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Tokyo Game ShowIndieCadeBlizzcon2nd European Conference on Games Based Learning
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Business Planning Part 1
Selecting your Business Entity (Con't)Limited Liability Company (LLC)First, a note on Corporations. Corporations are separate entities, and therefore profits may be double taxed. In other words, instead of profits from the business passing through to your personal tax return, the corporation’s profits are taxed independently (both income and employer payroll taxes). Your salary, which is taken from the corporate profits, is also subject to taxation (both income and employee payroll taxes). The profits are therefore taxed twice. However, shareholders (i.e. owners) of a corporation are in no way personally liable for the losses of the business. If the corporation can’t pay a creditor, that creditor cannot turn around and require payment from the individual shareholders beyond what has been invested in the business. An LLC has all of the tax benefits of a partnership or sole proprietorship (business profits are only taxed once) but it also provides the liability shield available to corporations. This means that the members are not personally on the hook for debts owed by the business. It’s important to note that individuals are still personally liable if they personally guaranty a loan or commit fraud. There’s also a legal doctrine called “piercing the corporate veil.” Treating your business like your own personal piggy bank (in legal parlance, “commingling funds”) and failing to observe common company practices (common practices include having routine business meetings with minutes, maintaining business documents, keeping your business license up to date, properly reporting business earnings, etc.) can cause you to lose your limited liability. An LLC obviously has a lot of advantages—you get all of the protection of a corporation and fewer tax headaches. However, it also requires a lot more work. Registering your LLC can cost you quite a bit and you will need to have several documents (Articles of Organization, Operating Agreement, registration forms, etc.) drafted before you can even get the proper license. As a small business, however, LLCs have several attractive qualities because they require fewer corporate formalities. Also bear in mind that "pass through" taxation is the default tax treatment for LLCs. One other major benefit of an LLC is that you are able to elect tax treatment. You can be taxed as a sole-proprietorship/partnership and be subject to income and self-employment payroll taxation, or you can elect to be taxed as an S Corp or as a C Corp. As the relationships of the members (similar to partners—members operate the organization) are determined by the operating agreement and Articles of Organization, it’s important that you work out the same factors you needed to consider when forming a general partnership before you start the registration process. It’s too costly and too time consuming to mess up, and as with all things in business, your goal is to do it right the first time. CorporationsCorporations are a separate and distinct entity from the people who run it. A corporation can enter into contracts, incur debt, and be subject to judgments. Corporations consist of a board of directors, shareholders, officers and employees. A corporation’s primary obligation to its shareholders (i.e. owners) is to make money. If you incorporate as a business, it is imperative that you are able to maintain traditional corporate formalities. This may mean holding annual shareholder meetings, having your officers elected by your board of directors, complying with your Articles of Incorporation, having regular board meetings with the minutes recorded, and maintaining financial documentation that in no way implies impropriety or commingling of funds. Failure to comply with traditional corporate formalities has fairly serious consequences. First and foremost, it may lead to the piercing of the corporate veil. This means that the individuals who run the corporation may be personally liable for judgments and debts against the corporation. As the primary function of a corporation is to prevent personal liability, this is a big deal. These requirements are overwhelmingly concerned with record keeping. While it isn’t necessary to record every minor decision the corporation makes, major decisions with written consents from the board of directors may be necessary. It may also lead to the dissolution of your corporate status. Considering the expense associated with incorporating your business, this is something you will want to avoid. The advantage of a C-Corp. (traditional Corporate status) is that you can have several shareholders and investors, which means you may be able to raise to more working capital. You may also issue shares and distribute dividends. However, it is important to note that your income from your C-Corp will be double taxed. As an officer of your corporation, you will be paid a salary as opposed to a share in the company’s profits. Your salary is subject to all of the standard employment taxes, such as FICA, social security, and federal and state income taxes. However, your corporation’s profits will also be taxed separately, so any income you earn from dividends or disbursements will be taxed as separate income. S-CorporationFor tax purposes, an S-Corporation is a federal tax classification that permits the entity to not be subject to an income tax (similar to a LLC). Instead, all profits and losses pass through to the shareholders and are taxed on their personal tax returns. The election to be treated as an S-Corp is based almost entirely on tax treatment. The fees associated with being treated as an LLC in some states (such as CA) may turn out as greater than they would be if you elected S-Corp treatment. In an S-Corp, instead of members (as you'd have in an LLC), you have shareholders. Those shareholders are subject to a pro rata tax, to be claimed on their personal tax statements, based on profits earned by the business. This means that shareholders are taxed based on the number of shares they own in the business. A majority shareholder will be responsible for a greater proportion of the taxes on the earned profits. This also means that shareholders who are employees will pay FICA taxes on their salaries as well as income taxes on their portion of the company's profits. This isn't necessarily a double tax—the salary is subtracted from the profits prior to application of the federal income tax. Non-employees are only required to pay the income tax commensurate with their ownership in the company. Because shareholders are taxed whether or not there is a cash disbursement of profits, it is advisable for S-Corps to provide cash disbursements of profits to shareholders that are at a minimum enough to cover the taxes themselves. This is usually set out in the shareholder agreements. The decision to be treated as an S-Corp. should be between you and your accountant. You get the same legal treatment as other limited liability entities, such as LLCs, LLPs, and C-Corps. Deciding to elect S-Corp status is usually something you can determine when you are filling out your annual or quarterly tax information. ConclusionThe foundations of your company will be based on these early decisions. Before you can build you business, you have to take steps to determine what is best for your business and the individuals who work with you. These general concepts will play a constant role in the success or failure of your business. The second and final part of this series will be posted on 5/12 - Ed.
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