Summary

A strong element of the RP sexual strategy is to improve your financial situation. Some of you may pursue this by starting your own business. Whether you’re a solo operation or with a collection of guys with complimentary talents, there are some key legal concepts that you should be aware of before you potentially find yourself in hot water.

Since there is so much (mis)information out there, this post will educate you on the general basics of business entities, including why people form business entities, what different business entities exist, and clarification of some commonly misunderstood business / tax concepts.

Body

It’s your friendly, neighborhood tax attorney /u/ColdIceZero, here to talk to you about my bread and butter: business formation and related tax topics. This post is not geared for upper-level business law students. The topics I discuss here are complex and have a lot of exceptions. This post is just to give you the basics so that you may be able to hold your own in a conversation.

How will this information benefit you?

First, the more financially successful you become, the more likely you’re going to run into these concepts. It’s better to have a basic understanding of the moving parts in these matters. Ignorance will lead you to make foolish decisions and get you into trouble.

Second, a basic familiarity with these concepts will help you identify the times when other people don’t know what the hell they’re talking about. Often, people will give advice with the best of intentions, without realizing that the information they’re providing is dead wrong.

What is a “business entity” and why should I form one?

A “business entity” is something you’re typically going to already be a little familiar with, at least by name. Corporation, general partnership* (this one is special), limited partnership (LP), limited liability partnership (LLP), limited liability limited partnership (LLLP)(and yes, those are 4 separate entities), and limited liability company (LLC) are the business entities you’re most likely going to interact with on a daily basis. There are a few other types, including business trusts, professional corporations (PC), professional associations (PA), and professional limited liability companies (PLLC); but this post will focus on the more common business types.

The whole point of forming one of these business entities is to separate your business assets from your personal assets. Why would we care about doing that? Well, if something were to go wrong with your business and you lose a lawsuit, you’re gonna have to pay. While many of you may not have a whole lot right now in terms of personal assets to lose, one day you may own a house, have a couple hundred thousand or few million in retirement accounts, and a bunch of other stuff that you are motivated to keep for yourself. A business entity is a legal construct that is designed to create a liability shield to protect business-related creditors from taking your nonbusiness property.

History

To understand this better, you have to know your history. In the beforetime, there was no such thing as liability shields. Pretend you’re a blacksmith in the Middle Ages. Your vocation includes shoeing people’s horses in the town. Courts and the concept of “legal liability” go back for thousands of years and would be a thing you’re sorta aware of (just like you are now).

One day, a shoe you put on a horse comes off, causing the horse to flip out. This happens while the horse and its rider were transporting precious goods over a river. While the rider was uninjured, the horse drowned and the precious goods were destroyed. Now you’re in trouble.

The value of the horse and the precious goods are more than you make in 6 months. You simply don’t have the cash lying around to pay the rider. Well, the rider could have the local sheriff seize control of your personal home and land (if you owned any) and hand over ownership to the rider.

That “personal liability” continues to this day. However, thankfully, much has changed in the last 160 years (Limited Liability Act 1855, woot!). The law now allows a person to segregate his personal, nonbusiness-related stuff from his business. Meaning, the only skin you have in the game is the amount you invested into that business. No more.

Imagine how crazy it would be if you owned a share of Circuit City or Enron when they went bankrupt, and their unpaid creditors knocked on your front door, demanding you pay at least your share of the debt. Now, you’re only on the hook for as much as you’ve invested in these entities, and the rest of your stuff is safe if things in the business were to go south.

What are the difference among the different business entities, and why are there so many different kinds?

Each business entity has, by statute, its own laws regarding business operation and the rights and duties of the owners, including which owners have the right to sign contracts on behalf of the business entity and committing all of the other owners to that contractual obligation. There are so many business types because each type of business entity sprung up and evolved, one after the other, over the years.

Corporations are the oldest type of entity. They were the first, and for a while the only, business entity to enjoy the legal blessing of liability shielding. They also have the most formal legal requirements, compared to the other business entity types (statutorily required meetings, formal meeting minutes, boards of directors, special ongoing filings, etc.). Lot of compliance rules to comply with.

