Consider Taxation, Liability in Structure Choice

Two men sat before Debra Esparza, director of USC’s Business Expansion Network.

“My business is a sole proprietorship,” one man began. “I’m the owner and he’s my partner.”

The statement revealed he needed basic knowledge about business structure. A sole proprietorship is a single-owner business that, by definition, can’t have a partner.

“It happens frequently,” Esparza said. “Someone doesn’t really know what kind of business structure they have.”

Choosing a structure for your business means taking into account whether you will operate it alone, with partners or with stockholders who own a part of the business. Each structure operates differently, with different registration requirements and different liability and tax considerations.

Because of the complexity of the rules involved, Esparza recommends consulting an attorney when creating most of the business types below:

* Sole proprietorship. In this setup, one person is the sole owner and has 100% liability and responsibility for the company.

“You and the business are the same,” Esparza said.

That doesn’t mean the company operates with only one person, she added. About half of all sole proprietors have employees, usually fewer than 10.

The owner, however, is the only one in the business entitled to its profit or loss, which is reported on the owner’s personal income tax form. Because the company does not exist as a separate entity, liability flows straight to the owner and his or her personal possessions, such as cars and homes, which can be demanded to pay business debts.

“Though it sounds scary, it’s the cheapest form of a business to start; most start-ups are sole proprietorships,” Esparza said.

Starting a sole proprietorship typically takes only the filing of a city business license. No attorney is needed to draw up legal papers.

In a sole proprietorship, an owner cannot give away equity (part of the business) to attract investors. An investor putting money into a sole proprietorship does not receive part of the business, only a return on his or her money.

Disputes arise when one or both parties misunderstand, Esparza said. A sole proprietor whose company flops may tell an investor the money has been lost along with the business. But in reality, the owner still bears responsibility to pay the investor back. Similarly, investors who put money into a company that triples in value won’t receive three times their money back, only their money plus a little interest.

* General partnership. A general partnership creates a separate entity--the partnership--owned by two or more people. The division of ownership can be divided in any proportion, not just 50-50, Esparza said.

Business profits and losses are reported on an information-only partnership tax return. But taxes are paid by the partners, who report as personal income their share of the profits or losses based on their share of ownership. Partners are liable personally for the business, just as in a sole proprietorship, but the extent of their liability is in proportion to their ownership.

Each partner needn’t put in equal amounts of money toward the business. One person’s share can be expertise and another’s start-up money. But the arrangement should be put in writing, and is usually done so with the help of an attorney.

“When times are stressful, and they always are in a small business, you need to have a written document spelling out each individual’s responsibilities, liabilities and what happens when one or the other dies,” Esparza said.

To save time and money, Esparza suggests that before seeing an attorney, the partners outline their basic agreement on an inexpensive partnership form available at stationery stores. A tax consultant also should help set up the partnership, she said.

* Limited partnership. A limited partnership has investors who own part of the business but who are prohibited from managing the company. The limited partners elect or appoint a general partner who operates the company.

In limited partnerships, personal assets of partners are exempt from liability. They can lose only as much as they invest. Usually, assuming the business is successful, their biggest profit will come when they sell their part of the business.

In California, a business organized as a limited partnership files an LP-1 form with the secretary of state and pays a $70 fee. If partnerships in the business are sold, more state fees are assessed by the Department of Corporations.

* Limited liability company. This relatively new form of organization allows investors or owners to take part in running the company. Investors report the business income and losses as part of their personal income, as in a general partnership, but they are not liable for the company debts and other legal obligations, as in a corporation.

Individuals engaged in businesses that require a professional license, such as a physician or real estate agent, are prohibited from forming as LLCs. Businesses file articles of organization with the secretary of state and pay a $70 fee.

* Limited liability partnership. These partnerships can be used by a specific group of professionals--attorneys and accountants. Each individual partner is liable for harm resulting from his or her own acts but not for the acts of the other partners. Businesses file articles of organization with the secretary of state and pay a $70 fee.

* S-corporation. S-corporations combine aspects of a full-fledged corporation with the tax benefits of a partnership. The corporation pays no taxes of its own. Instead, business profits and losses flow to the shareholders, who report them as capital gains or losses on their tax returns, and are taxed accordingly. Creation of an S-corporation, like creation of a C-corporation, allows a company owner to receive money in return for part of the business. Up to 75 investors are permitted to own one class of stock.

A management team makes day-to-day decisions, but the shareholders are the actual owners. A board of directors often oversees operations, giving approval to management team decisions and directing them as needed.

In California, S-corporations, like C-corporations, file articles of incorporation with the secretary of state. Business owners have 2 1/2 months after filing to file Internal Revenue Service Form 2553, which creates the S-corporation tax designation, said Phil Holthouse, a partner at Holthouse, Carlin & Van Trigt, a Los Angeles accounting firm.

* C-corporation. C-Corporations are separate entities with legal and financial responsibilities separate from those of the owners or shareholders. Owners or shareholders are exempt from legal responsibility for the debts and obligations of the corporation, unless they decide to personally guarantee financial or other arrangements.

The concept of “double taxation” applies to C-corporations because the business is taxed on its net profits, which then flow to the shareholders as dividends. The dividends are reported as personal income and taxed again.

The number of investors (shareholders) in a corporation is unlimited, and several classes of stock can be sold.

Filing articles of incorporation with the secretary of state creates a C-corporation. A $900 fee is usually required: $100 to the secretary of state for the initial filing fee, and $800 to the state Franchise Tax Board as a corporation tax prepayment. After that, an annual $10 filing fee is required to update the list of corporate officers.

Businesses can incorporate in other states. For example, companies often incorporate in Delaware because of tax advantages and corporation laws that favor management, Holthouse said.

But businesses incorporated in other states still must file a notice with the California secretary of state and follow the same state rules, and reporting, tax and operating procedures.

Exercise: Based on the details outlined above, talk to an advisor or consult a start-up guide to determine your business structure. To help, The Times has fashioned an online grid at https://latimes.com/smallbiz

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The USC Business Expansion Network is at 3375 S. Hoover Blvd., Suite A, Los Angeles. The phone number is (213) 743-1726.

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The Bottom Line

“Entrepreneurship 101” is a tutorial on how to choose, start, finance, plan and grow a business. The program, written by Times staff writer Vicki Torres, was developed by Debra Esparza, director of the USC Business Expansion Network, a community and economic development project. USC’s BEN has counseled more than 5,000 small-business owners in the Los Angeles area in the last six years, helping them with financing, business planning, accounting, marketing and other issues. The tutorial can also be found on The Times’ Small Business Web site at https://www.latimes.com/smallbiz

Entrepreneurship 101

Chapter 2: HOW TO START A BUSINESS

* Define the Business Concept

* Name the Business

* Deal With Red Tape

* Decide on a Business Structure

* Determine Start-Up Costs