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Forming A Business

What’s the best form in which to do business?

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Q: I’m currently the manager of a body shop in town, but
I’d like to be my own boss. I’ve found a good location to open
a new shop and plan on giving notice to my current employer in
the near future. My father-in-law is willing to advance me the
necessary start-up capital, but I want to start off on the right
foot.

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A: There are several appropriate forms for a small business,
be it a body shop or otherwise. You can operate as:

  • a sole proprietorship, either under your own name or with
    a fictitious business name;

  • as a partnership, either general or limited;
  • as a corporation, either a standard "C" corporation
    or under a Subchapter "S" election;

  • or as one of two new types of businesses, a limited-liability
    company or a limited-liability partnership.

Each of these various entities has its own advantages and disadvantages.
What’s right for you should only be determined after consultation
with your attorney and, if appropriate, your accountant. When
reviewing the forms of businesses, it’s important to remember
that, while general concepts tend to be relatively uniform, differences
exist from state to state.

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Sole Proprietorship

A sole proprietor is an individual who operates a business personally.
If his own name is utilized, there’s no need to file a Fictitious
Business Name Statement (sometimes known as a "dba"
or "doing business as"). For example, "Steve Jones’
Body Shop" does not need to have a Fictitious Business Name
Statement filed because the world can tell who owns the business.
However, if you do business as "Steve’s Body Shop" or
"Modern Body Shop," you will need to file a Fictitious
Name Statement, which is usually filed with the county clerk for
the county in which the shop is located.

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The primary advantages of a sole proprietorship include simplicity
and reduced legal and accounting expenses to start your business.
The primary disadvantage of a sole proprietorship is that you
have unlimited personal liability for the obligations of the business,
so if the business doesn’t pay its creditors, these creditors
have access to your personal assets. While certain potential obligations
can be guarded against with the appropriate insurance, there’s
no insurance that covers your inability to pay suppliers, your
landlord, etc.

However, many creditors – such as banks and landlords – will require
a personal guarantee for a small business, regardless of its form,
particularly if it’s newly established and without a favorable
operating history. A creditor such as your father-in-law would
generally be given a promissory note for the amount loaned and
would not be a co-owner of the business.

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Corporation

If you form a corporation, it’s a separate legal entity. While
your lease will be in the name of the corporation, most savvy
landlords will require a personal guarantee from the owner of
a new corporation without a proven track record. Other creditors,
such as suppliers, utility companies, etc., may not require a
personal guarantee.

The primary advantage of a corporation is limited liability. Absent
a personal guarantee, creditors can only look to the corporate
assets for payment of obligations and will not be able to look
to your personal assets – assuming you’ve complied with the formalities
of organizing and running your corporation.

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The corporation issues shares to its owners. Shareholders then
elect a board of directors, which then elects corporate officers.
There can be as few as one shareholder. If you wish to bring in
another owner down the road, shares can be issued or sold to him.
Investors, such as your father-in-law, can also be issued shares
and/or a promissory note. An investment for shares of stock is
known as an "equity" investment, while promissory notes
are "debt" investments.

Exclusive of fees charged by the state, the legal fees for forming
a simple corporation generally run a couple thousand dollars.
As a separate entity, the corporation must pay taxes on its predividend
profits. Dividends received by shareholders are taxable income
but are not deductible by the corporation.

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Generally, in a closely held corporation, income is paid out to
the shareholder employees in the form of regular compensation
and bonuses, minimizing or eliminating profits and avoiding double
taxation. Tax authorities may, however, challenge such compensation
as being unreasonable and recharacterize it as dividends that
are taxable, not deductible – which is the worst of both worlds.

Although people commonly talk about Subchapter "S" corporations,
there’s actually no such animal. Under the Internal Revenue Code,
a corporation may make a Subchapter "S" election if
it has no more than 35 shareholders and meets other criteria.
A corporation originally formed with a Sub-chapter "S"
election can convert to a Subchapter "C" corporation
and vice versa, but strict limitations exist as to how frequently
this can be done. The primary advantage of a Subchapter "S"
election is that there’s no double taxation. Shareholders are
taxed on their respective share of corporate income regardless
of whether it’s retained within the corporation or distributed
to the shareholders.

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General Partnership

Two or more people can form a general partnership with or without
a written partnership agreement. Management and control of the
partnership is by numerical majority unless the written partnership
agreement provides otherwise.

