Part III: Laws and Regulations

Chapter 6
CHOOSING THE RIGHT LEGAL STRUCTURE

IN This Chapter
Sole proprietorships
Partnerships
Corporations
Limited liability companies (LLCs)
Cooperatives

Introduction
This chapter discusses the advantages and disadvantages of the most common types of business ownership. Selecting the best legal structure for a new or growing business means considering liability, taxes, financing and related issues.
The Business Ownership Worksheet will help you make this important decision, but you will also need advice from an experienced accountant and lawyer. If you decide not to hire experts, you will either need to find a very patient advisor or mentor, or else plan to spend a lot of your spare time studying tax rules. Each state has its own set of forms and instructions, which can be just as time-consuming as the federal paperwork.
For a committed entrepreneur, choosing a legal structure is rarely a one-time decision. What makes sense for your business today may not make sense tomorrow. For example, some business owners start out as a sole proprietorship, and then switch to a corporation once the business grows.
For this reason, you should plan to meet every two or three years with a professional advisor who has expertise in the financial, tax and liability implications of business structures. This will ensure that an outdated structure doesn’t hold your business back.
Sole Proprietorship
This is the most common form of business ownership. It’s run by one person—or a married couple—with no outside owners or investors.
Sole proprietorships are the easiest business entity to form. In fact, you can form one without realizing it. For example, if you provide technical services to a local business without being on that business’s payroll, you are legally considered a sole proprietorship. The same is true if you offer handmade jewelry online, sell jam at your local farmers’ market or provide solo entertainment at weddings.
Pros
Sole proprietorships are easy to form and dissolve.
You have total managerial control over the business and receive all its income.
Bookkeeping and tax reporting are relatively straightforward.
Sole proprietorships may have a lower tax rate than other business structures.
Deducting business losses as a sole proprietor can offset taxes due on other income.
Cons
A sole proprietorship does not have a separate legal identity from its owner. You are personally responsible for every act and debt of the business. In other words, if you fail to pay a business-related debt, your creditor can legally come after your home, car and personal bank account. This personal liability also extends to the actions of employees or agents acting on your behalf.
Sole proprietorships can’t expand by attracting new owners and their capital. Debt financing must usually be secured by the owner’s personal assets.
Sole proprietorships end if the owner dies or is unable to work. The inheritance of business property and assets requires expert legal help.
Personal liability is the biggest problem with sole proprietorship. If your business exposes you to considerable financial or legal risk, an S corporation or limited liability corporation (LLC) may be preferable.
Tax Considerations
Sole proprietors report business profit and loss on Schedule C Profit or Loss From Business of their personal income tax return, which is due on April 15. The profit or loss then passes through to the personal tax return. You must also file Schedule SE to calculate your self-employment tax for Social Security and Medicare. If you expect to owe more than $1,000 in taxes, you must use Form 1040-ES to make quarterly estimated tax payments.
Although sole proprietors are legally allowed to mix personal and business assets, it’s best to keep your finances completely separate. Your business should have its own bank account, its own credit arrangements, and its own books and records. This is especially important when you have credit accounts, because interest payments may be deductible for business debt, but not for personal debt.
Forming a Sole Proprietorship
Most cities and many counties require sole proprietorships to register with them. Depending on your type of business and region, you may need additional licenses and permits.
If you do business under a fictitious business name—meaning any name other than your own—you must register the name with the appropriate state, county or city office.
If you have employees, you must submit IRS Form SS-4 to obtain an Employer Identification Number (EIN). If you don’t have employees, you can use your Social Security number as your EIN. However, it’s best to apply for an EIN regardless. That way, you’ll be ready to hire employees when it becomes necessary.
…
I’ve always loved spicy food. I like a little heat—or a lot—on just about everything, from french fries to ice cream. It’s an expensive habit, though. There are so many kinds of peppers, so many ways of using them, so little time to try them all. I had a cupboard full of bottles, and I went through them fast. For a poor college kid, that’s a lot of money. So as weird as it might seem, my business grew out of trying to save money, not earn it.
