What a lawyer is referring to when he talks about the "choice of entity" is the legal form which your business will take. As you probably know, there are legal creations which allow a business to take on an existence apart form its owners, even though the owners still control the business. Corporations and partnerships were the two traditional legal entities that allowed this, but that list has grown longer to include limited partnerships, limited liability companies, and Subchapter-S corporations.

Why is the type of legal entity you chose for your business important? Because owners can be liabile for tax liabilities and tortious (think slip and fall) injuries caused by their business. Whether the owner is then personally liable for such liabilities of the business often hinges on the type of legal entity chosen. What this means is that depending on the type of entity you choose, you (the owner) could be personally sued (as opposed to just your business being sued) by the government or private parties when things go wrong and people are looking to get money out of someone. With the proper choice of legal entity, you can worry less about such a thing happening (law, being an uncertain science, can never promise you that there is nothing to worry about).

Don't Perform Your Own Brain Surgery

Suffice to say that deciding on what type of entity to use is one of the more important decisions you face as the owner or promoter of a new business. The ability to sell your ownership interest in a business, the ease of later capital infusions, the relationship between co-owners, and, of course, liability for the business's tax or legal problems are all dependent upon the choice of entity. DO NOT TRY TO READ YOUR HOME STATE'S STATUTE CONCERNING THE CREATION OF BUSINESS ENTITIES AND ASSUME THAT THAT WILL BE ENOUGH TO INFORM YOU ABOUT WHICH ENTITY TO CHOOSE! You would never fool yourself into thinking that by boning up a little on surgical techniques, you could perform an operation on yourself. Do not make the foolish error of thinking a business lawyer's job is somehow easier than other professions which take years of study and practice; you will only be creating costly and potentially ruinous problems for yourself down the road.

Do your business a big favor. Hire a lawyer to help create it--those legal midwives can help you avoid mortally harming your business during one of its most crucial periods: the beginning.

What factors go into the Choice of Entity?

Every single fact concerning your business is relevant to the Choice of Entity decision. Not all of them are of equal importance, but they all matter to some degree.

For almost all start-up companies, the considerations that should be in the forefront are not the sale of ownership interests to the public or venture capital financing--these things come later (hopefully!). Instead, the initial focus should be on:

• the tax and tort liability issues,
• cost of maintenance of the entity,
• protection of intellectual property (very important and often overlooked),
• size and complexity of the entity,
• regulatory requirements that the local, state or federal government has placed on the proposed business activity,
• and other similarly mundane issues.

These are much more relevant to a young business, albeit less exciting than "going public" or getting venture capital money. Still, success depends upon them. Please pay attention to your choice of entity at some point, it really does make a very large difference later on.

Here is a list of standard business entities. Each one is a link to some basic information about the particular entity.

1. C-Corp
2. Limited Partnerships and Partnerships
3. Sole Proprietorship
4. S-Corporation
5. Limited Liability Companies

First off, get yourself a program called Quick Books (available from the Barnes & Noble website via the GIF below), or something similar to help keep track of your business's finances. We have found that these programs are an enormous help to young businesses run by people who are not very familiar with standard accounting and management procedures. ( We don't get any money for endorsing Quick Books so our recommendation is based on our experience and preference, not financial incentive.)

Second, do not ever make the mistake of saying ``I'll take care of the books, taxes, etc. later--I've gotta build my business first." A few simple actions at the beginning and regular bookkeeping will avoid enormous problems later on. People who start a business first and worry about the boring stuff, such as tax filings later, are sure to run into problems. This may seem like a no-brainer to most of you, but we have seen very bright millionaires who thought they could either outwit the IRS and state revenue departments or simply put off those boring tax rules for awhile. As you can imagine, the legal bills (and possible criminal penalties) associated with this attitude are debilitating to any business, let alone a small startup.

Please, please take care to file all necessary tax forms (local, state and federal) at the beginning. After that, keep your books and tax records up to date, this will help you avoid that tax-time crunch of trying to run your business while also re-creating a year's worth of financial records from memory (by the way, it simply can't be done, and you will lose money as a result).

We know that many (most?) of you do not know a deduction from a debit so we try to make these pages dealing with taxation as simple as possible. But if you do not understand something, or if you want more information, please let us know. We are in the process of revising the whole site and your input is very much wanted. Especially in an area like taxation which is a difficult subject for beginners.

Below is a list of topics for you to peruse. For people entirely new to tax and accounting, start from the beginning and work down the list.

• 1. Financial Records and Accounting
  2. Paying Federal State and Local Taxes
  3. Links to State Tax Agencies
  4. List of Common Small Business Deductions

This is a very bare-bones description of what bankruptcy is and what you need to know about it. Frankly, if your business is in danger of heading into bankruptcy, you need to speak to a good lawyer who can give you very specific advice based on your particular situation. And if a business that owes your business money has filed for bankruptcy, well, unless it is a lot of money, you can pretty much write off the debt and move on to other matters. This page, then, is a brief introduction to what bankruptcy is in a legal/financial sense, as opposed to the popular notion of ``no-clothes-left-except-this-oak-barrel" we all remember from the Warner Brothers cartoons.

When most people use the word ``bankruptcy", they are referring to a financial state of ruin and the end of a business. When legal and financial advisors use the term ``bankruptcy", they are referring to a situation where a business is currently unable to pay its bills as those bills come due or a business whose liabilities exceed its assets.

To a lawyer's mind or a financial advisor's mind, bankruptcy is merely another state of existence for a business entity, albeit a undesirable one. And those professionals see a bankrupt entity as one that might be able to continue despite whatever present problems it may be experiencing. Professionals have this view of bankrupt businesses because of their familiarity of the United States Bankruptcy Code (USBC). The USBC offers debtors, both individuals and business entities (i.e., corporations, partnerships, etc.) legal protection from creditors seeking immediate repayment. Since bankruptcy is a legal state, you should always contact a bankruptcy attorney for advice if you fear that you are sliding towards the abyss; he or she should be able to help you decide on the best course of action.

What is bankruptcy? When a business or a person declares bankruptcy, they file a petition with the local United States Bankruptcy Court. The court then forces all creditors to stop collection efforts and legal proceedings in other venues (i.e., other courts) and instead present all demands for payment to the bankruptcy court. This keeps the bankrupt business from having to fight creditors in multiple courts, some of which may be on the other side of the country. With all of the legal proceedings consolidated into one setting, the court then does one of two things:

Repayment Plan: The court sets up a payment schedule which is usually based on a plan presented to it by the bankrupt business. Under the plan, the debtor will pay back the creditors over time (usually a longer period than the original credit terms). The plan needs to show that the creditors will get more of their money back by allowing the business to continue than the creditors would if the assets were liquidated and sold. It is interesting to note that if a repayment schedule is presented and the court approves it, the former managers and/or owners of the business will usually continue to run the business throughout the bankruptcy proceedings unless the management was particularly awful or crooked in some way. After the bankruptcy protection period is over, and debts are repaid, the managers/owners can go on their merry way again (possibly ruining the business a second time).

Liquidation: If no repayment schedule is put forward, or if the repayment schedule is not approved by the court, the assets of the bankrupt business are sold by a person called a trustee who organizes the sale and disposes of the assets. All proceeds from this sale go to the creditors. All remaining debts are then wiped out and the former debtor (now debt-free) is given a clean slate. None of the creditors involved in the bankruptcy proceedings can pursue any legal action against the debtor for the debts that were discharged through the bankruptcy proceedings. That game is over.

From this short synopsis of the bankruptcy laws, you should be able to see that our nation's bankruptcy laws generally favor debtors; the courts are empowered to force creditors to take what they get from the debtor before the court discharges all remaining debt. The debtor, in effect, gets off ``scot free" and does not have to pay back the money he/she/it owes. This idea of giving debtors a clean start is only about one hundred years old, before that people who could not pay their bills went to jail!

But as you probably know, the creditors of the world do not just forgive and forget when a person or business declares bankruptcy. Any business or person who goes through bankruptcy proceedings has little hope of getting credit from any other source for the next ten years or so, unless a painfully high interest rate is paid along with the provision of some sort of collateral.

