your share of the partnership, you may have to offer it to the other partners first. You put those little clauses in the partnership agreement. 

So it's basically what if the partnership breaks up? How's it gonna be handled? So it's nice and clear and black and white, and nobody can argue about it because I've seen some pretty nasty, nasty arguments when it comes to partners breaking up that don't want to do business together anymore. 

And this has even happened when husband and wives break up and they're both in a partnership. so Even a husband and wife should do a partnership agreement. And just have it there because you never know what life's gonna throw at you. So you need to be prepared, and that's one of the things that you absolutely need to do. 

Can you do a partnership without a partnership agreement? Absolutely. Would it be wise to? Absolutely not. 

The next kind of partnership is called a limited partnership. And this is usually when you find somebody that they want to just put money into the partnership as an investment, but they don't want to do anything about running the partnership. Now, the thing about the limited partnership is that should the partnership go bust and end up paying hundreds of thousands of dollars. 

The limited partner will never be liable for more than the money that they invested in the partnership. That's it. And so that's a good thing for them. I mean, it's not a good thing they lost their money, but they'll never lose more than what they put into the partnership, like the general partners would owe. 

So. The other thing is a lot of the times, uh, to get a limited partner to come and help finance your partnership, you have to guarantee them so much a year. It's called a guaranteed payment, and that has a nice tax structure because the limited partners pay the self-employment tax only on the guaranteed payment part. 

That 15.3% we were talking about earlier. The rest of the profit that they may get from the partnership comes down as investment income, not subject to self-employment. It's just subject to, it's like capital gains . 

The thing about limited partnerships is that it has to at least have one general partner. Somebody's gotta be liable for all this stuff if it has a problem. 

The limited liability status can be lost for a variety of administrative reasons also. There are restrictions on the type of partners that can be limited partners. You have to do a separate tax return. And then you have to also track the basis for the partners, just like you would a general partnership. But the difference between the two is the limited partner can't lose more than he put in, and he's not gonna be liable for more than that. 

Then there are limited liability partnerships like in Delaware. Now, in a limited liability partnership, the partnership's required to register with the Secretary of State and maintain a specified amount of liability insurance, and in return, the partners are relieved of their personal liability for the obligations of the partnership. 

This is not available in all states, so you would've to check whether it is in yours. However, the partners do remain personally liable for their own negligence or misconduct, and if persons under their direct supervision and control. So the limited liability partnership is attractive to professionals who want the benefits of the partnership form, but without the personal liability for the professional misconduct of the other partners and employees. 

So it helps protect you, even though you're a general partner, it protects you from some of the other partners going off the rail and messing things up. So that's something you need to consider if you live in one of the states that offer that. 

So what's the difference between a limited partnership and unlimited liability partnership? Okay, so the limited partnership is the type of partnership that consists of at least one general partner and at least one limited partner, but a limited liability partnership does not have a general partner or a limited partner since every partner in an LLP is given the ability to take part in the management of the company. 

In other states you have something called a limited liability limited partnership. So only about half the states offer the protection under the limited liability limited partnerships. They're basically limited partnerships that have extended limited protections for general partners against other liabilities. 

In an LLLP, no general or limited partners liable for the partnership's obligations, which were created solely by another partner's malfeasance and certain states like Arkansas and Texas use a different name for these entities such as registered limited liability partnerships. 

You have to check whatever state you're in. You need to check what's available for you. So it's just not a matter of going up and shaking hands with somebody and say, Hey, let's do a business together. You need to know what the legal framework you want to do that business under. You want to know how to set up a partnership agreement to accomplish what you want, to make it fair and equitable for everybody and how it's gonna be split up in case the partnership ends. 

These are the things you have to take into consideration. And unfortunately, a lot of people don't because they don't know about these. They just shake hands and go to work and let everything fall as it may, and that's just not a wise thing to do. So going on from that. We have something called an LLC. 