When Jason Kim was in his third year at Savannah College of Art and Design in Georgia, he started a blog called Hothead, which reviewed hot sauces from around the world (starting, naturally enough, with the ones in his cupboard). His goal was primarily to get enough attention that manufacturers would send him free samples. Because he’s a skilled graphic designer and an engaging writer with a good sense of humor, his idea worked out nicely. Within a year, his blog and its related social media channels had become a mini-empire with over 50,000 followers. A good review from Jason meant sales of 2,500 bottles or more for a sauce manufacturer, so the samples poured in.
I learned a lot about peppers. I also learned that it’s not easy to write 10,000 words a week about hot sauce without repeating yourself, so I started thinking about doing more research- and travel-oriented articles, and maybe even adding some little video documentaries. Not only would it flesh out my content, but it would get me outside once in a while. I basically lived on the Internet at that point.
Anyway, I went down to Trinidad on break to do a feature on Moruga scorpion peppers, which are the world’s second-hottest after the Carolina Reaper. And one night, I was standing there just watching people roasting peppers and thinking about how every family seemed to have their very own recipe. And I realized I was tired of just being a consumer. I wanted to have my very own recipe, too.
…
PARTNERSHIPS
A partnership consists of two or more people who operate a business. Each partner contributes to the business and is entitled to a share of its profits. Legally, you don’t have to file any special paperwork to operate as a partnership. However, failing to create a partnership agreement at the outset can have disastrous consequences, both for the business and for the relationship of the partners.
General Partnership
A general partnership forms automatically when two or more people voluntarily agree to operate a business for profit.
The distributive share of profit or loss usually depends on each partner’s level of investment in the business. For example, if you provided 75 percent of the partnership’s initial capital and your partner provided 25 percent, that’s usually how you’ll split the partnership’s profit or loss (unless you come to a different arrangement in your partnership agreement).
Pros
Fairly simple and inexpensive to set up.
Partners may bring complementary expertise, funding, equipment or intellectual property to the business.
Partners can pool their resources to obtain debt capital, or bring in new partners to obtain equity capital.
As with sole proprietorships, business profit and loss pass through to each partner’s personal tax return.
Cons
Partners are jointly and severally liable for all business debts. If the partnership doesn’t have enough assets to cover an outstanding debt, creditors will go after whoever has enough assets.
Each partner usually has the right to sign contracts that are binding on the others. This means that if your partner buys a new computer for the business on credit, you could be stuck with the debt even if you didn’t agree to the purchase.
General partnerships usually end if one partner dies or withdraws, so it’s hard to use them in estate planning.
Partners pay tax on their share of profit even if they don’t withdraw it from the business.
Partners must know and trust each other. Personal conflict is the number-one cause of partnership breakups.
Joint and several liability for business debts is a very serious concern. As an example, suppose your three-person partnership owes $50,000 to a creditor. The creditor’s first action would be to go after the partnership’s assets. If those assets are inadequate, you and your two partners remain collectively and individually liable for the full debt. If you are the only partner with $50,000 in personal assets, a creditor can come after you for the full amount, regardless of your role in incurring the debt.
Apart from liability issues, the worst thing about operating as a general partnership is that all partners owe taxes on their distributive share whether or not they actually withdraw the money. In other words, even if you decide to keep your share of the partnership’s profit in the business, you must still pay personal income tax on that amount.
Tax Considerations
General partnerships do not pay taxes, but they must submit an annual “informational” return by filing Form 1065 U.S. Return of Partnership Income. It must also issue Schedule K-1 Partner’s Share of Income, Deductions, Credits, Etc. to the IRS and to each partner; this form states each partner’s share of the business’s profits or loss. The partners list partnership income or loss on Schedule E Supplemental Income and Loss of their personal returns. Like sole proprietors, partners must pay self-employment taxes and may be required to make quarterly estimated tax payments.
Forming a general partnership
Setting up a general partnership usually doesn’t take much money or paperwork. As with a sole proprietorship, you must register as a business and, if necessary, file a fictitious business name.