Who should declare Bankruptcy? Usually, a potentially bankrupt business is one that has been sliding into ruin for some time. Costs are going up, revenues are going down, or the business has just never been able to sustain itself without cash infusions from other sources. Eventually, the business's poor performance catches up to it and the business becomes so cash-poor that it cannot pay its bills and no one will loan the business any more money (big surprise!). At this point, a business should contact its creditors and try to work out a repayment plan. Make an honest effort to come to terms with all of your creditors. Bankruptcy is a very serious affair, requiring lawyers, courts and more than a little amount of money.

Also, do not use bankruptcy as a threat against creditors who are trying to collect their bills. Word will quickly get out that you and your business are deadbeats who will not pay their bills. Far better to come across as a cash-poor business trying to repay its debts than a broke business trying to strong-arm concessions out of creditors. Only if all creditors will not agree to a repayment plan without court intervention should you consider filing for bankruptcy.

Things to know. Bankruptcy courts are not stupid. Do not try to use them for anything except a true bankruptcy proceeding. We are not going to catalogue all of the ways that the bankruptcy court can punish people and businesses who try to use bankruptcy proceedings for improper reasons, but there are more than enough of them.

Also, in the three months before you go into bankruptcy, do not try to favor one creditor over another when it comes to paying your bills. Bankruptcy courts can go back and recover such money from creditors who received payments from debtors before the debtor filed for bankruptcy if those payments were more than the creditor would receive in a liquidation. Happens all the time. And if there is some sort of fraud involved in the payment of one creditor as opposed to another (i.e., payment is made without the debtor having received something of value in return) in the year prior to the filing of a petition for bankruptcy, the court can void the transaction and force the creditor to repay the money.

There are different types of corporations, but the one nearly every entrepreneur is interested in is the general business corporation. Corporations are creations of state laws (or a foreign nation if you want to be exotic). The basic structure and attributes of a corporation do not change much regardless of the state, although there can be a great deal of variety concerning the more particular characteristics and duties of a corporation in any particular state.

This guide to corporations is a rough sketch. Your state's laws may differ in ways that will affect your decision, so be sure to talk to an attorney familiar with corporate law. You do not have to incorporate in the state where you live. And just because you live in Utah, Michigan, New York, or wherever does not necessarily mean you want to incorporate there! Talk to an expert in corporate law who can explain (i) how your home state will treat a business incorporating there, and (ii) discuss the benefits of some of the other states commonly chosen by corporations as the state of incorporation. All states are not alike in their corporate laws. That being said, the differences among the states are hardly so stark that you will ruin yourself by choosing one state over another.

Formation

Laws governing incorporation must be strictly followed, otherwise the attempt at incorporation may fail and a partnership may result. The necessary actions to incorporate are fairly standard:

• prepare and execute a pre organization subscription agreement for the stock that the corporation will issue;
• prepare and file the corporate charter with the appropriate secretary of state;
• prepare the by-laws;
• hold an organizational meeting of the board of directors;
• establish the books, records, home office, etc. of the corporation;
• file any reports required by the state.

Mistakes in these documents can cause problems ranging from minor annoyance to business-killing litigation.

Please, if you have any hope of building a sophisticated business, do not try to create a corporation on your own or use an attorney who is inexperienced in this area. The author of this web page knows of a very successful businessman who tried to incorporate on the cheap with an attorney who did not know what he was doing, and then a few years later, when his business was booming and he was ready to leap up to the next level, that businessman had to spend hundreds of thousands in attorneys' fees and pay millions in settlement amounts to someone who deserved nothing, simply because the corporation had not been set up properly. His business lost the investors who were interested and he has yet to recover from the whole incident. Do you think it could not happen to you? That's is the kind of thinking that really makes lawyers rich! Avoid the courtroom solution, pay an experienced attorney to set up your corporation.

Characteristics of a Corporation

A corporation is an autonomous legal entity, existing apart from its shareholders, officers and directors, whereas neither the sole proprietorship nor the partnership can truly be considered distinct from the persons creating it. Corporations usually possess most of the economic powers that any person would: they can own property, sue in court, sell or transfer property, etc. For a startup, the most important characteristics of a corporation are the continuity of existence, lack of pass-through tax treatment, limited liability for investors, and the ease of adding investors and selling interests.

Continuity of Existence

Corporations have a kind of legal immortality. With proper care and maintenance, the Corporation should exist for as long as the shareholders desire. A corporation continues on regardless of the circumstances surrounding the owners. Deaths and transfers of interests in the corporation have no impact, and unless the state law has put a limitation on the existence of a corporation, it can continue indefinitely.

The shareholders can dissolve a corporation by a vote, and legal proceedings can also end a corporation's existence. Often, one of these two methods will be employed by shareholders when the corporation's outlook is bleak. Judicial dissolution is the commonly used method when there is infighting among the shareholders.

Minority shareholders should think about their relative lack of power and the inability to control the corporation's destiny before accepting this diminutive role. With proper lawyering, many of the pitfalls of a minority position can be avoided, but in the end it is still a minority position.

Limited Liability

Unlike partnerships and sole proprietorships, corporate shareholders are not liable for any of the corporation's debts. This means that what you pay for the stock or what you pay to incorporate is the total sum that you are risking, and nothing more. This is true regardless of how much a shareholder participates in management. A shareholder who owns 100% of a business and makes every decision cannot be held liable for the debts of the corporation, unless of course he runs afoul of a certain area of law known as ``piercing the corporate veil". Also, the corporation will be liable for the acts of its employees and agents who commit tortious acts, but the owner will not.

This protection against liability for corporate debt is deceptive to the uninitiated. You must understand that most lenders (banks, investors, etc.) who offer money to small corporations make the principal owners sign personal guarantees for the loans made to the corporations (we are talking about money, after all), so the limited liability of this structure (and all other structures) is somewhat misleading. You are likely to take on some of the liabilities of the corporation. The benefit to incorporating still exists, however, because you usually only take on those liabilities to which you consciously agree.

Limited liability will not protect you against lawsuits alleging fraudulent or criminal actions by you in the course of corporate business, but that is just common sense. After all, you cannot expect corporate laws to protect crooks from suffering the consequences of breaking the law.

Ease of Adding Investors and Selling an Interest

To add new investors or sell an interest, the transacting parties simply exchange shares. Absent a shareholders' agreement to the contrary, there is no requirement that the other shareholders agree to the transfer, and there is no way that the other shareholders can withhold any of the benefits of stock ownership from the new shareholders. The new shareholders step into the place of the old ones without any diminution of rights or interest. In a small business, this kind of transferability is not a good thing for the other, non-selling shareholders. after all, who wants strangers coming into the business through a stock sale? That is why a shareholders' agreement restricting such actions is commonly signed among the shareholders.

Formation and Maintenance

Corporations require a greater investment than most other business entities, except for perhaps a partnership or a limited liability company. In addition to the state filing fees, there is the initial organizational documents, where the shareholders, if there are more than one, agree about things like the number of directors, corporate officers, voting arrangements, sale of shares, etc. But note that attorney's fees to craft these agreements should be smaller than those charged for a partnership agreement due to the greater standardization of the corporation. This rule of thumb changes, however, if there are securities issues or complicated capital arrangements.

Maintenance of a corporation, on the other hand, is usually more expensive than other forms. States often require corporations to pay franchise fees or other taxes as part of their yearly re-licensing. Added to this is the expense of minute preparation, registered agent fees, board of directors proceedings and legal fees stemming from an increased need for attorney's advice about how to perform corporate actions "properly." Moreover, more owner and employee time is spent on caretaking of the entity than is generally performed for other entities.

Piercing the Corporate Veil

This is a dramatic name for a simple act. When a smaller corporation has financial trouble, and creditors are not going to get back all of their money, courts are often asked to issue a judicial order stating that the corporate owners are liable for the corporation's unpaid debts. If the courts agree to issue the order, this act is known as ``piercing the corporate veil." Before issuing such an order, courts look at certain actions by the owners and management of the business to determine if the order is warranted.

