Imagine that you decide to build a storage unit facility in your home state–you pay your taxes as necessary and got the right permits to set up shop–but you don’t file any special paperwork interacting with the Secretary of State’s office where you live. What just happened? You just started either a sole proprietorship (if it’s just you) or a partnership (if you share the profits and managerial authority with anyone else). There are no formalities that you must go through in order to create a sole proprietorship or partnership–it is the default rule created by law unless you file something to indicate otherwise.
This can have scary consequences for people unfamiliar with how the law interacts with their business conduct. For instance, if you start this storage unit and agree to split the management authority and share the profits with someone else, you are assuming the liability for their negligence. If they accidentally back up a truck into someone’s 2016 Ferrari, you are liable for that. And because partnerships don’t provide a shield against personal assets, the actions of your partner can touch your personal assets rather than the cash that you purposely direct into the business. Regarding intentional torts–e.g. if your partner deliberately rams the 2016 Ferrari–the tort liability law varies by state, but there is a possibility that you could be legally responsible for that as well.
Other consequences relate to opportunity cost. Countless online forums are filled with people who start businesses and then are unsure of whether they can start some type of retirement plan related to it. Yes, whether your default is a sole proprietorship or partnership, you are permitted to create a SEP IRA or a SIMPLE IRA. If you create a sole proprietorship, or go into business with no employees other than a spouse and have no intention of adding employees, you are eligible to create a Self-Employed 401(k). This knowledge is crucial for lowering your tax bill and deferring taxes related to retirement–it is not an exaggeration to suggest that the upper and lower boundaries regarding your legal savvy on this matter could have millions of dollars of consequences over a lifetime.
If you just go into business for yourself, and default as a sole proprietor, there are five things to know: you are the residual claimant, you are only taxed on your income once as the owner of the business, your liability is unlimited, the business is not freely alienable, there are no formation formalities required, and the proprietorship dies when you die.
For a partnership, there are two or more residual claimants (the partners), the liability is unlimited for negligence and possibly intentional torts, the economic interest in the partnership is freely transferable but nothing else, there are no formation formalities required though there does not to be some kind of indication from the conduct of the partners that authority and profits are somehow shared, and the partnership dies with the death of a partner (though a new partnership immediately springs up).
The characteristics of a corporation, meanwhile, have some important similarities and differences compared to the proprietorship/partnership structure. First of all, the residual claimants are the shareholders rather than the ones operating the business (the term “residual” refers to the value that is left over after everyone else has been given their contractual due–the employees have been paid, the creditors have been satisfied, and all legal matters have been settled. The remainder of the value that the liquidated corporation has left is the “residue”, and this is equally distributed among shareholders based on how many shares are owned).
For someone who is just getting started out, the advantage of setting up the business as a corporation rather than a partnership is because of the limited liability protections. Unless you are a shareholder-operator that runs afoul of the necessary formalities, the corporate veil cannot be pierced and you cannot be held liable for contract creditors or tort claimants. When you buy shares of a stock like Nike or Boeing, your liability is limited according to what you invest in the corporation. A $10,000 investment can only theoretically go to $0; you can never get a $25,000 bill to pay off Boeing’s debts. Once the assets of the corporation are exhausted, the third party has no right to claim the property of the residual claimants (the shareholders).
Unlike a partnership or sole proprietorship, there are formalities required in setting up a corporation. The specifics vary by state, but the general structure is this: you have to file articles of incorporation in the state that you want to incorporate, you have to pay a filing fee, the new corporation is born as a legal entity, and in exchange for that, you receive liability protections and a few other benefits but in exchange you agree to pay the corporate tax.
When someone starts a partnership, the partnership structure itself never pays a tax. The business earns a profit, pays it out to the partners, and then the partners are taxed on that (my alma mater offers a course called “Partnership Taxation” which is terribly named…the student that writes “Partnerships are not taxed” and then turns in the final exam should receive get the A+). With corporations, there is a double taxation. The corporation itself pays a tax that can be as high as 35%, and then when the remaining income is paid out to shareholders as dividends, the income is again taxed at a rate as high as 23.8%.
Most corporations choose to incorporate in Delaware, although it is common for there to be a lifecycle before that happens. Often, when a business just gets started, it incorporates in the state of where the founders are located because those are the laws that the founders and lawyers find familiar. As the business prospers, there is a reorganization in which the company re-incorporates in the state of Delaware. The triggering event that causes this is usually an initial public offering (IPO).
These kinds of differences bore the heck out of most people but are the types of distinctions that are quite important for a businessman to get the most out of his economic life. I have repeatedly stated that there are three knowledge areas where Warren Buffett has exceptional expertise that explain Berkshire’s longstanding success, and the knowledge of the implications behind each legal wrapper is what goosed Buffett’s income in the 1940s and 1950s. At a minimum, it is necessary for knowing what risks exposure you are assuming with your business efforts, and at a maximum, it can permit you to stockpile significant amounts of wealth by lowering tax bills and then finding the right types of tax shelters to redirect profits towards.
Notice: This article, which I believe may be of interest to readers, is for general information only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal or investment advice.
Originally posted 2016-03-13 18:37:05.