Although you can form a general partnership by verbal agreement—or simply by behaving like one—it’s best to create a written partnership agreement that states each partner’s rights and responsibilities. Otherwise, the laws of your state will govern your partnership by default. Also, working out the details of a partnership in advance may help the partners identify and resolve conflicts that could otherwise derail the business.
You can and should customize your partnership agreement to deal with management issues, distribution of profits, and the authority to conduct business on behalf of the partnership. At a minimum, it should specify:
How much capital, property and services each partner will contribute
The rights, duties and ownership interests of each partner
How and when the partners will share profit and losses
How the partnership will make decisions (e.g., must all partners agree, or does the majority rule?)
How partners will resolve disputes (e.g., mediation or arbitration)
Which partners can sign contracts and authorize cash withdrawals and salaries
The length of the partnership
Whether, how and by whom a partner’s ownership interest can be bought out (this is known as a buy/sell agreement)
How to expand or dissolve the partnership
One risk of doing business without a partnership agreement is that you may find it difficult to prove the existence of the partnership if a partner denies forming it. Conversely, you may find yourself in a general partnership without knowing it. You may think your “employee” or “consultant” is not a partner, but if you’re splitting profits and making decisions together, a court may class your business as a partnership, even though the form of the business is “employer/employee” or “hiring party/independent contractor.” This means that each partner has a continuing right to profits, a continuing right to managerial control, and a continuing right to inspect the company’s business records.
It may also mean that upon dissolution and winding up of the partnership (the cessation of business, payment of debts, sale of assets, and distribution of whatever’s left over), either or neither of you will have the right to use the company name.
Limited Partnership
In a limited partnership, one or more general partners manage the business. Limited partners are investors who give up most or all of their control over the business in return for limited liability.
Pros
Limited partners are usually only liable for debts to the extent of their investment. If you invest $15,000 as a limited partner, you’re exposed to no more than $15,000 in losses. However, most states provide that if limited partners cross the line between consulting and management, they may be jointly and severally liable.
Partners can provide additional funding for the business.
Limited partnerships offer a bit more flexibility than general partnerships. If there are two general partners, the death of one does not terminate the partnership. And because a limited partner is similar to a shareholder, a limited partner’s death doesn’t legally affect business continuity.
Cons
More expensive and complicated to form.
General partners are jointly and severally liable for debts.
Limited partners may not wish to invest without having the authority to make decisions.
Forming a limited partnership
In most states, the Uniform Limited Partnership Act governs partners’ duties, liabilities and rights. You must file a certificate of limited partnership (or a similar document) with your secretary of state. This process can be costly; you may need to pay for legal assistance, and you will also be subject to state filing fees.
Tax considerations
Tax considerations are similar to those of general partnerships, with the notable exception that limited partners do not pay self-employment tax. Consult a professional advisor to learn more.
Limited Liability Partnership (LLP)
This is basically a general partnership with limited liability for all partners. It’s formed by filing a certificate of partnership with the appropriate state body (usually the secretary of state). LLPs are not recognized by all states, and some states restrict them to professional groups like accountants and lawyers. If you operate as an LLP in a state that doesn’t recognize them, you will probably be treated as a general partnership. If your operations are limited to a state that offers LLP registration, there’s no reason not to take advantage of LLP protections.
As with a general partnership, profits are taxed as personal income for each partner.
Joint Ventures
Joint ventures are effectively short-term general partnerships formed for a limited purpose. Businesses typically use them to enter new markets or to gain access to new skills, technology or intellectual property.
Forming a joint venture doesn’t require you to file special forms. However, you should legally formalize your arrangement with a joint venture agreement. Like a partnership agreement, this contract should specify what each party will contribute, detail each partner’s rights and responsibilities, and explain how disputes will be settled. It should also note the purpose of the joint venture and explain the partners’ exit strategies. If the partners will be sharing sensitive business information, a nondisclosure agreement is also wise.
