Business Basics: Structure With Care
I had intended to write a major post for this week's CotC, on business structures, an intro for the confused or uninitiated, with extensive details, perhaps some research, and an extra bit on partnerships from my own experience. Instead, this is going to be more of a quick overview, but will still have some anecdotal, cautionary thoughts. It's going to be off the top of my head; what I "just know" and hope it's (still) correct and applicable. Extemporaneousness can be fun. Or not.
The first, simplest business structure is a sole proprietorship. That would be you, selling a product or service in an effort to profit. In some sense, we are all sole proprietors of our lives and their earning potentials, some better exercised or more in demand than others. You have sole liability and responsibility, and you alone benefit.
A sole proprietorship is simple to create; you just are. Depending on jurisdiction, naming, and extent of activity, there may be a local permit or DBA (doing business as) certificate needed, to enhance that level of government's revenue and control over you.
Generally you will use cash basis accounting, and you can be relatively loose with your money is the business money and vice-versa. The tax return is fairly simple, and the taxes are burdensome, or feel that way, due to supporting the entire weight of Social Security taxes yourself through what is delightfully called "self-employment tax." You might find yourself filing a schedule C, schedule SE, and a depreciation form with your 1040, though there are now simpler variants to make it easier for really small fry to be compliant through compliance made easy. I joke about it, but the easy forms are a good thing.
As a sole proprietor, you are the boss. Period. Not counting that ultimately the customers are your boss. You know what I mean. There are no meetings, no other people wanting to go in another direction, just you and your wits. At the same time, you have only yourself to rely on, if you disregard employees or a spouse who helps with things.
You draw money you have made as needed, or treat the business money as fungibly your money.
The next business structure usually comes third in such discussions, but I will talk about corporations second for my own nefarious purposes.
A corporation is its own legal entity; a "person" if you will. This allows the business in its own right to function, and continue functioning, regardless of who owns or manages it; to sue and be sued without liability flowing through to the owners in most cases; to own property, and so forth. As a proprietor, you are liable if someone sues you frivolously for screwing up. A corporation is so liable, but not the owners, unless certain conditions can be shown to apply.
A sole proprietorship can die, or be more difficult to pass along and continue, when you retire or die. A corporation has the benefit of indefinite lifespan and continuity, and in fact takes a real effort to dissolve.
It is more difficult to form a corporation, and there are rules that must be followed, even for the smallest ones. Publicly traded corporations have additional hoops.
Benefits include limited liability, ease of ownership transfer, tax and business expense advantages, real or perceived permanence, and clear distinction of personal from business finances, even if the corporation has but one owner.
In between the complexity of a corporation and the simplicity of a sole proprietorship lie partnerships. Basically take a sole proprietorship, add another owner without incorporating, and you have a partnership. This is a default. If two of you start a business together and do not form a corporation and issue stock to each partner, you have a partnership. It's about as simple to create as a sole proprietorship, but adds the aspect of having a partner, or partners, who also have a say in running the business.
How much say depends on what your partnership agreement says, if you have one. Here is where a partnership can be more complex than a corporation, with so many things to consider. There are defaults governed by state laws, I believe as codified in the UCC (uniform commercial code), if I remember right. For instance, splits of profit and loss default to being equal in the absence of agreement to the contrary.
You want an agreement; trust me. I am operating without one, and I know better. This was pounded into me in college, in business law, accounting in general, and advanced accounting in particular. By the time my advanced accounting class got done with partnerships, time was tight for non-profit and government accounting (fund accounting; ugh), mergers & acquisitions (pooling, etc.; ugh), and everything else. I know better.
When several of us started out saying "we can program circles around these so-called programmers who call Visual Basic support, we should write programs ourselves" and decided we would start "a business," it really amounted to a geek club at first. I was the token business guy, but everyone else was sure they knew more than I did, and I wasn't assertive enough. When we had our first revenue of any kind, everyone was in a panic. "Oh my God, we aren't incorporated, we can't take in any money!" I corrected that bizarre assumption and explained that in the absence of anything more formal, we were automatically a partnership.
We then proceeded never to get around to incorporating, for various reasons related in no small part to the same reasons we started out as ten people, have had eleven involved over the course of time, and are now down to 2.5 people I expect to turn into two, and could become one in the end.
Anyway, a partnership is simple in a way, but you have to file a 1065, somewhat complicated (my job), each partner gets an informational K1 form, and then each partner has to file at least one extra form, and potentially take some direct expenses not done on the 1065. You are taxed the same as if you were a sole proprietor.
In addition to profit and loss being allocated, when a partner does work and is being "paid" for it, that's expensed to the business as Guaranteed Payments to Partners, and credited to the partner in question for theoretical drawing. If the available cash to draw from the theoretical GPTP doesn't actually match what's been earned, a partner can have fun paying taxes on the theoretical earnings. Not that I would know about this personally, or know about tax liens, account seizures, or anything...
You need an agreement, or to be a corporation, or both. Each partner should have a defined, legitimate role, and be relied upon to fulfill it. If they do not, there should be consequences that can be enforced. If a partner's role is to provide capital and be mostly silent and uninvolved otherwise, great. Not involved in any way means not involved, and means you should be seriously questioning why that partner is there. If work, talent, existing customers, capital, or what have you aren't brought to the table in equal measure, then split of profit shouldn't be even. Duh.
Too many cooks. There needs to be good reason for a partnership. Now, you might like the simplicity of you and your friend going into business together. It's uncomplicated if you can agree enough, but agreeing at the start should include what happens when you someday don't agree. And you someday won't, on something. You might expect or plan for the partnership to be of limited duration, and so not want to add a corporate overhead and eventual dissolution to the mix. Do you really want joint and several liability? Liability goes right into each of your own pockets and personal assets.
Some things to work out:
What happens if a partner dies?
What happens if a partner wants to leave?
What happens in event you dissolve completely?
What about adding a partner?
Who will be responsible for what?
What happens if money is needed for the unexpected?
What if a partner can't do the job would be fired if he were a mere employee?
How will disputes be resolved?
When, how, and under what limitations may a partner draw?
Will there be minimum equity balances below which a partner may not draw?
What if a net loss gives one partner "negative equity"?
What will each partner be paid to work for the business as an "employee"?
There are probably many more I am forgetting. Basically, it's like a prenup for business, and must consider anything that can be in question, and look at things in harsh, pessimistic light rather than the glowing light and wonder of starting a business together. I
really should know better. I once wrote a dissolution agreement and managed the end of a very small partnership between two friends of mine who ended up hating each other. I think of them whenever I see the opening credits of films by a company that started later and used the same name they had used. That was an experience.
Well, I am not sure this turned out exactly as planned. If it enlightens, great. Business structure needs careful consideration, and my advice would be to lean heavily toward incorporating or otherwise being more formal, as with the newfangled LLC (limited liability company) that is available as an option at least in some states. An LLC combines features of partnerships with limited liability of corporations. If you are small and incorporate, an S corporation may be an option for combining corporate structure with a bit more simplicity, available if you have stockholders and revenues below a certain size.
Be aware that there are real differences, look into them, and be prepared to do it right. This is especially true with the potential for volatility extant in a partnership.
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