Generally, the court looks at three factors:

1. Did the owners fail to observe corporate formalities such as keeping minute books, passing resolutions, and holding board meetings?
2. Did the shareholders treat the corporation as a separate entity or as a simple artifice?
3. Did the corporation have any money to start with or in its infancy or was it merely a shell?

To avoid such judicial action, shareholders and directors of smaller corporations should follow a few basic rules:

1. Treat all corporate money as just that, corporate money. Do not commingle personal funds with corporate funds.
2. Deal with third parties as an officer of the corporation, not as a person making a business deal on his or her own.
3. Start the corporation with enough money to make it legitimate (how much is enough? Talk to a competent business attorney! At least if he gets it wrong you will be able to sue him if the corporate veil gets pierced because of undercapitalization.)
4. Treat the corporation like it is a separate entity. Take care of the minute books, save all documents, make sure the small stuff is taken care of and observe all formalities. A little time spent this way can save a lot of money later.

Where to Incorporate

As you may know, each state has its own version of incorporation statutes. Any one of the fifty states can be chosen by a small startup deciding to incorporate, regardless of what state in which the owners reside or conduct their business. Some states, however, are generally preferred due to their more sophisticated body of law concerning corporate law. Delaware, New York, and (happily, for all you Left Coasters) California are all considered to be among the "top-level" states when incorporating a new business.

People often choose Delaware as the state of incorporation due to the flexibility and the management-friendly body of legal rulings handed down by the state's court system. With an expeditious incorporation process, no minimum capitalization requirements and broad rules concerning a corporation's indemnification of its directors, Delaware is in some ways very attractive to small startups. Nevada and Maryland are among the other corporation-friendly states.

Please note, however, that where you incorporate is not the only place where you will have to worry about state laws affecting your business. Whatever states (or countries!) in which your business (be it a partnership, corporation or anything else) actually does business, your business will be subject to that state or country's laws, and you could be hauled into court in that jurisdiction as well. As ever, sound legal advice is a good thing when entering a new state or country for the first time. California, for instance, requires ``foreign" (this term includes corporations from other states) corporations to comply with some terms of the California state corporate laws when those foreign corporations start to do business in California.

Management and Control

According to law, day-to-day management of a corporation rests with the officers appointed by the board of directors, who are ultimately responsible for the management of the corporation. The board of directors is elected by the votes of the shareholders.

The exact duties of the board and the officers are usually spelled out in the by-laws or, less frequently, the articles of incorporation.

Oftentimes, there are agreements between the shareholders of smaller corporations dictating who the shareholders will put on the corporate board of directors. Other voting arrangements include creating different classes of stock entitled to different numbers of votes.

In addition to voting for the board, shareholders typically have the right to inspect the corporate records and official documents.

Death of a shareholder has no impact on the corporate structure, unlike a partnership.

Fiduciary Obligations of Officers and Directors

Remember those fiduciary duties partners owed one another in a general partnership? Well, they apply to officers and directors of a corporation too. In essence, the fiduciary duties of a director or officer require them to act in good faith, in the best interests of the corporation, and use reasonable care when performing their duties. Essentially, this means that you have to do what is best for the corporation, even if that is not what is best for you. These duties exist whether the corporation is public or private. Although these duties sound easy enough, in the tangled spaghetti relationships that usually exist in small corporations, where directors are often shareholders, officers and sometimes creditors, discerning the proper course of action under these duties is often difficult. Failure to perform the duties creates liability for the officer or director who does not perform up to the Law's demands. In sum, it is best to have a lawyer involved in corporate affairs; he or she can help the officers and directors perform their proper duties. And again, if the lawyer screws up and the officer or director gets sued, that person can turn around and sue the lawyer if the lawyer's advice was very bad. Lawyers are good for some things!

Recently, courts have begun imposing the fiduciary duties on the majority shareholders of small corporations who are dealing with the minority shareholders. For instance, if the corporation is very profitable and the minority shareholders want a dividend to be paid out, but the majority shareholders are refusing to do so (and probably hoping that this forces the minority shareholders to sell their shares to the majority shareholders at a lower price), a court is likely to step in and treat the majority harshly. The court may impose a monetary award to the minority shareholders or otherwise involve itself in the management of the business until things get worked out.

Transferability of Interests

As said earlier, unless there are specific agreements to the contrary, owners of shares may freely transfer them to potential purchasers (subject to securities laws).

Parties may contract to impose reasonable restrictions on the sale of shares in a corporation. This type of agreement, called a shareholder's agreement, is often done to prevent a shareholder from selling to a new party which the other shareholders find unacceptable. Also, majority shareholders usually have a duty not to knowingly (including those instances where they should have known) sell their shares to a purchaser who intends on ``looting" the corporation's assets.

But just because you can transfer shares does not mean someone will be eager to buy them. Shares in a small corporation are often difficult to sell, unless the shares are listed on a recognized exchange, and even then large blocks may be difficult to sell. Small businesses are often dependent on the personal relationships of the people running them; continuation of sales, supplies, and personnel may all depend heavily on the few people running the corporation. A person buying such a business cannot be sure that when he buys the business, he will get everything that he sees in the business before the purchase. Moreover, if it is less than a majority stake, the purchaser is stepping into position of weakness relative to the other shareholders. So exit from the corporate form is usually just as difficult as it is for a partnership.

Tax Aspects of a Corporation: This is the downside to corporations, at least as far as small businesses are concerned. With a corporation, you do not get the ``flow-through" tax benefits that all of the other small business entities enjoy. What this means is that the profits and losses of the company are the company's profits and losses, not yours. The corporation will have to file a tax return and pay taxes on the income it receives. Then, if there are any dividends to be paid to the owners (you!), those owners will have to pay taxes again on the money received as dividends. This is the double taxation of corporations that so many shareholders grumble about.

There are ways, however, for small corporations to avoid the double taxation of income. Often, a small corporation will pay its owners salaries rather than pay dividends, so the corporation gets a deduction for the amount paid to shareholders. But the IRS watches such salary payments very closely, and if you push it too far, they may be treated as dividends. Not surprisingly, startup businesses rarely adopt the traditional corporate format (unless it is going to ``go public" almost immediately after creation, something that occurs about as often as Immaculate Conception). Instead, small businesses opt for one of the other corporate forms we discuss in the other sections of the Choice of Entity Chapter

There are two types of partnerships, general and limited, each of which are discussed below. Like all other business entities, partnerships are a creation of state law. The majority of small business enterprises where there is more than one entity are general partnerships. Given the liability such business people face as a result of this, this fact is somewhat disturbing.

General Partnerships

General partnerships consist of two or more partners, and each one of those partners carries unlimited personal liability for the obligations of the partnership. Each partner has complete and equal managerial control over partnership affairs unless there is a partnership agreement stating otherwise.

The law governing general partnerships can be found in the Uniform Partnership Act. The U.P.A. is a model law that states around the country have adopted with greater or lesser fidelity; states often modify it or fail to update their laws as the U.P.A. is revised, so there is some variance among the states. The laws contained in the U.P.A. are general guidelines for partnerships and are usually open to modification by the partners. In the parlance of attorneys, the U.P.A. rules are "default rules" that apply if the partners have not expressly contracted otherwise. Because the U.P.A. serves as only a fallback or "default regime", businesspeople are left a great deal of flexibility to craft agreements governing the innumerable issues that could be important to their business.

Although a partnership can be formed very informally and without legal aid, it is preferable to have your lawyer draw up an agreement reflecting your particular needs, if only to prevent future disagreements over present intentions of the parties.

A partnership has some characteristics of a separate legal entity. Often, a partnership can sue other parties in courts and convey or buy property. But partnerships retain one very large disadvantage of the sole proprietorship: partners are held personally liable for the obligations of the partnership. Unpaid debts and tax bills of the partnership can result in the partners' personal assets being subject to seizure.