Tax and liability issues vary with the terms of the joint venture agreement, and they also depend on whether the relationship is contractual or entails creating a separate legal entity. You will need expert legal help when making these decisions. International joint ventures will require the help of attorneys familiar with foreign laws as well as international trade laws.
…
Through trial, error and lots of research, Jason arrived at three recipes that, as he put it, “represented what I thought of as ideal hot sauces. They had the elements I liked best from all my favorite blends.” After researching permits, food safety and local commercial kitchens, he manufactured and bottled a batch of each flavor and announced their arrival online.
Fifteen minutes later, he was sold out. He spent the next three days packing and shipping orders. Then he made slightly larger batches, and the same thing happened.
On the surface, I was excited. But deep down, I was worried. It was like, “Help, I’ve created a monster!” Yeah, it’s great that people like it. But making the sauce took a lot of time, and packaging it took a lot of time, and mailing it took a lot of time. The blog was already eating up a lot of my life, to say nothing of school. It just wasn’t sustainable. I had no plan in place for starting a business, let alone having one.
That big, sudden influx of cash worried me, too. I wasn’t an overnight millionaire or anything, but I’d made a pretty sizable amount of money and I had no clue what to do about it.
…
Corporations
A corporation is a legal entity separate from the shareholders who own it. The “corporate shield” doctrine limits personal liability for debts, provided the corporation is operated legally. If a corporation doesn’t follow the law, creditors can pierce its corporate shield. For this reason and others, you must seek legal advice before forming a corporation.
Pros
A corporation can shield owners from debts and liabilities. For instance, if someone falls down in your store and sues your business, the business is responsible for any financial or legal judgments, instead of you personally.
You can raise money by selling stock.
The business continues even if the owner dies or sells to a new owner.
You may be able to deduct employee health insurance, as well as benefits such as group term life insurance, company vehicles and public transportation passes.
Cons
Time-consuming and expensive to form.
Strict regulations and paperwork, including required meetings, documentation and reporting.
If corporate rules aren’t followed, the owners can be held responsible for the corporation’s debts and liabilities.
Corporations must pay federal taxes by March 15.
The Internal Revenue Code recognizes two types of corporate structures: C corporations are governed by Subchapter C of the Internal Revenue Code, and S corporations are governed by Subchapter S. We will discuss each, and then discuss the features they have in common.
C Corporations
Most large businesses in the United States operate as C corporations. These are usually large, publicly held companies, but they also include small and even single-owner companies. A C corporation may have a single shareholder who comprises the entire board of directors, holds all the corporate offices and is the only employee.
Tech startups and other growth-oriented businesses often operate as a C corporation, mainly because of the flexible options for raising money from investors.
Pros
The corporation, rather than its shareholders, is liable for the debts, actions and obligations of the business.
A C corporation may have more than one class of stock (such as common stock and preferred stock) and an unlimited number of shareholders.
Venture capitalists generally prefer to fund C corporations, due to their flexible ownership rules.
Only C corporations can be traded on a national exchange.
Cons
C corporations may be subject to double taxation. This happens when the corporation pays tax on its income, and you pay tax on any dividends you receive as a shareholder.
Obviously, double taxation is a serious disadvantage. However, it can often be avoided through careful year-end planning, because reasonable salaries and fringe benefits (such as medical and dental plans, insurance, and retirement plans) are deductible. (The key word here is “reasonable”; if you pay yourself a very high salary to avoid taxation, the IRS may challenge the deduction.)
For larger corporations, the effect of double taxation is also mitigated by the Jobs and Growth Tax Relief Reconciliation Act of 2003, which reduced the maximum tax on dividends to 15 percent.
Tax Considerations
C corporations report business profit or loss on IRS Form 1120, which must be filed by March 15. Shareholders do not pay income tax on corporate profits. Instead, they are taxed on distributions from the corporation, which are reported on Form 1099-DIV. Shareholder-employee compensation is fully deductible, as is the corporation’s share of payroll taxes. Corporations that expect to owe more than $500 must pay quarterly estimated taxes.
The state in which you incorporate may impose additional taxes on your business.
