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To Incorporate or Not to Incorporate

Written by: Craig Jennings

Article Overview: if that were the only question, this would be a lot simpler. There are several legal structures available for your business. How do you choose the best one?

To Incorporate or Not to Incorporate

if that were the only question, this would be a lot simpler. There are several legal structures available for your business. How do you choose the best one?
For the person planning a startup, this is a big question. For the entrepreneur in business, this is a question which is occasionally worth revisiting.

Note from my attorney who looked over this document: "CJ, I know you want to make this simple and straightforward, but remember, any time you are dealing with legal issues, nothing is simple, clear, straightforward or easy."

Let's have a look at what's available, and the pros and cons for each.

Sole proprietorship. You are the company.
Partnership - both (all) of you are the company.
S Corporation - an incorporation process much used by small business.
C Corporation - The chosen instrument for larger corporations.
LLC - Limited Liability Company - a flexible tool, works well with complex structures.
In this newsletter, we'll have a look at Sole Propetorships and Partnerships, along with their pros and cons. In the next, we'll deal with the balance.

Like so many questions and answers around small business, there's no perfect solution, despite advice you may get to the contrary, usually from people selling a solution!

Sole Proprietorship - Version 1 - Your answer to the question: When Can I Start?
You can go to almost any bank and ask them for a (free) checking account for your new business. Give them your name and social security number. Make a deposit, get some checks, and, one hour later, you're in business! THAT'S IT!

If you buy bricks for a dollar each and sell them for two, you can pay for the bricks out of your new checking account, and deposit the payments, in cash, or in checks made to you, in the same account. When you pay income tax, your income less expenses is the fundamental measure of the success of your business. A net loss may reduce your tax payables.

Features:
You are a sole proprietor.
No formation document is required.
You are personally liable for all debts.
Unless you close it beforehand, the business lives as long as you do, ends when you die. It cannot survive you. (Be careful not to die before you've finished with your Sole Proprietorship!)
Tax goes on your personal return - Income on Schedule C.

Sole Proprietorship, Version 2 - The DBA
A second form of sole proprietorship is one you register with the County Clerk. You can register it under your name or under a new name you thought up. The clerk will search to uncover any naming conflicts - then charge you a fee. In Nassau County, this cost me $39.75 including notarizing costs; in the boroughs of New York City, it runs about $120. You'll hear the term DBA. It means you're Doing Business As - whatever name you chose.

You're protected against someone nearby (same county) opening up a business with your business name.

Pros and cons (for both versions)
Pros: Simple & Flexible, minimal paperwork, just say "I'm open for business!" (Foreign nationals are astounded at how easy it is to start a small business in the U.S.A.)
Cons: You, your assets, your house, your savings account, are totally at risk if your business gets in trouble. All the business obligations are your personal obligations. Since you are your business, you can be sued for what your business does, and if the other guys win, they can get your savings and your house!

Sole Proprietor Summary: A great way to get started - you can test your business concept without a lot of tedious preparation. You can switch from this to another option any time you like. Suggestion: if you're planning a skydiving business, or something else where a lawsuit is possible, you'll probably make that different choice right at the start ! (And some insurance might not be a bad idea…)

Partnership:
A partnership is a multiple proprietorship, and it can be set up as a Multiple Proprietorship, following the steps for Sole Proprietorship Plan B, above. (First version means that one partner has sole control of the money, so second, registered version is probably going to be your choice.) You'll probably ask the bank to honor either partner's signature on the partnership's checking account. Alternatively, you can ask the bank to require both signatures for higher dollar amounts.

Features: You two have agreed to combine your talents, and your capital. It's now up to you both!

You two are the proprietors.
No formation document is required except DBA.
You two are personally liable for all debts.
Unless you close it beforehand, the business lives as long as you two do, ends when one of you dies. Either partner can exit by providing written notice to the other. The partnership cannot survive you both. In the absence of a written agreement, state partnership law governs.
Tax goes on your personal return - Income on Schedule C.

Pros and con - Partnership
Pros: You've agreed to combine your talents and your resources with someone else. You have someone to talk to, to plan with, who'll share your successes and commiserate with your failures. You've created a team. Your record-keeping needs are modest. Income goes to Schedule C, divided by half, of course.
Cons: You and your partner are fully liable for the obligations of the business. This is not a 50-50 deal, it's 100-100 - what the lawyers call "joint and severally liable." If your partner buys a Mercedes with partnership funds, the partnership gets to pay for it, even if he decides to drive to Canada and stay there.

Either partner can withdraw from the partnership by giving the other written notice. Ah, but now how do we divide the assets and liabilities?

BIG PARTNERSHIP RULE! Never enter a partnership without a written agreement which includes strategies for dissolving the partnership!!! Why is this one of the most difficult pieces of advice to take? I think it's because at the outset, you're operating out of the same ego - the business is "ours," and you see that you've just acquired an enormous asset in your partner. The whole agreement concept seems mean and stingy, and both of you are working so smoothly that a dissolution agreement sounds like a pre-nup.


Ah, but behind the traits that you admire in your partner are the traits that make him/her human, and you will discover them later. And he/she will discover your "other" traits, also later! When one ego becomes two, you have new and unsuspected dynamics coming forward.

I've saved the worst news for last. One partner can hold the business hostage and paralyze the business process as long as he/she wants! Or, alternatively, clean out the checking account.

Personal note - I've done this wrong myself more than once. Made the mistake I'm describing above. One ended in bad feelings between myself and someone I respected. A second ended in personal bankruptcy. Not fun, not recommended.
We've reviewed the options you can enter and exit quickly, and cheaply. But in each of them, there's no inherent protection from liability.
It would be great to have our own sky-diving business, but what if a client's chute doesn't open, and we get sued? There are 3 additional structures, all involving incorporation, which have significant set-up costs, significant tax consequences and significant record-keeping consequences, but, if something goes horribly wrong, allow the business to take the fall rather than you.

There's one more legal term you (and I) should know about - a UPL. A UPL is the unauthorized practice of law, giving what might be construed as legal advice! Please note that this is not legal advice; it is intended to promote or spark thought and discussion from a business perspective, possibly to be followed by obtaining legal advice and assistance from a lawyer!

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