Not a lot of people have heard LLCs, but they don't really understand what LLCs are. LLC is not a corporation. A lot of people think the C at the end stands for corporation. It does. It stands for company. It's limited liability companies, and these are not a federal level designation. They're only valid at the state level. 

I mean, the IRS knows they're out there, but they don't treat them. As a separate entity at the federal level, only at the state level. All 50 states now have limited liability company designations. They're all a little bit different because they're all individually created by individual states. 

There's a broad overview of what they do, but they're handled differently in each state. And if you have a sole proprietorship or you have a partnership, then you need to also get an LLC designation. And this is why. Originally, a sole proprietor or a partnership, if they were sued by somebody, then all the members of the owner of the sole proprietorship or all the members of the partnership were liable for whatever they were being sued for. 

They could come in and they could attach all of your personal assets to satisfy the judgment. And this created a situation where a lot of people were creating corporations, even though they were a small, small business, they were creating corporations just to not have that liability against them. 

So what the state started doing is creating a new format called a limited liability company. And what it does, the only thing it does is it gets limited liability to sole proprietors and partnerships, the same type of limited liability that, for instance, a s corporation would have or a C corporation for that matter. 

So they help protect your assets, so somebody sued the business, it's gonna give you a limited liability. They can attach the assets of the business, but they cannot attach your personal assets. So if you're starting a, a sole proprietorship and you decide, well, it's going to be profitable, so I need to start protecting myself. 

You have to go to your particular state and you have to sign your business up as a limited liability company for that state. And the rules are a little different because limited liabilities, I think it took about 10 years before all the states finally passed the limited liability format for sole providers and partnerships, but by all means, you need to do that. 

It's a very, very simple thing. It's usually you have to pay a yearly fee to the state for it to be registered with the state as an LLC. There's no extra overhead for them like there is for corporations. You don't have to have shareholder meetings or anything like that and the tax structure doesn't change. You do the taxes just like you normally do with a sole proprietorship or a partnership. And of course there's no double taxation like on a C Corp or anything like that. 

So those are really the pros of the LLCs. I mean there's some cons of the LLC. There are very, very few, and they basically are the same as the initial legal format that's underneath it. Because it's just like laying something over the top to help protect your personal assets. 

And that's all it is. It's simple. It's a no brainer if you're a sole proprietorship or a general partnership and you need to be doing this to protect yourself. There's a lot of people that are just sue crazy in this country and you need to protect yourself from those people. 'Cause you never know when they're gonna come around the corner. 

So we've got sole partnership, we got partnerships, we got LLCs to help protect yourself. Let's go to S corporations. S corporations weren't always around. S corporation, a lot of people think it's a separate legal thing. It's not. 

It is a C corporation that does an S election with the IRS. You see all corporations start out at the state level. They're a state entity. You go to your state and you register your corporation as a C corporation. What makes it a S corporation is that you file a form with the federal government saying, I don't wanna be taxed as a C corporation. I wanna be taxed as an S corporation. Well, what does that mean? And, and it's very important because s corporations are one of the few ways that you can shield part of your profits from payroll taxes. And when you think 15.3% of your net profit can just go to that alone, that can be a huge number. 

So why not protect yourself? What happens is that a C corporation, they pay the taxes themselves. They pay taxes at eh corporate level, the shareholders don't pay the taxes. On an S corporation, the profits are passed down to your personal return on a form called a K one. And you pay the taxes on your share of the profits of the S corporation on your personal return, the corporation doesn't pay them. . 

This is very advantageous in that in many cases, the tax rates on your personal return are going to be less than they are at the corporate level. This was particularly true, like 15, 20 years ago. I mean, the corporate tax rates were like up to, I believe 39%, but if you brought that profit down to your personal return, you could pay maybe 12% on the taxes. 

So it would really save you a lot of money and a lot of people were signing up for S Corporation because of the liability number one, but of the tax savings, number two, and that's still true today. The bad part about that is there's a lot of extra paperwork there. You have to file as corporation tax return with the IRS and for many of the states . 