S Corporations
S corporations are created through a special IRS tax election. They differ from C corporations in that their profits and losses are reported on the shareholders’ personal tax returns in much the same way as sole proprietorships or partnerships. This avoids the risk of double taxation.
S corporations also offer tax benefits on distributions. Provided the S corporation pays its employees “reasonable compensation” based on industry standards or fair market value, profits can be distributed to owners as dividends, which are taxed at a lower rate than income.
If the IRS finds that compensation was not reasonable, it may view dividends as “wages” and tax them accordingly.
S corporations are limited to 100 shareholders. However, an owner and his or her spouse—and their respective estates—can qualify as a single shareholder. Further, all members of a family and their estates may qualify as a single shareholder. Consult a tax attorney to learn more.
State rules on S corporations vary, so don’t choose this election unless you’ve researched the laws in your home state. States that don’t recognize S corporations will probably treat your business as a C corporation.
Pros
Owners enjoy limited liability.
Business income, deductions and losses flow through to shareholders’ personal tax returns, avoiding double taxation.
Only wages of employee-shareholders are subject to employment tax.
Cons
Limited to one class of stock.
Limited number of shareholders.
Strict regulations on shareholder compensation.
Tax Considerations
S corporations work very much like a partnership for income tax purposes. Business income or loss flows through to the individual tax returns of the owners. Form 1120S must be filed by March 15; corporations that expect to owe more than $500 must pay quarterly estimated taxes.
Export Corporations
If your business is organized for import or export, you may want to form either a Foreign Sales Corporation, or an Interest Charge Domestic International Sales Corporation. These highly specialized corporations provide significant tax advantages. You may even want to run a subsidiary export corporation under your regular company. You should talk to your accountant and lawyer about this.
Forming a Corporation
You can form a C corporation by filing articles of incorporation with your state’s department of commerce or the local equivalent. This registers the corporation’s name and specifies its purpose, incorporators, registered agent, principal place of business and stock shares. Your lawyer can help you prepare this document.
Once articles of incorporation have been filed, the corporation must have an organizational meeting to approve bylaws, issue stock and elect its first board of directors. A corporation is not legally formed until these steps are completed.
To operate as an S corporation, you must file IRS Form 2553 Election by a Small Business Corporation. This form is due no more than two months and 15 days after the beginning of the tax year in which you wish the election to take effect, or at any point during the tax year preceding the one in which you wish the election to take effect.
The IRS will usually accept or decline an S corporation election within 60 days of receiving Form 2553.
Bylaws
Bylaws explain the rights and duties of the board of directors, shareholders and officers. Certain bylaws may be required, depending on your state. Typical issues include:
The location and timing of meetings
The percentage of ownership required to call a meeting
What business can be conducted by what percentage of the ownership interests
How officers and members of the board of directors elected and compensated
Who has the authority to enter into contracts and sign checks
Employment guidelines (including methods for terminating employees who have ownership interest)
How the corporation will wind up its business
Board of Directors
The board of directors sets the policies of the company, approves major expenditures, and elects officers to be in charge of specific aspects of the business. It usually consists of five or fewer people. In a closely held corporation with a single owner, the board may consist of the shareholder, one or two family members, and one or two advisors.
When choosing a board of directors:
Look for diverse skills, such as finance, marketing and accounting.
Choose people who will speak their mind. Members who agree with you all the time will be much less useful to you than people who tell it like it is.
Tell prospective board members what you expect of them in terms of time commitment, work load and compensation (if any).
When there are several owners, each usually has a seat on the board, at least initially. A chairperson is elected at the corporation’s annual meeting and runs the board meetings until replaced or voted against at the next annual meeting.
Officers
Usually, a corporation’s officers include a president, a treasurer and a secretary. The officers actually run the company; they hire and fire employees and work to grow the business. Most states allow a closely held corporation to elect one person to multiple offices, so you can be chairman of the board, president and CEO all at once.
Shareholders
Shareholders are the people who own a corporation’s stock. Their rights and duties are set forth in the bylaws. Ultimately, all power in the corporation rests with a majority of the shareholders, because they elect the board of directors. If shareholders are dissatisfied, they may hold a special meeting and either elect a new board of directors, or require that the board replace the officers or other employees.
