The Dilemma of Choosing a Business Organization – Part II

You remember our friends, John Green and Mary Jones. They are opening up a new coffee shop, “Coffee Haus.” They’ve asked my advice about what form of business
organization or entity they should be.

In the previous column, we eliminated sole proprietorship as an option. If John and Mary do nothing, they are, by default, a general partnership. This means that they are
each personally liable for the debts and obligations of the partnership.

They do not like the exposure. They saw what happened to MacDonald’s when the woman spilled scalding coffee in her lap. It cost the company millions of dollars in
judgment and attorneys fees. They’ve also heard of grocery stores and other coffee places being sued when patrons slipped and fell as a result of spilled drinks. Also, while they
can sign the lease for their store in the company’s name, as a general partnership they remain personally responsible for rent even if the store fails. They want to know if there
is any protection. The answer is, beyond insurance, not much.

So the next option to consider is becoming a corporation. The formation process is very simple. You choose a name that is not already taken, file a one page Articles of
Incorporation with the Secretary of State, pay the filing fee that is less than $100, and receive back confirmation that you are the proud parents of a brand new baby
corporation. You should also have By-laws specific for your new entity, initial minutes of meetings of the shareholders and directors, appropriate resolutions for banking, selection
of fiscal year, and a variety of other issues. Any good business attorney should be able to set this up for less than $1500.

But, to John and Mary, what are the advantages of being a corporation? For a business that invites in the public and provides them food and drink in a hopefully
crowded and busy environment, a corporation offers personal liability protection. With some exceptions (a topic for a future column), the owners and directors of a corporation
are not personally responsible for its debts and obligations. Now, certainly if John gets angry at a customer and throws hot coffee on him, John will have some major personal
liability exposure. But if the corporation is acting as a corporation and the owners are acting reasonably, they probably won’t have to worry about paying the corporation’s
debts from their personal finances.

Taxes can pose another problem. You see, while there are numerous types of corporations you can choose, most small businesses select either a “C” or an “S”
corporation. By default, when a corporation is formed it is a “C” corporation. This means that the corporation itself must pay taxes on its income and then any money that the
owners make is also taxed. The clever nickname for this is “double taxation.” To avoid this, a corporation (as long as it meets certain basic requirements) can choose to be taxed
as a partnership and request “S” status designation from the IRS. In the eyes of the IRS, an “S” corporation essentially does not exist for taxing purposes. All of an “S”
corporation’s income is treated as having been earned by its owners and taxed as such while the corporate entity is ignored. The euphemism for this is “pass-through”, since the
income passes through the corporation to the individual owner.

The basic requirements to be an “S” corporation are that it can have only 75 shareholders (which cannot be another corporation), no shareholder may be a nonresident
alien, and there is only one class of stock. Since John and Mary satisfy these requirements, they can become an “S” corporation. However, as I caution all my clients,
do not make a decision about what entity form to take and whether to become an “S” corporation without consulting with a good business accountant.

When I present this option to John and Mary, they seem interested but they ask, “What is this new thing, limited liability companies? Is there any advantage to that?” My answer is
in the next column.©

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