Again, you have to get into state regulations on all of this stuff, but you need to know the law . The reason why you should have one or another is just what I'm trying to get here. So, the nice thing about the S corporations, it gives you that limited liability protection, the same as you would with a C corporation. 

You don't have double taxation on profits like you do with a C corporation. We'll get into that and the ownership is easily transferred. You just sell your stock in the corporation and take your money and go just like you would buy and sell on the stock market. 

It is a totally separate entity from the shareholders, and the self-employment tax is not assessed on the entire profit of the business. The way that works is basically, if you're a profitable S corporation, you're expected to be a W2 employee of that corporation. Which means if you're making, I'd say if you're making 40, $50,000 or more in, in profits, you have to be W2ing yourself. 

I don't care if it's just a thousand dollars a month. The IRS as a basic rule says you should be paying yourself between 40 and 60% of the net profit of the business in salary. That's what they're looking for. Now, why would they look for that? Because you have your social security and your Medicare payments taken out of your W2 just to see if you were working for somebody else. 

So you got money going into your Social security and Medicare accounts and the rest of the profit outside of that, W2 comes down in the K one as investment, not subject to that 15.3% payroll tax. Well, that can make a huge difference. If you're making a quarter million dollars a year in your business. Even a hundred thousand dollars a year profit in your business, it can make a huge difference. 

And so that's why you wanna do this. But if you don't pay your self W2 and you bring the entire profit down on a K one, not subject to the taxes, well, the IRS considers that evasion of payroll taxes, and they can come in and they can recalculate and say, this is how much you should have paid yourself in W2, and here's the bill for all Social security and Medicare you didn't pay yourself. And that can be quite a surprise, and you don't want that to happen to you. 

So you have these extra layer of rules and regulations when it comes to S corporations because they put some restrictions on it because it is such a favorable tax situation that you can do. 

They put regulations. You can't have any foreign partners. You can't have more than a hundred shareholders. You're gonna have do, a board meeting, a shareholder meeting at least once a year. You know, write minutes, the whole thing, just like a C corporation would. So there's a bunch of little rules there. 

And you have to be careful you don't violate any of those rules for S corporation or the government can come in and they can dissolve it for you and hand you a bill saying, oh, I'm sorry, they take the S corporation away and then you're a C corporation and you have a whole another set of roles that you gotta abide by. 

So you have to be careful, but. The S corporation is probably one of the last havens that really can protect a lot of your money from excess taxation, and that's why it's so, so popular with so many people. 

Plus now there are some states that require certain trades to be at least an corporation or an S corporation, I think here in Florida, if you're a painter or electrician, plumber or whatever, you have to be in a corporate structure, because of liability issues and you should be anyway, but , certain states actually require that. 

So you have to concern yourself with those little things too. You really have to educate yourself on legal formats and the requirements in your state for each of those. And there's just no way I can go over all of 'em here in a brief moment. Uh, but those are things you need to take into consideration. I just wanna let you know why you need to take them into consideration. 

I'm not here to teach you all the complexity of each. That would take hours and hours and hours and hours and hours 'cause it's taken me decades to learn it. 

So let's go on to C corporations. They can be privately owned or they can be publicly owned. Of course, we see them on the stock exchanges, but there's plenty of privately owned corporations c corporations in the country also. 

This is the format I have. Of course, I started my business in 19 94 and I went into C corporation because then there wasn't a lot of advantages in s corporations that there are nowadays. For instance, you were way limited on benefits. 

Nowadays they've increased the benefits that s corporations can give to their stockholders too, where it's almost on par with C corporations now. So nowadays, if I had to do it over, I would probably do an S-corporation and I could change it into an S Corporation at any time. 

But if part of your tax structure or part of your planning in the future is to be able to, for instance, sell your corporation in one unit, or if part of your plans for the future is to be on the stock exchange, you want to be a C corporation. If one of your plans is to start this revolutionary new business and go it up to the point where somebody comes and buys it from you, then you probably wanna be a C corporation. 