Individual shareholders are liable for the debts of the company only to the extent of their investment in the shares.
Buy/Sell Agreements
The organizational meeting is a good time to adopt a buy/sell agreement. This is crucial to the success of your corporation whether it has two or 20 owners. Issues it should address include:
How can an owner be expelled from employment or ownership?
How do you terminate the business relationship and get your money out?
What happens upon divorce or death?
Do you fund the buyout upon death or disability with an insurance policy?
Will relatives inherit the interest of a deceased or retiring owner?
Your business advisors can help you resolve these questions.
Running a Corporation
Whether you choose to operate as a C corporation or an S corporation, you will have to follow strict rules to maintain your corporate status, including:
Annual meetings. The board of directors and the shareholders must each have an annual meeting. However, most states allow for these meetings to be held jointly. The bylaws of the corporation state when the meetings are to be held, what type of notice must be given, and what activities may take place at the meetings. They should also specify the number of persons to be elected to the board of directors each year.
Corporate recordkeeping. Most states require corporations to keep annual minutes and financial statements; shareholders have a legal right to review these records. Your corporation should maintain a minute book containing the registry of shareholders, a copy of the articles of incorporation, the bylaws, the organizational minutes, and the minutes from annual meetings. Annual minutes should describe salaries paid to the principals; loans to and from the corporation; major purchases or sales of equipment; real estate and leases; and major policy decisions and activities. The minutes should also describe employment agreements; pension or medical plans; reimbursement for vehicle expenses; authorizations for major travel or training expenses, and similar actions.
Annual reporting. Most states require corporations to file an annual report with the state department of commerce. Your lawyer and accountant can handle much of this paperwork.
…
I had reached an interesting point in my life. A few thousand people were demanding bottles of hot sauce I didn’t have, I’d just doubled my annual income in a matter of hours, and it looked like I was facing 25 to life in a commercial kitchen. I don’t know what I expected when I offered my hot sauce online, but it wasn’t that.
To put it another way, I needed help. I decided to start with the money issue, since I couldn’t make any other plans until I knew if I’d have to send everything I’d earned to the IRS.
On the advice of his friend Thom, who worked in admissions at the University of Georgia, Jason contacted an SBDC counselor. The counselor put him in touch with a CPA named Deana Miller, who specialized in online business.
Deana was awesome. It seemed like she knew...well, everything. After 10 minutes with her, I was thinking, “OK, this person is clearly a genius, and everything’s going to be fine.”
After 20 minutes with her, I was thinking, “I wonder how fast I could move to a desert island?” Because for every aspect of my situation that I thought was complicated, Deana brought up five more complications I hadn’t thought of.
After hearing Jason’s story and asking some questions, Deana ran through the list of problems he was facing.
First, he hadn’t set himself up legally as a business, which made him a sole proprietor by default. This was a dangerous way to operate for someone who sells food, because if anyone got sick from one of his sauces, he would have no personal liability protection. Worse, the fact that he had been selling online, to customers all over the world, brought all sorts of legal issues into play: What happens if there’s a problem with a buyer in another country? Which laws would apply?
Then she got around to taxes, which is when Jason started dreaming about desert islands.
…
Limited Liability Companies
An LLC is a hybrid form of ownership that combines the best features of partnerships and S corporations: It’s usually taxed like a sole proprietorship or partnership, but liability is limited like a corporation. (Also like a corporation, the “shield” of an LLC can be pierced if it doesn’t follow the law. A common example of this would be a business that doesn’t keep business and personal assets separate.)
LLCs tend to be more flexible than S corporations. There’s usually no limit on the number or type of owners, and there may be multiple classes of ownership interests.
In some states, a membership interest can be paid for with a promise of future services, or with an unsecured promissory note, in addition to the forms of payment authorized under corporate law (e.g., cash, property, services rendered, and secured notes). But if the LLC is capitalized solely with promises, it runs the risk of being deemed undercapitalized, resulting in personal liability for LLC members.
