Martial Arts Professional Magazine

As I wrote in my August/September column, the best way to keep what you have is not to have anything in your name. To implement that strategy, you must choose the right business entity (or entities) to limit exposure of your assets to (successful) lawsuits and separate your asset ownership. This month, I’ll explain Sole Proprietorship, General Partnership and Corporation.

Sole Proprietorship

A sole proprietorship is simply “you doing business.” There is no filing requirement and no formal paperwork, except if you do business under a fictitious or trade name. In that case, you must usually file a “d/b/a” (doing business as) with the secretary of state of the state where you do business.As a sole proprietor, you report your income on schedule “C” of your federal income tax return. Your liability is unlimited because you and your business are one and the same. If your business is sued, then all of your personal assets, including your home, are at risk. If your business is bankrupt, then you must file personal bankruptcy to avoid the business debts.

General Partnership

A general partnership is formed when two or more individuals or entities agree to do business together, for a profit. No written partnership agreement is required, although one can be created. A general partnership can be created, even if you did not intend it (i.e., a judge will let you know when you are sued for something someone else did on your behalf - this is sometimes known as “partnership by estoppel”).

The partnership itself does not pay taxes; it files an informational tax return with the IRS. This return (IRS form 1065) simply summarizes the income, expenses, profits and losses of the partnership. The bottom-line profit or loss “flows through” to the partners who report their share of income or loss on schedule “E” of their personal income tax returns (the partnership will send each of the partners an IRS form K-1, which states the partner’s share of profit or loss).

A general partnership does not protect its partners from liability protection. Partners are jointly and severally liable for each other’s tortuous (wrongful) acts. “Jointly” means that if one partner causes the partnership to be sued, all partners are liable; “severally” means that all partners are liable for 100% of the judgment. If you are the “silent” partner who invests the most money and has more assets than your partner, then you have the most to lose.

Corporation

A corporation is an entity that exists separate and apart from its shareholders. It requires the filing of a certificate with your secretary of state, called an “articles of incorporation.” The corporation issues stock to its owners, called the “shareholders.” The shareholders elect a board of directors. The board of directors in turn appoints officers, such as president, secretary and treasurer.

The major policy decisions of a corporation are made by the board of directors in the form of a “resolution.” The officers of the company perform the day-to-day functions of the corporation. The shareholders own the corporation, but cannot directly run the corporation’s business.

In most states, one individual can be the shareholder, director and serve as all of the officers (in a few states, the offices of president and secretary cannot be held by the same person - check your state law). A “one-man” corporation is perfectly legal, but the individual must be careful to disclose the capacity in which he is acting (president, chairman of the board, etc.).

“S” versus “C” Corporation

There are two basic types of corporations for tax purposes, “C” corporations and “S” corporations. A corporation is a “C” corporation by default; the “S” status must be elected. All large, publicly traded corporations (e.g., IBM) are “C” corporations. A “C” corporation files its own tax return (IRS form 1120) and pays taxes on its income. The good news is that the tax rates for regular corporations are usually lower than personal tax rates to approximately $100,000. The bad news is that when profits are distributed, they are taxed again on the shareholders’ personal income tax return. This is what we commonly call “double taxation.” “C” corporations can permit employees, however, to take certain “fringe benefits,” such as health plans, medical reimbursements and life insurance. None of these benefits is taxable to employees, and the expense is deductible to the corporation. A “C” corporation can be a great tax savings vehicle for small, family businesses.

An “S” corporation is a “flow-through” entity. It files an informational return (IRS form 1120-S) and the profits and losses flow through to the shareholders. An “S” corporation, like a partnership, sends each of its shareholders an IRS form K-1, which states the shareholder’s share of profit or loss. This profit is not normally subject to self-employment tax. Unlike a “C” corporation, the “S” corporation does not have the same “fringe benefits,” but it still has tax advantages over a sole proprietorship.