FAQ: Small Business Matters


 

(Click question to see the answer.)

 

Forming a Corporation or other Business Partnership

Should I incorporate my business?

Answer: Incorporating is one of a number of choices. The most common are sole proprietorship, partnership, corporation and limited liability company or LLC.  It is an important decision. It should be made only after careful consultation with an attorney and an accountant.

What? I'm a sole proprietor? What does that mean?

Answer: Sole proprietorship is the default choice for business owners. If you do nothing, you will be a sole proprietor. All income of the business will be reported on a special schedule of your regular tax return. The amount you pay in self-employment taxes will be based on all business income.  You as the sole proprietor will be personally liable for all business obligations such as rent, supplier bills, loans, wages as well as the negligent acts of employees. This means that all your personal assets will be subject to the claims of business creditors.  It is not unusual to start out as a sole proprietor, but as you begin to commit to contracts, sign leases, hire people and sell products or services, the level of business risk rises. At that point it may be time to consider alternatives in order to insulate personal assets from business liabilities or gain tax advantages.

What's a partnership? How is it different than being a sole proprietor?

Answer: The partnership of two persons is just a sole proprietorship “times two,” with the added wrinkle that each partner is personally liable for the business liabilities of the other partner. There is no insulation of personal assets against business liabilities. Nor are there tax advantages. If a partnership is still the way you want to go, don’t do it without a written partnership agreement spelling out the rights and duties of each partner.

What is a corporation? Are there advantages to incorporating?

Answer: The corporation has the great advantage of insulating your personal assets – your house, your savings and other things- against most business liabilities.  As a general rule the only assets at risk are the ones which the corporation owns.

To get the protection of the corporate shield the corporation must be properly created and properly maintained.  Proper formation includes drafting articles of incorporation, bylaws, voting in the persons who will manage the business, filing the articles and other necessary steps. Proper maintenance includes keeping business assets, business bank accounts and business books and records separate from personal matters.

The law treats the corporation as a “person” separate and distinct from the people who own it, so the affairs of the owner and corporation must be kept separate. Proper maintenance also includes holding annual meetings and filing annual reports with the Maine Secretary of State. None of this is difficult or expensive but it must be done.

I've heard about two types of corporation, an S corporation and a C corporation. What's the difference?

Answer: Of the two kinds of corporation, the “C” corporation and the “S” corporation, small businesses use the S far more often than the C.  The main advantage of the S over the C is that the C is subject to double taxation but the S is not.

For both types, salary paid to the owner-employee is subject to employment taxes, but profit over and above salary is not. Sole proprietorships do not get this break. The sole proprietor will pay 15.3% in self-employment tax on income up to $106,800.  If the business is incorporated, the tax falls on salary, say $75,000, but not on  the next $31,800 of income. This saves almost $5,000 in taxes.

A potential disadvantage of the S corporation is that the owner pays taxes on profits that are invested in the business rather than paid to the owner. Another potential disadvantage of the S is lack of flexibility in the way income is paid out to owners. If there are two owners, one invested $75,000 in the company and the other put in only $25,000 but does all the work and they want to split profits 50/50, they will not be allowed to. They have to split 75/25. The limited liability company is more flexible in this way.

What is a limited liability corporation? How does it compare to these other options?

Answer: The limited liability company, or LLC, is a hybrid of the corporation and the sole proprietorship. Like a corporation, it has the big advantage of insulating personal assets such as your house, savings and other things, against most business liabilities. Like an S corporation, it is not subject to double taxation. Like a partnership it has flexibility allowing the owners more choices in how they divide profits and losses. Another advantage is that it can be run with less “corporate” formality.  A potential disadvantage of the LLC is that all income up to $106,800 is subject to employment taxes.

Purchasing a Business

Should I purchase a business?

Answer: Buying a business is as important a move as you will ever make, and should not be made without consulting an attorney and an accountant. The purchase agreement should be carefully reviewed and, if necessary, negotiated before you sign it. There are a number of related questions for buyers.

Should I buy the assets or should I buy the corporation or LLC that owns the assets?

Answer: The choice relates to, among other things, whether you also get the (unwanted) liabilities of the business.

  • It is necessary to check for liens on the assets. If there are liens, they will have to be paid off when the deal closes.
  • How you allocate the purchase price among the assets could make a difference when you depreciate them on your income tax returns.
  • It may be necessary to make the seller agree not to open a new business in competition with the one you are buying.
  • If the seller leases his business space, you may need to take over the lease. The lease must be reviewed to see if you need the landlord’s consent to take it over.
  • You will rely on balance sheets and other financial statements the seller shows you. The purchase agreement should give you the legal power to hold the seller accountable if they are false or misleading.