Pros
Limited liability, like a corporation.
No double taxation, like a partnership.
If one partner can utilize tax losses better than another, the LLC allows beneficial allocation of that tax benefit.
Less recordkeeping and fewer startup costs. LLCs are generally easier to set up and maintain than S corporations.
Flexible profit sharing.
Cons
Different states have different rules and tax policies for LLCs. This can be especially problematic if you plan to operate in more than one state.
LLCs normally dissolve if a member withdraws or dies. A well-crafted operating agreement can prevent this.
LLC members must pay self-employment tax.
Because LLCs can’t issue stock, they tend to be less attractive to investors.
Equity-based compensation arrangements for LLCs—such as “profits interest” rights—tend to be more complicated to structure than they are in a traditional corporation. Although LLCs should not overlook this method of attracting and retaining key employees, they will almost certainly need help from an attorney who specializes in this area.
Liability Limitation
LLC owners can still be held liable in certain circumstances:
If you owe federal or state taxes, LLC status will not protect your personal assets from seizure.
If you mix your LLC’s money with your personal money, you may lose your liability protections.
If you harm someone intentionally or through negligence during the course of your business, you may be held personally liable.
Many lenders require LLC owners to personally guarantee loans. This means that the owner must repay the loan even if the business fails.
Tax Considerations
Legally, an LLC is not a taxable business entity. As with sole proprietorships, partnerships and S corporations, profits and losses normally pass through to individual members’ personal tax returns. In some cases, the IRS will view your LLC as a corporation and tax it accordingly. In others, you can specify how you elect to be taxed in your operating agreement—i.e., as a corporation, partnership or single-owner business—and then file your election with the IRS on Form 8832. You can also elect to be treated as an S corporation by filing Form 2553. Some states also tax LLC income, so research the laws in your state before choosing this structure.
LLCs operating as sole proprietorships will file Schedule C. Partnerships will file Form 1065, and LLCs operating as a corporation will file Form 1120.
LLC members must file Schedule SE to calculate self-employment tax, and may be required to make quarterly tax payments.
Forming an LLC
In most states, forming an LLC requires nothing more than filing simple articles of organization with the secretary of state or its local equivalent. You should also create an operating agreement that sets forth the rights and responsibilities of each member. Note that some states may have additional rules for LLC formation.
Consult a lawyer or accountant about the costs and advantages of LLC ownership in your state.
…
That first meeting with Deana was such a rollercoaster ride. She’d tell me something scary about Georgia tax law, and I’d say, “So I’m doomed, right?”
And she’d say, “No, not necessarily, because of some recently enacted exemption or other.”
And I’d say, “So everything’s fine, right?”
And she’d say, “Not really, because of some totally different tax law that only applies to people named Jason on alternate Thursdays.” It was a fun little chat.
Toward the end, though, she brought it down to a very basic question that I had no trouble understanding: Do you want to keep making and selling hot sauce? Because if you do, we can make it work. But if you don’t want to, or you don’t feel up to it right now, we’ll need to handle the money you made online in a different way.
Those were good questions. So I told her I needed to talk to some people and sleep on it.
Jason talked to his teachers, his parents, his girlfriend, and his online community. In the end, he decided to go for it.
Jason met again with Deana and a lawyer colleague, and the three of them came up with a game plan. First, Jason would form an LLC in order to get personal liability protections. Next, instead of making his sauces himself, he would contract the work to a copacker who would not only handle the manufacturing, bottling, warehousing and distribution, but would also deal with regulations and product liability insurance.
While Jason was researching copackers, he had a stroke of luck. A small artisanal hot sauce manufacturer called Las Llamas—which made one of Jason’s favorite sauces—contacted him and offered to manufacture and sell the sauces using their own facilities and supply chain. This would enable Jason to focus on the part of the business he loved: hunting down unusual peppers and creating novel recipes.
It took me a while to finish a business plan and hammer out all the legal details with Deana and the lawyers, but when I woke up, Hothead, LLC had formed a strategic partnership with Las Llamas, LLC and I was officially a hot sauce tycoon.