Formation

Formation of a partnership can be easy. Two people who say to each other, "We're partners!" may be partners under the law, even of they do not write anything down or say another word on the topic. Clearly this is not the best way to form a relationship where any more than nominal amounts of money are going to be involved.

Assuming you have a lawyer form a partnership for you, it will probably be more expensive than either a sole proprietorship or a corporation. (See the respective sections on formation for each of them to determine why this is.) The additional expense comes from the attorney-time necessary to craft a partnership agreement. Partnership agreements tend to be less standardized than other business entity agreements and thus need more attention. In any event, the expense should not be over $2000 and it is worth the expense to have the clarity that a well-drafted partnership agreement can bring to your partnership (Lenders and investors like clarity.)

Similarly, it is possible that the law will treat you as partners in certain circumstances (e.g., sharing profits in some instances, failure to legally create a limited partnership or a corporation, representing oneself as a partner) even without any agreement between the supposed partners. Even though formalities are unnecessary when forming a partnership, each state's law should be consulted to insure that there are no particular requirements (for example, New York requires a filing in every county where the partnership will be doing business).

Forming partnerhsips haphazardly is very risky financially since, as noted above, each partner is liable for the partnership liabilities and a partner's personal assets can be seized to pay such liabilities (see below for more). When coupled with the fact that each partner has complete and total power to act on behalf of the partnership, you have a potentially ruinous situation. Imagine, for example, your partner taking out a loan from a bank in the partnership's name, which he could legally do, and then he loses it all in a risky derivatives deal that was a "sure thing". Who is liable? The partnership, and that means you are liable. Such occurrences can be avoided.

Maintenance Costs

Partnerships are often cheaper to maintain than corporations. Partnerships do not have to make minutes detailing their actions like corporations, nor do partnerships pay taxes (the partners pay taxes individually on the income they receive from the partnership). There are no directors, officers, etc., just the partners.

Personal Liability for Partnership Debts

Each general partner in a general partnership has personal liability for all of the partnership debts. Under the Uniform Partnership act, general partners are jointly liable for partnership obligations. This means that each general partner must, in the event of the partnership being unable to pay its bills, pay the proportionate amount of the partnership debts equal to his ownership interest in the partnership. For example, if the partnership in which you have a 66% ownership interest cannot pay its bank loan of $100,000, then you will be personally liable to the bank for $66,666.67 of that amount (perhaps more depending on the state law and loan terms). The other $33,333.33 would be owed by the owner(s) of the remaining 33% interest.

Moreover, general partners are jointly and severally liable for the tortious acts of co-partners who are acting within the scope of the partnership business. Suppose, that there is a civil court case against your business which results in a $100,000 judgment against your business, you would be personally liable for all of the money owed, regardless of the percentage of your ownership interest. Assuming that your partnership was broke and you paid the whole $100,000, your 66% would allow you to seek reimbursement for the 33% of the $100,000 from your co-partner(s), but if they had no money you still have to make up the difference.

If that is too much like math word-problems, just remember this: Any judgment rendered against a bankrupt or cash-poor general partnership can result in the personal assets of the partners being seized to satisfy the judgment. That means your car, house, bank accounts, etc. are subject to seizure to pay the debt. Think about this when you are choosing your partners and making your choice of entity.

Management and Control

The law is fairly quiet about management of a partnership, saying only that in the absence of an agreement to the contrary, all co-owners of the partnership have an equal right to manage the affairs of the partnership regardless of the actual ownership percentage. This means that a partner owning 90% of a partnership cannot overrule his two partners who own 5% each. This dispersal of management authority can be avoided by the partnership agreement. Not surprisingly, this is often done when partnerships are formed, and management authority is commonly given to the partner who will be most active in partnership affairs.

Due to the law's lack of guidance on management, there is a great deal of flexibility in structuring a partnership's management. This structuring almost certainly has to be put into written form and will require an attorney's attention. One of the traditional reasons people preferred partnerships is that there was this flexibility of management structure, as compared with the rigidity of the corporation. The development of a hybrid entity, the Limited Liability Company, has changed this, however. Limited Liability Companies are discussed elsewhere in the Choice of Entity chapter.

Fiduciary Relationship (the ties that bind!)

Partners in a partnership are bound together in a peculiar legal relationship: fiduciaries. While the law may forgive a person's transgressions against other legal relationships like marriage, brotherhood, and parent/child, the law actually cares about fiduciary duties, and will not look kindly on those partners who do not honor the fiduciary relationship. (Maybe this is because money is at the heart of a fiduciary relationship rather than love. The law understands money, not love.) As a fiduciary of your partners, you will owe them your complete loyalty, honesty and fairness in all business dealings with one another. Once you enter the partnership, you cannot open a competing business, deprive the partnership of your time or skill, misappropriate partnership property (including intellectual property like computer programs), or take money out of the partnership without proper procedures being followed.

There is a positive side to this fiduciary relationship. The law recognizes that people want to choose people with whom they will share this type of relationship, so there are rules concerning the inclusion of new partners. No person can become a member of the partnership without the consent of all the partners. To illustrate, if one of your partners sells his partnership interest to another person who is not a partner, that new person is NOT a partner with all the rights and obligations that the law grants and imposes, at least not until you agree to have the new person as your partner. Note, however, that the new person would have a right to get the profits or losses that their ownership interest entitles them to (e.g., a 50% interest entitles them to 50% of the profits).

Dissolution

Partnerships, unlike corporations, do not have perpetual existence. Partnerships generally end upon the occurrence of the following events: the death, retirement, withdrawal, expulsion, incapacity, or bankruptcy of a partner; court ordered dissolution of the partnership; or the expiration of any date set as the termination date in the partnership agreement. A well-crafted partnership agreement can avoid the operation of the law in this area, but it should be kept in mind that the partnership entity is generally more delicate than a corporation or LLC.

Tax Aspects of a Partnership:

Taxation Basics The good news is that partnerships are not subject to federal income tax on the income they earn. The bad news is that the partners are considered to have earned the income attributable to the partnership (you don't expect Uncle Sam to let you keep all of that money do you?). What happens is that at the end of the partnership's tax year, the books for the year are closed out, and all money left over after bills, expenses, etc. are taken care of is (as far as the IRS is concerned) divided up among the partners according to their ownership percentages. And regardless of whether the money actually gets paid out in this, the IRS treats it as though all profits of the partnership have been distributed to the partners according to their ownership interests.

Pass Through Taxation Process The partners then pay income tax on the money they received from the partnership as though that money was personal income. Alternatively, if the partnership lost money that year, the partners get a deduction equal to the losses equal to their ownership percentages (limited by the basis of what the partner invested and/or the passive activity rules). (Like any other business entity a partnership must obtain a federal employer identification number using Form SS-4 and file its annual returns even though it is not acutally paying taxes.) The partnership annual tax report is made on IRS Form 1065. Remember, the partnership does not actually pay any taxes when it sends in Form 1065, this is filed only for informational purposes. States almost always have a form which is equivalent to Form 1065 and this must be filed annually as well.

The partnership (i.e., one of the partners) must prepare and provide each partner a Schedule K-1, which shows each partner's share of the partnership's profits and losses. The K-1 forms are then filed with each individual partner's personal tax return. THOSE INDIVIDUAL PARTNERS THEN PAY INCOME TAX (or claim losses) IN AN AMOUNT EQUAL TO THEIR PROPORTIONATE SHARE OF THE PARTNERSHIP'S INCOME (or losses).

Distributive Share Sounds easy, right? Imagine you own a 50% ownership interest in Tanned Feet Partnerhip (a fine investment on your part, congratulations). At the end of 1998, Tanned Feet has income in the amount of $200,000. You will have to pay income taxes on $100,000 of that amount. This $100,000 is considered your ``distributive share" as a 50% partner.