General partnerships are special. They’re special because (1) the partners (owners) in a general partnership do not enjoy liability shielding, and (2) general partnerships can be created by accident. Many states have the rule that a partnership is an association of two or more persons to carry on as co-owners a business for profit. That’s it. So when you and your buddy decide that you’re both going to start a lawncare business in your neighborhood, that’s likely a partnership. One problem that could develop is when he totally commits to everyone in the neighborhood that y’all can handle their lawn service on the same day, and he doesn’t bother to tell you. It means your balls are likely in a vice, and you’re personally liable for the harm done for not being able to keep up with all those commitments.

Well, for a long time, only corporations had liability shielding, and everyone else was in a general partnership. A bunch of people didn’t think it was fair, so the limited partnership came about, offering liability shielding for some partners in a partnership; but not all partners. Then after that, the other flavors of partnership were created, which created limited liability for all of the partners, not just some partners. Then over the last 25 - 30 years, limited liability companies have shown up on the scene.

Partnerships and LLCs both generally have fewer statutory formalities (e.g. perhaps no required meetings, no meeting minutes, no formal board of directors), and LLCs offer the most flexible in terms of statutory requirements. Because LLCs offer the most flexibility in terms of having the fewest formal requirements and the flexibility in determining the rights and duties of its own members, far and away, LLCs are the Number 1 most created business entity type today.

Make no mistake, whether your business assets are protected by a corporation, a partnership, or a limited liability company, all of these business types offer pretty much the exact same level of personal liability shielding. No one business type really offers a “greater” level of personal liability shielding over any other business type.

Which type of business entity should I create and why is it an LLC?

While LLCs generally offer the greatest amount of flexibility while still offering the same nonbusiness-asset-shielding protection as the other business entity types, there are many reasons why people still choose to form partnerships and corporations.

One reason is the perceived level of prestige that comes with forming a particular type of business entity. I’m a lawyer. As a lawyer, I know that it’s tradition that lawyers in big law firms seek to become “partners” in their law firm. Owners of partnerships are called partners. Owners of corporations are often called stockholders. And owners of LLCs are called members. So, to be a “partner” in a law firm, the law firm generally has to be a partnership.

Same thing can be said for corporations. Some people feel a certain level of prestige for having titles like “CEO” or “Chairman of the Board of Directors,” even when they’re doing literally the exact same job as they would in any other entity type and the corporation consists of two people and is only generating $5,000 a year in revenue.

Another reason why people select a certain entity type is that statutory law may require a particular entity for a particular type of business. In many states, for example, major financial institutions (insurance companies, banks, mortgage lenders, etc.) are required to incorporate as corporations.

Further, startup companies that are receiving an influx of venture capital (VC) financing / investing from a major VC group tend to be corporations because VC and other investor groups are most familiar with that type of business entity (plus, there is a lot of established law regarding corporations compared to partnerships or limited liability companies because corporations have been around the longest).

I can’t tell you which entity you should choose because the answer will depend on your particular circumstances.

Tax – the most important part of this post

It irritates the hell out of me when I hear *educated * business people and CPAs fuck this part up.

Everything we’ve discussed so far has been at the state level. We have not at all discussed federal rules. When you organize an LLC, you file the paperwork with your state’s Secretary of State office. When your business grows and you start opening stores in a neighboring state, you file organization forms with that state’s Secretary of State office. When you get sued, you’re going to be sued under state law. Whenever anyone says “LLC,” they’re referring to a state-level liability shielding entity, whether they realize it or not. On the federal level, there are no business liability shielding statutes; however, there are federal tax classifications.

If a state-level business entity were a vehicle, then its federal tax classification would be that vehicle’s color. The federal tax classification has nothing to do with liability shielding or the duties or rights of the owners. The federal tax classification relates to the tax consequences for the business entity and the business owners as property (for example, money) starts moving into the business and out of the business to the owners.

Confusingly, there are basically 3 federal tax classifications: (1) corporations (broken into either C-Corp or S-Corp), (2) partnership, and (3) disregarded entity.

Please, sweet baby jesus please, try to understand this: there is a difference between a Limited Liability Partnership (LLP) for state-level liability-shielding purposes and a “partnership” for federal tax purposes. Despite them both having the name “partnership,” these are two different things, NOT the same thing. An LLP may have a partnership tax classification, but it isn’t required to have that particular tax classification over instead being taxed as a corporation (C-Corp or S-Corp). Let me be more specific:

Tax - Disregarded Entity

This one is the easiest. If you are running your business solo (meaning, you’re the only owner), then you don’t have to worry about the other types of federal tax classifications. You do not need to file documents with your state’s Secretary of State office to own and operate a business. If you are operating a business that you alone own, then you don’t have to worry about any of the other federal tax classifications. Your business is “disregarded” by default because you are the only owner. You just report all of your tax items on Schedule C of your Form 1040.