The collaborative relationship has been great for me. I don’t know if I would ever have been able to graduate if I had to do even a tenth of the work that Las Llamas did on my behalf. It’s like having training wheels; they helped me learn to build up speed and steer without falling on my face.
As successful as the sauces have been, I’m also interested in branching out to other products—spicy ketchups, spicy chocolate sauce for ice cream. Maybe even a Muruga scorpion popsicle! At this point, there’s solid evidence that if I like something, there are at least 10,000 other strange people out there who’ll like it too.
As far as my own hot sauce addiction goes, let’s just say I’m not having any trouble keeping my cupboard stocked these days.
…
Cooperatives
Cooperatives combine the equal control of a partnership with the legal structure of a corporation. Although they don’t offer the tax benefits of a corporation, they do pass profits and losses through to members (who are typically also employees). Profits are usually distributed to members according to their economic interest (“patronage”) in the cooperative.
Much like a corporation, the members of a cooperative can hold shares and elect a board of directors and officers to run the business. Unlike a corporation, the amount of shares an individual holds does not give that person’s vote more weight than those of other members.
Members of a specific community may feel especially comfortable with the structure of a cooperative. For example, it’s common among smaller agricultural businesses in the Midwest. However, a number of large national firms also operate as cooperatives, including Ace Hardware, REI, Sunkist and Land O’ Lakes.
Pros
Cooperatives allow members to pool their talents and resources to achieve goals and obtain benefits (such as bulk-purchase discounts) that they couldn’t get on their own.
Cooperatives usually aren’t taxed on profits distributed to members.
Employees and customers have actual ownership in the cooperative, leading to more engagement and involvement.
Cons
The democratic nature of decision-making can make seemingly simple choices more difficult. Business owners who are used to calling the shots may find it difficult to work within a cooperative’s “one member, one vote” framework.
Cooperatives may have limited access to capital as a result of limitations on the power of investors.
Tax Considerations
Cooperatives do not pay federal income tax. Normally, income from cooperative is reported on Form 1099-PATR, Taxable Distributions Received From Cooperatives, of each members’ personal tax returns, as specified under Subchapter T of the tax code. Due to the wide range of state laws governing cooperatives, you will need help from your accountant to understand the tax implications of operating as a cooperative in your area and industry.
Forming a Cooperative
If you elect to do business as a cooperative, you’ll need a written contract establishing the cooperative enterprise and describing how it will be managed on a day-to-day basis. Depending on your state, you may be able to register as a cooperative under a specific cooperative statute; state rules vary greatly, so research your options carefully.
If you must incorporate, the process is similar to that of a regular corporation. You will need to file articles of incorporation (or a similar document) with your state’s business registration agency, create bylaws and elect a board of directors. You’ll also need to create a membership application, which all prospective members must complete to be viewed as legal members of the cooperative.
Conclusion
The type of business entity you choose determines:
Your amount of personal liability
How you and your business are taxed
Your estate planning options
How easy it is to transfer your business to family members, employees or a purchaser
Your options for generating capital
Your options for attracting executive talent
You must consult with a skilled lawyer and accountant before selecting a legal structure, so that you can make the best choice.
Remember to follow all the rules governing your type of entity. This will ensure that your business is able to continue in that form and that you retain all rights and benefits as the business owner.
Once again, always seek advice from your lawyer and accountant when considering the legal structure of your business!

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| NxLeveL® TECH TIP BUSINESS RESOURCES AND THE WEB
Online Licensing and Registration Tools Here are some sites that will speed up the process of finding official information on taxation, licensing and legal structures: Register With State Agencies. This SBA page offers links to business registration resources for all 50 states. www.sba.gov/content/register-with-state-agencies Employer Identification Number (EIN) application. You can apply online for an EIN at sa.www4.irs.gov/modiein/individual/index.jsp. Learn About Taxes and Credits. This search tool helps you locate taxes and credits for which your business may be eligible. business.usa.gov/taxes-and-credits