Unless there is an agreement to the contrary, the law and the IRS considers all partners in a partnership as owners of equal shares of the partnerhip. This means that if you have three people in the partnerhip, you each own 33.33% unless you agree otherwise. (Any such agreement should absolutely, positively, with no exceptions be put into writing and signed by each partner!) If you agree to split the partnership income in an unequal way, maybe to reflect the fact that some people bring more valuable skills or work longer hours to advance the business, the tax code and the law recognize this and will tax you accordingly. So if you report that a person holds a 65% interest in the partnership's income, that partner will owe income taxes on 65% of the partnership's income.

The Bad News There is a downside to the partnership taxation laws. If a partnerhip retains money at the end of the year instead of paying it out, the partners must still pay income tax on their respective shares of the partnership income. For example, if Tanned Feet Partnership earned $200,000 in income during 1998, and rather than being paid out to the partners, this money was kept in the partnership to buy additional computer hardware, the Tanned Feet partners would still have to pay taxes on the $200,000 income. If you think that you are going to run a business which will require a lot of retained capital, you may want to consider a C-corporation. (Remember that an S-Corporation is taxed much like a partnership, so it would not help you in this situation.)

Contributions and Capital Accounts The money and property ``given" or contributed to the partnership by the partners are called ``contributions". The value of contributions given by each partner forms each partner's ``capital account". A capital account is more a financial record of your investment in the partnership than an actual ``account" in the way a bank savings acount is an account. The capital account helps determine the tax you owe on distributions paid to you by the partnership.

A partner's capital account is increased by the value of the property she contributes to the partnership. A partner's capital account is decreased by her share of the partnership's distributions. The amount of the capital account forms the partner's tax ``basis", and until the capital account reaches zero, the partner will not owe any taxes on the distributions she receives.

For example, suppose that in return for a 50% interest in Tanned Feet Partnership you give Tanned Feet Partnership $10,000 cash and $10,000 worth of computer equipment. This gives you a $20,000 capital account. At the end of 1998, Tanned Feet has made income of $200,000. You receive $100,000 from Tanned Feet as a distribution. You do not owe taxes on the first $20,000 of this $100,000 since you were only recouping your initial $20,000 investment. You do owe taxes on the remaining $80,000, however. Your capital account is also now reduced to zero so any future distributions will be fully taxable unless you increase your capital account with additional contributions to the partnership.

Contributions of property rather than money bring other tax rules into effect. Generally, the value of the property you contribute to the partnership will determine your capital account. But if you have already depreciated the property or if the value of the property has increased, you are caught up in a more complex taxation problem than we care to discuss here, and if you are contributing mortaged real estate to a partnership make sure you talk to your accountant!

Capital accounts are adjusted upward during the life of the partnership as well whenever a partner contributes additional money or property and decreases whenever there is a distribution of money (or recognition of losses).

Contributions of Services If you or another partner is a ``skills" person who contributes no money or other property but is instead receiving a partnership interest for bringing a unique (or not so unique) set of skills to the partnership, you should be aware that the IRS does not recognize this as a contribution. As far as the IRS is concerned, a person who receives a partnership interest without making a capital contribution of money or property is getting a valuable asset for nothing. This is a taxable event and the person receiving the partnership interest will have to pay income taxes on the value of the ownership interest received. Keep this in mind if one person is putting in $100,000 for a 50% interest and another is putting in nothing for her 50% interest. The person who put in nothing just received a $100,000 taxable asset.

We know that this brief description of partnership taxation is going to make tax attorneys cringe, but it's all you probably need for right now unless you intend to be a passive investor in a partnership in which case you probably have enough money to hire an accountant. (Passive investors are people who are just putting money into a business without performing any additional work on behalf of the business. People visiting this website almost certainly will not fall into this category.)

Limited Partnerships

A special type of partnership is the limited partnership. This type of partnership is found in almost all of the fifty states. Although it is based on the structure of the general partnership, the limited partnership has some very significant differences. Each of the following subsections will try to point out these differences.

Formation

To form a limited partnership, there are strict and inflexible statutory rules which must be followed, otherwise the attempt to form the limited partnership fails and a general partnership usually results instead.

A certificate must usually be filed with the state Secretary of State office or the office of the County Clerk in the county where the limited partnership will operate to provide a public record of the existence of the limited partnership. The filing certificate must contain whatever information is required by that state's limited partnership act and signed by the partners.

Formation and maintenance costs are still higher than those of corporation for the same reasons that the general partnership costs are higher.

Limited Liability

Limited partnerships have one very large advantage over the general partnership: limited partners do not take on personal liability for the obligations of the partnerships, they are only liable to the extent of the money contributed to the partnerships. The general partner in the limited partnership, however, retains all of the personal liability for partnership debts that one finds in the general partnership entity.

It is important to know that the limited partner's protection against personal liability can be lost in cases where a limited partner is found to participate in the control of the business beyond the limited role allowed to limited partners. What is the boundary of the limited role allowed to limited partners? How much participation is too much? Good question. This is an open question, so get help from your lawyer to help prevent the unintended loss of limited partnership status.

Limited Partnership's General Partner

As mentioned earlier, the limited partnership must have at least one general partner who is personally liable for the debts of the partnership debt. But since this general partner can be a corporation, this requirement does not mean that one of the members of the limited partnership needs to accept potentially ruinous liability.

The general partner controls the limited partnership with the same scope of powers as a general partner would have in a standard general partnership.

The general partner also owes the limited partnership at least the same level of fiduciary loyalty that a general partner in a general partnership owes, perhaps more. Limited partners in a limited patnership, however, generally do not owe fiduciary duties to one another.

Continuity of Existence

The death, retirement, withdrawal, or bankruptcy of a limited partner does not end the existence of the limited partnership, but instead only requires an amendment to the limited partnership's certificate. The limited partnership interest may be transferred to another person without the consent of the other limited or general partners. But the limted partner will still lack some rights unless there is approval by the other partners. The death, retirement, withdrawal, or bankruptcy of the general partner will dissolve the partnership.

Why use it?

The limited liability partnership is often attractive to entrepreneurs because they can retain control of the business by acting as the general partner, while still being able to offer limited partner investors the tax benefits of a tax flow-through entity. But with Limited Liability Companies now offering the same benefits without requiring a general partner, limited partnerships are becoming old news.

A sole proprietorship is an individual (or married couple) who owns a business which is not otherwise incorporated or organized as a separate legal entity (i.e., there is no partnership, limited liability company, corporation, etc.). Putting it differently, sole proprietorships are businesses where an individual conducts business and holds title to property in his or her name and is directly and personally liable for the obligations of the business. There is no corporate entity or other legal device employed to hold the business assets or ameliorate the liability of the owner for any debts or obligations of the business.

Despite the personal liability that comes with the sole proprietorship, this form can be preferable where the owner contemplates no complex financing and no co-owner relationships with other parties. In fact, there are 15 to 20 million sole proprietorships in the United States. This comprises over 80% of the businesses in the United States!

Maintenance costs are very low for the sole proprietorship. Apart from any "doing business as" filings necessary if the sole proprietorship is using a name different from that of its owner, no documentation is needed to organize a sole proprietorship and no special record-keeping or corporate formality is necessary. You would not even need an attorney to form this type of business entity. By hanging out a sign, you have opened up a sole proprietorship.

Unlike other forms of business entities, there are no specific statutes governing the creation and existence of sole proprietorships. Instead, basic rules of contract law, tort law, and property law will apply. In addition to these basic concepts, all regulatory restrictions applied to businesses generally will apply to the sole proprietorship (e.g., environmental laws, civil rights laws, etc.).

The existence of the sole proprietorship ends upon the death of the owner and the property of the business will be disposed of according to the terms of the owner's will. All assets of the sole proprietorship are owned by the owner as personal property.

On the whole, if you are planning to have a business of any sophistication, you probably want to avoid this entity.

Tax Aspects of a Proprietorship

The tax code treats the sole proprietorship and the owner as one and the same: income earned by the business is seen as income of the owner and must be reported on the owner's IRS Form 1040. Expenses of the business are also claimed by the owner as deductions against income on the owner's year-end tax return.