You not only have to know what you want now, but you should be taking a look at what you wanna do in the future when you're looking at these legal formats. Also, the thing about the C corporation is that you can, as you're starting out, you can form the C corporation with the state and then you can file the S election for a better tax situation with the IRS until such time as you wanna sell your business. 

And then all you do is go to the IRS says, okay, I wanna revoke my S corporation and I wanna go back to a C corporation. Fine. Then you can sell it. You can list it on the stock exchange. You can do whatever you want. 

As a single entity, you sell it as a single entity. Instead of piecemeal, like all the other legal formats. So you have to look out there. Okay, is that where I want to head? Alright, that's where I want to head. All right. I form my corporation. I do an S election for now. Until such time, I'm ready to sell it and walk away with a profit or make it public, whatever your plans may be, revoke this election, and then off you go to the races and hopefully you fill your pockets with a lot of money for all the work that you just did. 

These are the things you need to know, not only for today, but planning for tomorrow. And this is one of the reasons legal formats are so important, but most people do not pay attention to them whatsoever. So the other downfall though, of a C corporation and why very few people do it when they're still small, unless that's part of their planning is that there's a double taxation of profits because when you pay out dividends from the corporation, just like if you owed stock in IBM or anything else, they pay you dividends, which is part of the profit. 

That's how they pay you in dividends. Well, the company, the C corporation, has to pay tax on those dividends, and when you receive them from the company, you also have to pay tax. So it's called double taxation. So this is only legal format that has double taxation on part of its profits. And that can be a big drawback. You have to take that into consideration Also. 

They're more complex and expensive to create and maintain. Of course, they require the separate tax return. Now while there's no foolproof way for me to help you choose which legal format's best for you, learning the basics of all the legal formats like I've been talking, should give you a pretty good idea what direction would be best for you. 

So you should remember that your initial business format doesn't have to stay the same throughout the life of your business. You may wanna start with sole proprietorship to see if your business model is going to make you money and move on to a partnership or corporation if the business takes off. So if you decide to start your own business as a sole proprietor, then as I said, I advise you to form a single member limited liability company. 

A single member is a sole proprietorship, a multi-member is a partnership, okay? Because as I said, the IRS doesn't recognize LLCs, so they'll tax a single member LLC as a sole proprietorship and they'll tax a multi-member LLC as a partnership. So really the small costs and the minimal of time involved in forming an LLC is really well worth the protection. 

And if you want to shelter part of your profits from payroll taxes, create an S corporation. Now there's additional cost and paperwork requirements, but the amount of taxes that you save by doing it really would pay for the extra cost. It really would. And you could save a lot of money. So that is the basics of all the legal formats. 

And I could go on and on and on about all the little things, but, that's one of the reasons I wrote the book so I could give a more, better, longer explanation of all these different things that you need to take into consideration as you go on your business journey from small to large. 

And I hope you're gonna be successful. I hope that, okay, I'll start as a sole proprietorship and I'll end up selling it for a billion dollars and, and walk away and with my retirement money and that'd be great. Does that happen? Yes. We hear about it once in a while. It probably happens more often than we know, and it takes a lot of work to get to that point. 

But if you know how all the pieces fit together, you're going to get there faster. And you're gonna get there safer, and you're gonna make more money in the process and it's gonna take less stress out of your business journey. So I hope you take all of these into consideration. Next time when we get together, we're gonna talk about the second pillar, and that's taxes. 

And that is probably for most people, the biggest line item expense of their entire business. So you need to know how to handle those, how to watch for it, and it should be an interesting discussion. So for now, I thank you for listening in and we'll see you again . 

You have been listening to the Mastering Business Basics Podcast with your host, Roger Pearson. For more information about all of the business education options that are available, we invite you to visit seagull technologies.com and continue your journey.