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Consider entity, liability when setting up business

Posted online

by John Landwehr

for the Business Journal

Starting a new business is like going on the first date with a new acquaintance. Expectations generally exceed reality, and the risk of failure goes with the territory. But going on that first date might be the first step toward a long-term relationship. And starting your own business can lead to independence and financial success, rare phenomena among mere employees of larger firms.

It's hard to prepare for that first date (other than obvious things like taking a shower and using liberal quantities of mouthwash), but there are a few items to consider and implement before you give your two-week notice and head out on your own.

Choose a business entity. If your business will involve no risk of liability, you might just remain a sole proprietor, but even then you may want to consider incorporation or some other business entity.

Some personal expenses like health insurance, may be deductible, and you may be able to draw income from the business through leasing arrangements that are not subject to withholding and Social Security taxes. There are several entities to choose from that are not expensive to create.

?Incorporation is still attractive for many ventures. If you elect Subchapter S status, the corporation pays no tax since all profits and losses are passed on to shareholders, just like a partnership. A special version, the Statutory Close Corporation, eliminates many corporate formalities. You can even operate without directors or meetings.

?Limited liability companies have become very popular. Like a corporation, an LLC allows its owners, called members, to avoid being individually liable for many business debts and claims. This means that although you may be liable for your own negligence, your individual assets will not be subject to collection for acts of the business, such as an employee hitting a busload of lawyers while delivering your products.

LLCs require no annual reports at the Secretary of State's Office, and the operating agreement can be tailored to your specific arrangement.

?Straight partnerships are not recommended unless there is no risk of business liability. General partners are individually liable for all acts of the partnership. You can file as a limited liability partnership and avoid that problem, but if you forget to file annually (which is easy to do since the Secretary of State's Office does not send out a notice) you automatically lose your protected status. I've never met a limited liability partner who couldn't just as easily be a member of an LLC instead.

Maintain and protect your name. Most business entities are legal fictions created to avoid individual liability. Once you've gone to the trouble to create one, don't let down your guard. You have to continue to act like a corporation or LLC. Your bank accounts, advertising, contracts and the embroidered logo on your golf shirts should all reflect corporate or LLC status.

If you don't need a separate business entity, or even if you form an entity but want to use other names, you can file a fictitious name registration with the secretary of state for just $10.

The filing does not protect your name forever, but it is your official statement that "John's Popcorn Stand" is the way Smith Enterprises LLC is doing business, and if someone chokes on a kernel, they can't sue John Smith individually.

The only way to really protect a name, or a logo, (and even then it's not bullet-proof) is to register a trademark or trade name. If you're going to spend a lot of money to promote a particular image, you might consider taking this step early in the game. The Internet has complicated this problem since "John's Popcorn" can be marketed all over the world. There are now special ways to register a business name being promoted on the Internet.

Get your accountant in the loop. One person you should talk with before and during the formation of a business entity is your accountant or tax preparer. You don't want to show up next April 14 and tell him you've formed a new corporation. Some IRS filings, such as the Subchapter S election (which can have huge ramifications) have strict deadlines.

Your accountant can also help you choose between entities because there are subtle tax advantages and disadvantages to all of them, depending on your situation.

Ways not to economize. A lot of small businesses overlook, sometimes intentionally, withholding requirements and workers' compensation insurance. The IRS and Employment Security will require compliance unless you can establish that you're using independent contractors.

There are lists of factors which determine that status, but a good rule of thumb is that if yours is the only business the worker is involved with, he's probably an employee. And the written agreement that says he is an independent contractor will not persuade anybody.

If you have five or more employees (or any employees at all if you're in construction) you must provide workers' compensation insurance. There is a mandatory $25,000 fine if you don't. These are expenses that you might as well include in your financial projections. If your success depends on cutting these corners, think again about your venture.

Dealing with disabilities. Now that you've started your business, you might have to hire some help. You've heard about the Americans with Disabilities Act, and it scares the hell out of you. Like most federal acts it is pretty complicated, but there are some basics. You can ask the applicant if he can do the job, but you can't ask him if he is disabled. You can't require a medical exam until after you've offered him the job, subject to the exam. You have to make reasonable accommodations if he has a disability.

I recommend that if there is any question about his ability to perform the job (especially if your medical questionnaire, required after the offer of employment, reflects prior work injuries) have a doctor tell you whether he can do the job. Then it's not your decision, and you have avoided hiring someone who cannot perform or might even be a professional claimant.

Think about the unthinkable. All good things come to an end. If you're going into business with one or more other persons, you must sit down and ask each other some hard questions. What happens if one of you falls in love with a flight attendant and moves to Greece? What happens if one of you dies or gets divorced, or both? What are the expectations in terms of time and money?

Unless there is an even split of investment and duties, the likelihood of conflict is significant. Business splits and successions are bloodiest when nobody thought to document expectations and scenarios at the front end. Statutory close corporations have some built-in succession parameters. In an LLC, you can cover these issues in the operating agreement. Every regular corporation needs a buy-sell agreement, even (and maybe especially) when the principals are related.

Consider preferred stock or a note (instead of voting stock) for nonactive players. Consider employment agreements tied to profits or sales volumes if the division of labor is not equal. Think about a covenant not to compete so your buddy thinks twice before he walks out with your ideas and your customer lists.

The best way to draft a fair agreement is to do it when the parties don't know what side of the bargain they will be on. In other words, do it when you're forming the business.

Develop a good relationship with a solid lender. Businesses require debt, and most require lots of it. A good loan officer can be a great source of objectivity and accounting reality. But often they get paid based on volume, and sometimes SBA guarantees and production pressures entice them to make loans they shouldn't make. You don't want to be on next year's work-out list. Don't borrow money from a loan officer who doesn't ask hard questions and who smiles all the time.

Other resources. This article is strictly the Cliff Notes version. In addition to seeking good legal advice, persons starting up small businesses can contact their local University Extension Center for lots of free information.

Each county has an office. Some provide excellent seminars. The state has a resource at its Business Assistance Center, on the Web at

or by phone at 888-751-2863.

(John Landwehr is a partner in the Jefferson City firm of Cook Vetter Doerhoff & Landwehr PC. The preceding article was provided by the Missouri Bar Association.)

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