Another important point to remember about sole proprietorships is that sole proprietorships are taxed on all net income; there is no way for your small business to retain earnings without you being taxed on that money. So if you expect or want to use income from the business to grow (i.e., you are going to reinvest the profits back into the business), you may want to consider creating a C-corporation. (A C-corporation is not taxed on retained earnings.) For instance if your sole proprietorship had income of $50,000 one year and you wanted to invest that money in new computer equipment, you will pay income tax on that $50,000. If, however, your business was a C-Corporation, that $50,000 would still be taxed but at the rate for corporations, not individuals. This would mean more money with which to buy computer equipment. (There are downsides to C-corporations too, such as double taxation.)

Reporting Income from Your Sole Proprietorship The only forms you need to file to report your income from your sole proprietorship are:

1. Schedule C which is attached to your annual 1040 form. (It comes with instructions .) Schedule C must be filed whenever your sole proprietorship income exceeds $400 but you should file it even if you do not make $400 in a year. You will be able to get business deductions for losses only if you file your Schedule C. Filing also starts the statute of limitations clock on the IRS's ability to audit you on that year's business operations.
2. If you have a pretty small business, you may be able to file Schedule C-EZ instead of Schedule C. To be eligible to file Schedule C-EZ, you must meet the following conditions.
   (a) gross receipts of less than $25,000
   (b) claimed business expenses of less than $2,500
   (c) no inventory
   (d) no employees
   (e) cash accounting methods are used
   (f) no depreciation of assets claimed, and
   (g) no overall loss being claimed.

   Most people just opt for filing the regular Schedule C since it is almost identical.

3. Estimated Tax Payments. If (1) you are going to owe more than $1000 in income taxes AND (2) at the end of the year your tax bill will be less than either 100% of your tax bill for the previous year or 90% of the tax you will owe, then you must make quarterly estimated tax payments. You must make these payments using Form 1040-ES. This form and your payments must be made on April 15, June 15, September 15, and January 15. (These estimated tax payments will include the money you owe for payroll taxes such as Medicare and Social Security. See below!) Please note that most states are also addicted to prepayment of taxes, so you will probably have to send the state some estimated tax payments as well.When you estimate the quarterly tax payment, what you should do is figure out how much you will probably owe in income taxes at the end of the year. Then plan on sending in one quarter of that amount with each tax payment. Using the previous year's income tax bill is a very good way to estimate the current year's tax payments. As long as you pay about 90% of your tax bill over the course of the four quarterly installments, you will not incur the 9% penalty for failure to comply. But if your adjusted gross income exceeds $150,000, you will need to pay no less than 105% of the previous year's tax to avoid the penalty. (And if your adjusted gross is this high, you probably should have an accountant who is helping you manage your tax affairs.)
4. Employee Taxes. If you have employees, then you definitely need to read our sections concerning employees and the tax laws.

Crib Notes--Sole Proprietorship

• Selling the Business: Selling a sole proprietorship is more difficult than selling a corporation or LLC.
• Existence: The business and you are one, if you die, the business assets are treated as part of your estate.
• Liability: YOU have liability for all business debts and legal troubles!
• Taxes: All business income is taxed as your personal income.

An S-Corporation is a hybrid between partnerships and C-Corporations. S-Corps are formed much like a C-Corp and have a very similar structure. There are shareholders, by-laws, articles, stock, etc. just like a C-Corp. But the tax treatment of the S-Corp is markedly different from that of the C-Corp.

Unlike a C-Corp, all income and losses of a S-Corp are attributed pro rata to the owners. This means that there is no ``double taxation" of corporate income like there is with the C-Corp.

Another advantage to a S-Corp is the lower taxation rates applicable to S-Corp income as compared to the C-Corp. You see, the tax rates applied to regular C-Corps are generally higher than those applicable to individuals. Thus, when S-Corp's income (i.e., profits) is distributed, it will be taxed at the rate of the individual owners, rather than the higher rate applicable to C-Corps.

Please note, however, that you need to meet certain guidelines to be eligible for S-Corp status. Almost any small business will meet these guidelines, however, so you can just let your accountant or attorney know that you want to form an S-Corp.

In addition, you need to file a document with the IRS in order to qualify as a S-Corp. Form 2553 is the S-Corp election form. Once filed, the S-Corp election will remain in force until you notify the IRS that you revoke the the S-Corp election. Please note that you can file an S-Corp election at any time for a particular tax year up until the sixteenth day of the third month of that tax year. (e.g., March 16th was the last day that you could elect S-Corp status for tax year 1997. But you can file for 1998 at any time in 1997 and until March 16th, 1998.)

If you are going to run a small business, the S-Corp structure is a much better entity than the traditional C-Corp. So you should probably make an S-Corp election if you wish to use a corporate entity. But, frankly, we are not big fans of S-Corps. We think that the limited liability company is a better entity, but we prefer the exotic over the mundane, so maybe we are biased. We also prefer the limited liability company because it requires less formality than the S-Corp, a consideration when we advise business people who will be too busy to worry about corporate minutes, resolutions, etc.

Limited liability companies (``LLC") were first allowed in 1977 when Wyoming passed a statute allowing their creation. Now every state and the District of Columbia allow business people to form LLCs. The main advantages to an LLC are the protection the LLC owners receive from business creditors and the fact that, unlike a limited partnership, the owners can still participate in the management of the business. We discuss these interesting entities in this section and conclude with a brief discussion of the taxation issues involved in an LLC.

Formation

An LLC is formed by submitting articles of organization with the Secretary of State of a state. There is a fee usually associated with the formation of the LLC, the size of which varies depending on the state.

After the parties submit the articles of organization, the owners of the LLC (called ``members") usually enter into a written agreement about how the LLC will be run, who is in charge of running it, how profits will be divided up, etc. This agreement is called the operating agreement and it is similar to a limited partnership agreement. If there is no operating agreement, then the ``default" rules for running an LLC kick in. These default rules are found in the LLC statutes of the state where the articles of incorporation are filed. Generally speaking, it is better to have an operating agreement than it is to rely on the default rules, if only because it forces the members to think about many practical aspects of running a business at the outset and then agree about such matters before real money is at stake.

The people who actually run the LLC for the members are usually called the managers. The managers can be, but do not have to be, members of the LLC. The managers can be set up to resemble a board of directors if that is what the members want.

LLC Advantage Over Partnership Entities

The LLC has one very large advantage over the general partnership: members of an LLC do not take on any personal liability for the obligations of the LLC and they are only liable for debts of the LLC to the extent of their ownership interest in the LLC. (And there is no requirement that there be a general partner who retains personal liability for the LLC debts that one finds in limited partnership entities.) Moreover, unlike a limited partnership, there is little chance that members will somehow lose the LLC's liability protection through involvement in the business affairs of the LLC.

LLC Managers

As mentioned earlier, an LLC can opt for a management structure that allows certain people called ``managers" to control the LLC. These managers usually possess the same scope of powers as a general partner would have in a standard general partnership: they can sign contracts, sell assets, and make other important business decisions for the business. The actual powers are spelled out in the state statute or, more often, in the LLC operating agreement.

But managers are not required for an LLC. The members may simply retain all managerial authority for themselves. Or they can grant partial or limited powers to certain members and/or managers. In fact, almost any practical division of power among members and/or managers is possible with an LLC. This flexibility of control by the owners is one of the very best features of the LLC.

Continuity of Existence

The death, retirement, withdrawal, or bankruptcy of a member or manager may, in some states, end the existence of the LLC. But the laws concerning this issue are currently changing, so we cannot tell you the state of the law in general. The operating agreement will usually cover this topic and your attorney should know whether the state where the articles of organization are filed allows continuity of existence in such instances. (If he does not, find a more sophisticated attorney!)

Apart from the death, retirement, bankruptcy or withdrawal of a member or manager, an LLC usually only ends upon the date of expiration (often set at 25-30 years from the date of formation) or, if there is no expiration date, then upon mutual agreement of a majority of the members.

Why use it?

