Frequently asked questions about corporate and intellectual property law

Question: I am planning to start a business selling drilling equipment over the internet. I will have no partners. Should I set up an entity for the business and, if so, which type?

Answer: You can operate as a proprietorship, C corporation, limited liability company or, if you qualify, as an S corporation. There are advantages and disadvantages to each.

Proprietorship: With a proprietorship you save the expense of incorporating as well as the expense of filing a separate tax return, as all your business income and expenses could be reported on your Schedule C. However, you would be personally liable for all debts of the company, whether you guaranteed them or not, including for damages and injuries caused by your employees. This is the worst choice for a new business.

C corporation: With a properly structured and operated C corporation (as well as with any of the other choices discussed below), you will not be personally liable for debts of the entity that you do not guarantee, or injuries that you did not personally cause. However, the corporation would be required to pay income tax on any profits. Then you would be required to pay income tax on any later distributions of that same money. You could avoid this problem, in most cases, by paying all the income of the company to yourself as compensation. On profits you don't distribute to yourself, because tax rates are graduated and start low, you may pay less tax by keeping the money in the corporation than paying it as compensation. The problem is that if you ever sold the company, a buyer would probably want to buy the assets rather than your stock to avoid hidden and/or unknown corporate liabilities, and you would be hit by the double tax at that time. Sometimes venture capitalists will require the use of a C corporation, but otherwise I suggest you avoid using this entity.

S corporations: If you are the only shareholder and are a resident of the U.S., you can form an S corporation. There is no double tax with an S corporation. You also can likely take a part of the company income as a distribution and thereby avoid FICA and Medicare taxes. The IRS has been cracking down on this in recent years and you need to make sure that you have good advice on whether your compensation is reasonable. To the extent you pay yourself a distribution instead of compensation, you will save up to 15 percent in FICA and Medicare taxes, up to $102,000 for 2008. If you are sure that you are not going to have any other partners or investors, and you qualify, this is probably the best choice.

Limited Liability Company: With a limited liability company you can be taxed as a proprietorship. In this case you would have the same limitations of liability as with any other type of entity, but the tax treatment of a proprietor (i.e. no need to file a separate tax return and no double tax). If you added partners or other investors, you could elect to be taxed as a partnership, which would give you great and desirable flexibility regarding the allocation of income, losses and distributions. Additionally, if you change from being taxed as a proprietorship to any other format. However, you would not be able to avoid any FICA or Medicare taxes.

Conclusion: You should always check with your tax advisor, but, if you may want to add partners or investors later, you probably want to start out as an LLC. If not, go with an S corporation. While setting up these entities yourself or with an online service might save money in the short run, I have found that many clients make costly mistakes with this approach and recommend always hiring a corporate attorney to set up these entities.

Rob Hassett is an attorney in technology, entertainment and corporate law with the Atlanta law firm of Casey Gilson P.C. He also teaches in the professional education program at Georgia Tech and is the co-author of a volume on Internet Law. If you have a question about intellectual property or corporate law, you may contact him at rob@internetlegal.com. This column is for general information only and does not constitute legal advice.