If your state allows single-member LLCs, then you can create one of those and file your business earnings on your Schedule C. The LLC is “disregarded” by the IRS by default because there is only one owner.

If you are a single-owner of a business, you have the option to elect tax treatment as a C-Corp or an S-Corp, but it’s not a requirement to do so. The reasons why you’d do this will depend on your specific business situation.

Tax – Partnership

If there are at least two owners of the business, then the default federal tax classification is a partnership. If you’re a partner in a state-level entity partnership (LP, LLP, LLLP, or general partnership) or you’re a member in an LLC with at least one other person, then y’all’s default federal tax classification will be partnership. Generally, y’all have the option to elect federal tax treatment as a C-Corp or an S-Corp; but again, it generally isn’t required. There exist many, many partnerships and LLCs that are taxed as C-Corps or S-Corps, and there are many business reasons for doing so.

Tax - Corporation (C-Corp and S-Corp)

As previously stated, pretty much any business type may choose to elect the federal tax classification of corporation. There are certain businesses that do not have a choice and must be taxed as a corporation. For example, state-level liability shielding corporations (called per se corporations) must be taxed as a corporation.

Things people say that indicate they don’t know what they’re talking about (do not take legal or tax advice from these people):

  • If someone says “…taxed as an LLC…”. There is no “LLC” federal tax classification. You’ll be taxed as a C-Corp, S-Corp, partnership (default if two or more owners), or a disregarded entity (default if only one owner). In fact, some strife has arisen when attempting to interpret partnership tax regulations and how they apply to LLCs. For example, the partnership tax code makes reference to “general partners” as distinct from “limited partners” in certain tax situations, without actually defining the difference between the two. Well, there are no partners in an LLC… at all. Period. So how do you apply these laws when partners don’t exist in LLCs? In short, anyone who says “taxed as an LLC” is not to be trusted to advise you on business tax matters.

  • If someone asks “should I create an LLC or an S-Corp?” The question assumes that these are mutually exclusive alternatives. To a tax attorney, this question sounds like “should I buy a truck or the color green?” It doesn’t make sense. Just like it’s possible to buy a green truck, it’s possible to have an LLC that’s taxed as an S-Corp. These people have read the buzzwords somewhere online but did not take the time to understand what they mean.

  • Alternative to the above, if someone tells you that “an S-Corp (or C-Corp) provides the same liability shielding as…”. No, no it doesn’t. These are tax classifications, not liability shielding mechanisms. That’s what the state-level business entities do. If you hear someone say this, please ask them for a citation, preferably one in Title 26 of the United States Code ‘The Internal Revenue Code,’ Subtitle A ‘Income Taxes,’ Chapter 1 ‘Normal Taxes and Surtaxes,’ Subchapters C and S (for C-Corps and S-Corps, respectively), the places in the law where C-Corps and S-Corps are discussed in detail.

  • If someone says “you should get a C-Corp because [investors][stocks][shares][VCs][etc.]”. This one is close to making sense but isn’t exactly quite right. Once again, the speaker here is confusing state-level corporations with the federal tax classification, C-Corp. Once again, that sounds like “you should get a vehicle that’s blue because you can haul a couch with a blue, you can help people move their furniture with a blue…” The speaker means the state-level corporation, not the federal tax classification C-Corp. The state-level corporation creates the majority of the characteristics the speaker is referencing, not the federal tax classification.

Conclusion

So we’ve learned that it’s important to shield your personal, nonbusiness assets from your business assets. We’ve learned that there are a variety of ways to accomplish this, through the variety of business entity types. We’ve also learned that there is a distinct difference between a business entity’s state-level liability-shielding and a business entity’s federal tax classification.

When a lot of money is moving around, it’s in your best interest to understand the playing field to, at minimum, ensure that you’re not receiving shitty advice from someone who doesn’t fully understand what they’re talking about.

Part 2 will consist of the basics of how to create a business entity at the state level, things you can do to maintain the integrity of your liability shield (or at least make it harder for people like me to veil pierce), a few things to considered when forming a business with other owners, and what you can do on your own and when you should seek the services of a business / tax attorney.