The LLC is often attractive to entrepreneurs because they can retain control of the business by acting as the manager or controlling member while still being able to enjoy the tax benefits of a tax flow-through entity. It is rapidly becoming the preferred entity over limited partnerships and S-Corporations (both of which provide similar tax benefits) because the LLC does not need a general partner and does not require the legal (i.e., costly) ``maintenance" associated with a S-Corporation.

Tax Aspects of a Limited Liability Company:

The LLC enjoys the same ``flow-through" tax treatment that partnerships and S-Corporations do. The rules concerning capital accounts, contributions and other basic partnership taxation principles apply to LLCs as well. So you may want to jump to our discussion of partnership taxation if you haven't reviewed it already.

In short, this means that although the LLC must file a tax return, the LLC owners report income and pay the taxes owed on such income using their personal returns. The LLC itself does not pay taxes on its income. (At this time, the IRS has not developed a separate tax return form for LLC, so the same form used for partnerships is used, Form 1065.) The owners will each file a Schedule K-1 with their personal income tax return, which will show their ``share" of the LLC income. While this structure avoids the double taxation dilemma of the C-corporation, there is a downside. The taxation downside is that, unlike a C-corporation, an LLC (like the partnerships and an S-Corporation) cannot retain earnings without the owners of the business having to pay income taxes on those earnings anyway.

One of the very best features of the LLC is the fact that you can divide up the ownership interests differently from the rights to distribution of profits (and losses). For example, suppose you went into business with another person and both of you wanted to own 50% of the business. But you were going to work at for LLC all the time while the other person was going to keep her full-time job and work for the business part-time. Well, you could each still own 50% of the ownership will dividing the profits interests into a 75%-25% split or some other ratio to reflect your different levels of effort. While you can still technically do this with a partnership, it is more difficult from a tax compliance point of view.

You should also be aware that some states impose a tax on LLC income tax (for no clear reason other than a simple money grab). So you should check with the state tax authority of each state in which your LLC will earn income to make sure that you are not going to have to pay an additional amount of money in LLC income taxes.

We recommend this structure, it really is a good entity. But it is one where you need the advice of a very good business attorney if you want to implement some of the more sophisticated LLC ownership options. As ever, we would be happy to guide you to local competent counsel in your area who could help you.

By law, you must keep financial records which are reliable and provide an accurate view of your business. Internal Revenue Code Section 6001 requires businesses to keep records appropriate to their trade or business. The IRS has the right to view these records in the event they want to audit your business's (or your personal) tax return. If they do not like what they find, the penalties can be deadly to your business and your own personal financial well-being. In addition to the IRS's ability to audit your books, states often have laws requiring such records and surprise auditors who show up unannounced insisting on seeing your state tax records.

Common sense demands financial records as well. Without financial records you are probably going to lose deductions and have much less control over how much money you make (or lose). For those of you with no accounting experience or training, record keeping may seem like a daunting and burdensome task, but it does not have to be. In this section we will discuss ways to make it simpler and, hopefully, less expensive.

Do it Yourself or Hire Someone Else? Many small business owners hire someone to ``keep the books" rather than do this work themselves. Bookkeepers can a certified CPA, a secretary or even someone who works part-time keeping track of financial records. The price for such services should be somewhere between $10 and $40 an hour depending on the level of qualifications and experience. (Clearly, the CPA is going to be the highest priced bookkeeper.)

Always, always, always check into the background of your bookkeeper. You need to do this for two reasons. First, you need to make sure that the know exactly what they are doing. Your bookkeeper must know about payroll deduction, income taxes, state and local taxes, filing deadlines, etc. Second, you must determine that your bookkeeper is so ridiculously honest that you can actually trust that person to watch YOUR money. Giving someone control over your money is a very, very serious matter, as you well know. it is made more serious by the fact that if your bookkeeper does not pay taxes either on time or at all, your business and YOU PERSONALLY will be held liable by the IRS and your state and local tax authorities. There would, of course, be fines and penalties as well as the underlying tax bill.

While we understand that you probably have no desire to engage in routine record keeping and tax work, you might want to consider developing your own record keeping system. Consult a tax professional who can help you develop your record keeping system, preferably a CPA who specializes in helping small businesses in your industry. Once you have the system in place and know how it works, then hire someone to look after it for you and teach them to use your system for your books. Then you are not dependent ion your bookkeeper, if he leaves, you can do your own books until you hire a replacement. Or if your seems untrustworthy or incompetent after you hire them, you can perform your own checks of your records to make sure everything is okay.

Doing it Yourself First of all, buy Quick Books from Intuit. (You are using a computer to look at this so we assume you have a computer already.) Using computer programs to keep track of business affairs is probably the best record keeping advance since the development of the double-entry accounting system, there is no point in not taking advantage of this, right? You will no longer have to worry about sloppy handwriting, computational errors, and data reorganization. We use Quick Books for Tanned Feet, an investment advisory service, a law practice, and a (flagging) music promotion business. For each of these types of service-businesses, Quick Books is more than adequate. If you have inventory Quick Books is more complicated, but it is still far better than keeping records on paper. The biggest payoff to using Quick Books is at tax time. With a few clicks of the mouse, you are nearly done gathering all financial information necessary for tax filings.

Quick Books accounts can be set up in about an hour. You may want to spend an afternoon reading through the manuals and information they send along with the program--it is very helpful. We really cannot emphasize enough how much a computer system will help the neophyte business person organize and maintain their business records, so even if you do not like Quick Books, try another program Such as Peachtree Accounting.

For those of you who insist on keeping your records on paper (Can you tell we are really trying to persuade you not to do this?), the method of organizing your records of expenses and income is fairly simple. You record all money paid to you, paid out to another, owed to you, or owed to another in your business's ``ledger". Any office supply store will carry a selection of lined paper set out in ledger format. Use this ledger to set up a list of your business expenses as they are incurred (money paid out), another list of money which is paid to you (business revenue).

Good record keeping is essential for any business. From the beginning, there are three types of records your business should absolutely maintain: a record of expenses, a record or income, and a record of assets. We briefly discuss each of these below. We do not delve very deeply into exactly why you need to keep these records, but as you read other sections in the Taxation section of this page, it may become clear. If it does not become clear, no big deal, just believe us when we say that your accounting bills will be far smaller if you keep these records in order.

Receipts and Record of Expenses Like any business, you will incur expenses. Most of these expenses are deductible when tax time comes. All receipts, invoices, canceled checks, contracts requiring payments by you (e.g., leases) involving a pay out of money from your business should be stored in a folder. (Preferably a folder which contains evidence of similar expenses -- it is best if you order them by type rather than by date.) Credit card statements should be kept even if you have the underlying receipts from the transaction.

You should jot down a quick note on all canceled checks and copies of receipts reminding you of what the expense involved. For instance, if you take a client out to dinner, write the client's name on the receipt, why you were having lunch (i.e., what business matter you discussed), the amount of the bill, and the restaurant. Or if you buy office supplies and the receipt does not list the items purchased and their respective cost, write them down yourself.

In addition to such records, you should keep a journal or ``record of expenses" recording, at the least, the following information:

• 1. How the expense was paid (credit card, cash, check number)
  2. Date of the transaction
  3. The party to whom the money was paid.
  4. The particular type of expense involved (e.g., office supplies, equipment, utilities, rent, etc.)

Income/Revenue Records Hopefully, like many enterprises, your business will make money as well as spend it. Just like expenses, you need to record all income (revenue) of your business. Your business's income, or ``gross receipts", needs to be carefully tracked because not all money your business receives will be taxable income. Money you receive from clients in return for your business's goods or services is taxable income. Money you receive from the bank as a loan is NOT. At the end of the year when you are figuring out your tax bill, it is vitally important for you to be able to separate the two and pay tax only on the former.