While partnerships have the advantage of not being subject to
double taxation, every general partner has "joint and several"
liability for partnership debts and obligations. Therefore, even
if you’re only one of 10 equal partners, creditors can look to
you for all of the partnership debt.

Given the unlimited liability of a partner for all the debts of
the partnership and the potential exposure for debts either not
covered by insurance or for which your insurance is insufficient,
it usually makes little sense to operate a business such as a
body shop as a general partnership.

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Limited Partnership

A limited partnership is somewhat different from a general partnership.
Control of the business is by the general partners only; limited
partners are basically passive investors whose involvement in
running the business is quite restricted. Your father-in-law could
be a limited partner if he didn’t want to make a straight loan.

If limited partners become actively involved in running the business,
however, they’re subject to the same unlimited liability as are
the general partners of a limited partnership. Otherwise, liability
is equal to the amount of their investment in the partnership.

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Like general partnerships, limited partnerships are not separate
tax-paying entities. Both the general and limited partners pay
taxes on their share of partnership profits, whether distributed
or not. Investors, such as your father-in-law, frequently are
made limited partners, while the owner/managers of the companies
are general partners.

Limited-Liability Company

A limited-liability company is a relatively new form of business
entity that combines some of the best aspects of a corporation
and a partnership. Limited-liability companies, which require
two or more owners (or in some states, one owner), are a form
of business in which the owners are protected from individual
liability (as in a corporation) yet receive tax treatment similar
to that of a partnership. While limited partnerships provide favorable
tax treatment, at least one person must be a general partner and
thus be subject to unlimited liability. In addition, certain Subchapter
"S" election limitations (such as no more than one class
of stock and restrictions on the type and number of shareholders)
do not apply to limited-liability companies.

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Limited-Liability Partnership

The final entity is a limited-liability partnership, which is
quite new. The first statute to authorize a limited-liability
partnership was enacted in Texas in 1991. A number of states authorize
limited-liability partnerships only for certain professions, such
as medicine, engineering, architecture and law. Other states permit
all types of partnerships to operate as limited-liability partnerships.

Some states limit a partner’s liability to situations where he
has individually acted negligently or otherwise wrongfully, or
supervised the wrongdoing. Other states, however, limit the individual
partner from liability from all acts of the partnership.

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Tax treatment is usually the same as other partnerships.

Business Decisions

While it’s usually possible to convert from one form of business
to another, it’s frequently a complicated and expensive process
that may have significant negative tax consequences. Deciding
which business entity is right for your shop requires considerable
thought, the weighing of alternatives and competent legal advice.
Make your decision wisely and carefully, and your new venture
will be one you’ll enjoy and profit from in the future.

Paul Rice is a Palo Alto, Calif., attorney who, for 20 years,
has represented body shops, distributors, manufacturers and others
in the collision-repair industry.

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Check It Out

If you’re thinking about starting a new venture, there are several
appropriate business forms for a body shop:

  • A sole proprietor is an individual who operates a business
    personally. The advantages of a sole proprietorship include simplicity
    and reduced legal and accounting expenses to start the business.
    The primary disadvantage is unlimited personal liability.

  • A corporation is a separate legal entity that issues shares
    to its owners. Shareholders then elect a board of directors, which
    then elects various corporate officers. The primary advantage
    of a corporation is limited liability.
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  • A corporation may make a Subchapter "S" election
    if it has no more than 35 shareholders and meets other criteria.
    The primary advantage of this is there’s no double taxation. Shareholders
    are taxed on their respective share of corporate income regardless
    of whether it’s distributed.

  • Two or more people can form a general partnership, and management
    and control is by numerical majority unless the written partnership
    agreement provides otherwise. Every general partner has "joint
    and several" liability for partnership debts and obligations,
    which means even if you’re only one of 10 equal partners, creditors
    can look to you for all of the partnership debt.
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  • In a limited partnership, control of the business is by the
    general partners only; limited partners are basically passive
    investors whose involvement in running the business is restricted.
    Both the general and limited partners pay taxes on their share
    of partnership profits, whether distributed or not.

  • A limited-liability company requires two or more owners (or
    in some states, one owner) and is a form of business in which
    the owners are protected from individual liability (as in a corporation)
    yet receive tax treatment similar to that of a partnership.

  • A number of states authorize limited-liability partnerships
    only for certain professions, while other states permit all types
    of partnerships to operate this way. Tax treatment is usually
    the same as other partnerships.

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