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Chaldean Business Leaders Choose The Right Business Legal Structure
By Bedre Konja :: Tuesday, November 27, 2007 :: 43303 Views :: Article Rating :: Business & Finance

One question that Chaldeans must answer when starting a business is “What legal business structure is the best for their business?”  This is one of the most important questions a Chaldean entrepreneur must ask.  Particularly for Chaldeans who plan on providing goods or services to residents trapped in high crime areas. 

The business legal form can have significant implications on the amount of money Chaldeans pay in taxes, their personal risk in the business, as well as their ability to get loans or raise money. Prior to making a final decision Chaldean entrepreneurs should religiously explore their options. 

Chaldeans have a handful of options when choosing what legal form their business is to take.  There legal forms are sole proprietorships, partnerships, limited liability companies/partnerships (LLCs /LLPs), and incorporations (either C-corporations or S-corporations).  The idea is to structure your business in the best way possible to help you succeed. 

What follows here are the issues of liability protection, business appreciation, active versus passive income, and retrained earnings in the business.  Chaldean entrepreneurs should understand how their business should be structured in order to help them when dealing with these issues.

Liability protection.
Chaldeans should generally rule out sole proprietorships and partnerships right away because of lack of liability protection.

Sole proprietorships and partnership arranged businesses are not regarded as a separate legal entity from you, so your personal assets are part of the business. This means that if the business is sued for whatever reason, your personal assets are at stake. This includes your home, car, bank accounts, jewelry, clothing, and most anything else of value. 

Partnerships are even more risky for Chaldeans: your personal assets are on the line for anything that your partner may do.  For example, if your partner should argue with a client who happens to have a heart attack during a frustrating and heated discussion and decides to sue, both you and your partner are at risk of losing most all you own.  

LLCs, LLPs, C-corporations, and S-corporations have better liability protection and viewed under most conditions as separate legal entities. That means that the business is like a separate person that you control.  If anything should go wrong and liability becomes an issue, the only things at stake for you as an owner is what you have put into the business along with any personal guarantees you have made.

A limited liability company has one or more members (similar to a partnership) who either directly manage the company or who may hire one or more managers to take care of the business. An LLC has features of a partnership and a corporation. "Ownership" of the LLC is based on the individual "member's interest," i.e., the member's share of the profit and losses of the company, rights to receive distribution of assets, and to participate in the management of the company.

A limited-liability partnership (LLP) is similar to a general partnership, except the partners are not personally liable for negligent acts conducted by other partners or employees not under their supervision.  The difference between LLC and LLP is that some professional groups are required to form an LLP

A corporation is a legal entity that can exist separately from its owners. Creation of a corporation occurs when properly completed articles of incorporation (called a charter or certificate of incorporation in some states) are filed with the proper state authority, and all fees are paid.  The paperwork is much easier than most think.  Many states offer templates and the internet is full of example charters. 

Business asset appreciation.
A second item to consider is whether the assets of the business are likely to appreciate, or increase in value over time. If your business has appreciable assets, an LLC is likely a better legal form than a C- or S-corporation. When C- and S-corporations are terminated, assets are distributed to the owners and gains realized from appreciated assets (such as land) become taxable at a personal level. This tax obligation may be very high. You may have no choice but to have to sell the assets just to pay the tax.

In an LLC, business assets are considered to be personal assets, and no distribution is recognized when the business is terminated. Therefore, no tax obligation would be realized until you actually sold the assets.

Active versus passive income.
Another important tax issue for business owners relates to the earning of active versus passive income. Active income refers to your salary, or what you make from the business by performing job-related tasks. This portion of income is subject to Social Security and Medicare taxes, or employment taxes, which are about 15% (up to $87,000 of income). Passive income refers to dividend, rental, or royalty income from your business that you did not earn performing job-related tasks, and is not subject to employment taxes. As an example, if you started a small retail store and managed the store, your active income would be the salary of a comparable retail store manager and any income above that would be considered a dividend, or passive income.

In an LLC, you cannot distinguish between active and passive income, so you can end up paying significantly more in employment taxes than what you owe. For example, if income before tax for your retail store was $60,000 and your salary was $45,000, you would pay employment taxes on all $60,000 in an LLC even though you earned $15,000 in passive income (this is true even if you leave the $15,000 in the business and don't take it home). In contrast, in an S-corporation you could recognize the $15,000 as a dividend and only pay employment taxes on your salary of $45,000. You can also distinguish between the two in a C corporation, but dividends are paid after corporate taxes are taken out, so they essentially get taxed twice.

"Check the box" options in tax filing allow LLCs to elect to pay taxes as S-corporations (and distinguish between active and passive income), so it is not essential that you set up as an S-corporation from the start if you will have both active and passive income. But this is an important issue to understand and plan for, and setting up as an S-corporation may eliminate some confusion at tax time.

Retaining earnings in the firm.
While most people think C-corporations are bad from a tax perspective because of the double taxation on dividends, there are instances where tax advantages exist when compared to LLCs and S-corporations.

Income from C-corporations is taxed at a corporate rate, while that from LLCs and S-corporations is taxed at a personal rate. If you do some analysis of corporate tax rates versus personal tax rates at different earnings levels, you will find that in some cases the corporate tax rate is lower. So, if you are planning to retain earnings in the business to fund growth rather than take earnings out as dividends, Chaldean entrepreneurs should investigate the tax differences and consider a C-corporation.

While this is not a complete set of considerations for choosing a legal form of business, looking at these aspects will help Chaldeans get started in the selection process. Chaldeans will likely come to the conclusion that an LLC or S-corporation is right for their business, but do some research and hire a reputable business consultant.

Doing your research ahead of time will save you money, time, and frustration.  Having a knowledgeable consultant or business advisor will save you much more in the long run.  

Bedre Konja is a senior business consultant and entrepreneurial manager for Illinois and Michigan based, Magi Consulting,   Mr. Konja is a CPA and licensed tax attorney.  Magi Consulting specialize in helping entrepreneurs start, grow, and manage their business.   Services offered by Magi Consulting  include capital fund management, new business development, acquisitions and mergers, organizational policy and procedures, technology integration, auditing, and assisting private companies in going public.   Mr. Konja lives in the Chicago suburb with his wife, and six children.