Different businesses use different methods of recording their business income. Your local grocery store probably uses electronic cash registers which feed their totals into a central system. A local government one of the authors worked for during college simply deposited its revenues in a bank account and recorded the amounts deposited. You, being the business-savvy entrepreneur of the computer age, will keep track of your income on your accounting program, right? Right?! (Or you could use a manual system. See below. <sigh>)

It is absolutely vital that your records of income received (or other moneys received, such as loans) give you at least some indication of precisely where the money came from and why you received it. You see, if the IRS audits you and it finds that your business's bank records show deposits totaling $200,000 but your tax return shows reported income of $150,000, a stern IRS auditor is going to ask you how your business came to posses that unreported $50,000. if you cannot say precisely what its was (e.g., money lent by your bank, return of money lent to a relative, money inherited by you and put into your business, etc.), the IRS will label it ``unreported income" and you will have to pay taxes on it as if this was business income.

Your record of revenues received should, at the least, record similar information:

• 1. The type and amount of payment.
  2. Date of the transaction.
  3. The party who paid the money.
  4. The work performed or good provided.

Asset Records All equipment (e.g., computers, fax machine, copiers, etc.) and other assets which have a life span of more than a year must be recorded and the cost amortized (i.e., deducted) over the life span of the asset. Thus, you need to keep records concerning your business's asset. You must keep asset records providing the following information:

• 1. Description of the asset.
  2. Date of acquisition.
  3. What month you started using the asset (usually the same as purchase).
  4. Total amount paid for the item, including taxes, delivery charges and fees.
  5. Sales price of any asset sold.
  6. Date of sale of any asset.
  7. Cost of selling the asset (advertisement, broker's fees, etc.)
  8. Whether you use the assets for personal use and, if so, how much time the asset is employed for such uses.

Again, there are excellent computer programs which will help you maintain these records!

FEDERAL TAXES

Most importantly, get an Federal Employer Identification Number from the IRS. Assuming that you are not planning on operating a sole proprietorship without employees, you need to send the IRS information about your business. Use IRS form SS-4. Do this just after you create your business entity. (Banks, customers, suppliers, etc. may ask you for this number so you really should get one as soon as possible.) Apart from that, some pretty good free information can be obtained at the IRS website. They have publications for businesses which can be downloaded for free (everybody loves free!). To get to the IRS website offering free business information, click here.

Here are the basic federal taxes that your business may have to pay, depending on the state you live in and the type of business you operate.

1. Income Taxes on the Business and the Owner and How to Pay Them: Once a year, businesses will have to report to the IRS and (probably) the state tax agency the amount of money earned by the business in the prior year. The actual amount of federal income tax that your business pays each year is determined partly by the type of legal entity you have created. Therefore, the different legal entities file different forms with the IRS.

Sole proprietors file IRS form Schedule C along with the owner's regular 1040. If your sole proprietorship business has net income, then you must also file Schedule SE along with the regular 1040 to determine the Social Security and FICA taxes you must pay.

Partnerships, limited partnerships and limited liability companies file IRS form 1065 to report partnership income (but remember that you will have to report your share of the partnership's income on your 1040 return as well). Just like for a sole proprietorship, please note that as a partner in a general partnership you are required to file Form Schedule SE. (See discussion immediately above)

A C-Corporation files 1120 or 1120-A. Remember that the C-Corporation must pay income taxes on its profits and the stockholders must also pay taxes on the dividends they receive (this is the infamous ``double taxation of C-Corporations). So the corporation's profits will be taxed as it receives income, and then taxed again when those profits are distributed to the shareholders. Moreover, if you are an employee of the corporation as well as an owner, you need to pay income taxes on the salary paid to you.

S-Corporations file IRS form 1102-S.

Note that as far as the IRS is concerned, you and your business are two separate entities, and both had better have their taxes in order!

2. Income Taxes on Employees and How to Pay Them:

Withholding (Income) Tax: If you have employees, you have the headache of withholding taxes from their paychecks and periodically sending that money to the federal government. Each time you hire an employee, that new employee needs to fill out an IRS Form W-4, listing the the exemptions and additional allowances claimed by the employee. You then use this form to withhold the proper amount from the employees' paychecks, and send that money on to the federal government. At the end of the year, you must give each employee an IRS Form W-2. The W-2 will simply list the amounts withheld from the employees' paychecks and sent to the federal government. There must be a separate copy of the W-2 for each of the taxing jurisdictions (federal, state, and local governments) plus one more for the employees' records. You will also have to send a copy of the employees' W-2s to the IRS yourself. Also, if your business involves more than $20/month in ``tips" to employees, your employees must report such tips to your business. Your business then has to withhold the appropriate amounts from the employees' wages.

Social Security/Medicare/Unemployment Taxes: Social Security, Medicare, and Federal Unemployment taxes will all have to be paid if you have employees. Social Security and Medicare taxes must be withheld from the employees wages and your business will have to match the employees' ``contributions" to these federal programs. These taxes are paid together and appear on the annual tax return for the business. And just like the income tax, if your business involves more than $20/month in ``tips" to employees, you need to account for these tips as part of these payroll taxes.

If you have employees during the course of 20 weeks of the year or you paid your employees a total of more than $1,500 in a year, you probably have to pay the federal unemployment tax. The federal unemployment tax, unlike Social Security and Medicare, comes solely out of your own pocket, with no contribution from the employee. Note that if your business' federal unemployment tax burden exceeds $100 per quarter for two quarters, then you need to make monthly deposits of the money owed. Form 940 is used annually for a business to report its Federal Unemployment Tax due. Please note that IRS form 940EZ can be used by a business if your business (i) has employees in only one state, (ii) pays all state taxes sums due by the 940EZ date, (iii) the Federal Unemployment Taxes paid are also taxable by the state governments.

To Pay Federal Taxes on Employees:

Paying federal business taxes requires two actions: (1) EACH QUARTER, using IRS Form 941 , report the income and payroll taxes withheld from the employees' paychecks and, (2) EITHER MONTHLY OR SEMI-WEEKLY deposit the funds you have withheld by sending a check to a bank authorized to receive money on behalf of the IRS.

Reporting must be done every financial quarter. Money deposits of payroll taxes must be done every month or every other week, depending on the size of your payroll contributions. For the first year of your business, deposits will be monthly. After that, the IRS will tell you how often you must deposit the withheld payroll taxes.

3. Excise Taxes on Businesses and How to Pay Them: Federal excise taxes are imposed on the sale or use of certain items of property or certain transactions and on certain occupations. If your business involves firearms, alchohol, motor fuel, trucks, or gambling you really need to look into the excise taxes. Depending on the type of business you operate, your business may have to pay excise taxes. IRS Form 720 lists the broad categories that this tax applies to. Form 720 needs to be filed every fiscal quarter. If your business uses heavy trucks, buses, or trailers, on public highways, then your business may have to pay a special excise tax levied on such vehicles and IRS Form 2290 would have to be filed.

STATE TAXES

Depending on your home state's laws, you will need to file sales tax, employee withholding tax, income tax, and possibly others. The best way to find out exactly what you will need to file is to either contact a local accountant, or, if you want to save some money (and that is why you are here after all), contact the state yourself. The state tax departments often have guide books to help small businesses (and large businesses) comply with the tax code. Click here for a list of links to the individual state tax agencies' websites.

Your state will almost certainly require your business to have an employer identification number issued by the state. Your state employment development office can provide you with more information and the proper forms. (Do not confuse the number assigned to your corporation, partnership, or LLC by the Secretary of State with the Employer Identification Number. These are two different numbers, issued by two different state agencies.)

Again, just like federal taxes, there are legal penalties for not paying state taxes, and these penalties include criminal penalties.

LOCAL TAXES

Now you definately need to consult your local authorities. There really is no way to guess what possible local taxes, fees, etc. you may be subject to, so we can only tell you to contact your local government office in charge of revenue.

But remember that there are multiple levels of local taxation. There may be a county assessment on assets and a city or municipal tax on income.

Final Word

If we can give you two last bits of advice, here they are. First, get professional help with your taxes. We know that it is expensive, but even if you have to use a young person just getting started in the accounting/tax law field, it will probably be worth your money. Paying taxes are enough of a bitch, don't try to figure out the laws too.

Second, as we said before, get a good computer program--AND USE IT! If you use a program like Quickbooks to keep track of your receipts and disbursements and balance your books according to a regular schedule, tax calculations and professional advice should not too costly.