Business Formation Choosing a Business Entity Choosing the right business entity allows the entrepreneur to reduce liability exposure minimize taxes and ensure that the business can be financed and run efficiently Formalizing the business also clarifies the ownership stakes of all participants in the venture When choosing a business entity the entrepreneur should consider 1 the degree to which the entrepreneur s personal assets are protected from liabilities arising from the business 2 how to best pursue tax advantages from maximizing the tax benefits of start up losses avoiding multiple layers of taxation and converting ordinary income to long term capital gain 3 attractiveness to potential investors and creditors 4 the ability to offer ownership interests to attract employees and vendors and 5 the costs of running the business entity An entrepreneur can choose from several different types of business entities Sole proprietorship corporation general or limited partnership or limited liability company Each state has its own laws regulating how a business may organize and operate Sole Proprietorship A sole proprietorship is a business owned by one person It has no legal distinction from the owner and usually requires no governmental filing other than a fictitious business name statement disclosing the name of the business and the name and address of the owner A sole proprietorship is probably the most common form of small business Corporations Most large businesses operate as corporations the most familiar entity and that most closely regulated by law A corporation s principal appeal is the limited liability provided to its shareholders A corporation s creditors can collect only from the corporation s assets and cannot collect directly from the shareholders even if corporate assets are insufficient to pay all debts and liabilities A corporation is a legally distinct entity owned by its shareholders Shareholders elect a corporation s board of directors but otherwise do not actively manage the corporation The board of directors usually makes the major corporate decisions the corporation s officers who are appointed by the board of directors conduct the corporation s day to day management A single person can be a corporation s owner and sole director and may serve as any officer required by law A corporation survives the death of a shareholder or other changes in ownership A corporation is taxed as a separate legal entity unless it is an S corporation discussed below Under current federal income tax law a corporation is taxed on its net income defined as gross income less allowable deductions Corporate tax rates range from 15 to 35 Non cash property will be taxed as part of the corporation unless the person or group of people contributing the property owns at least 80 of the corporation If the corporation distributes money or other property such as dividends to its shareholders the shareholders will be taxed on the distributions Preserving Limited Liability Piercing the Corporate Veil Proper operation of a corporation limits the shareholders liability by preventing the corporation s creditors from reaching the shareholders to satisfy the corporation s debts and liabilities Should a court wish to disregard a corporate entity however it can hold the shareholders personally liable Under the alter ego doctrine a court will determine whether the shareholder s use of the corporation perpetuated a fraud or injustice It will examine numerous factors such as 1 Was the corporation undercapitalized given the risks inherent in the business 2 Were corporate assets used for personal reasons 3 Were corporate assets commingled with personal assets 4 Were corporate and personal books kept separate 5 Did the board of directors or shareholders properly authorize corporate actions Corporations should observe the following procedures to preserve the limited liability for their shareholders Obtain and record shareholder and board authorization for corporate actions Keep corporate and personal funds separated Maintain corporate records completely properly and separately from personal records Make it clear on all contracts with others that they are dealing with the corporation and sign all contracts as Corporate Name By Name and Title Maintain an arm s length relationship between the corporation and shareholders Disinterested board members should approve any business transactions with directors or shareholders without the vote of interested members and after full disclosure of all material facts of the transaction Provide sufficient amount of capital and insurance for future business needs in light of the risks involved S Corporations An S corporation does not pay federal income taxes instead passing the tax liability to its shareholders Thus an S corporation s profits are taxed only once In other types of corporation income is taxed twice once as corporate income and again as income for shareholders who receive distributions Shareholders generally choose to form an S corporation when the corporation is profitable and distributes nearly all of its profits to the shareholders or when the corporation incurs substantial losses that shareholders wish to deduct from their personal income tax returns An S corporation s losses flow through to the shareholders who can deduct those losses from their personal tax returns subject to certain limitations Profits and losses must be allocated based on share ownership for tax purposes Shareholders of an S corporation must include on their individual tax returns the profits of the S corporation even if no money was distributed to them To qualify for S corporation status a corporation must meet the following criteria 1 It may have no more than 75 shareholders who are individuals certain tax exempt organizations certain trusts or estates and none of whom are nonresident aliens 2 It may issue only one class of stock 3 The corporation generally cannot own 80 or more of any other corporation Because all shareholders of an S corporation must be individuals an S corporation cannot raise funds from venture capital funds corporations or institutional investors The one class of stock requirement prevents the business from issuing inexpensive founders stock for key employees Most corporations that raise money from outside sources will issue two classes of stock convertible preferred stock for investors and common stock for the employees Common stock is often issued at a small
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