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Choice of Business Entity in North Carolina
So, you’re about to start a company in North Carolina? First off, congratulations! Starting a company is an exciting adventure that you get to make into whatever you see fit. It is a lot of work, I know, but when you put all the work in, it’s worth it in the end.
At this point in your startup process, I’m assuming you’ve got some sort of plan. You know where this venture is headed, and you know what your goals are. Whatever your goals, at this point, it is vital to have them.
Before we start, always remember that if set up properly, it isn’t that difficult to switch between entity types, but it will cost you a minimum of the state filing fee for a new entity, plus whatever other expenses you’ll incur.
There are six main choices for entity type:
- Sole Proprietorship
- Limited Partnership
- Limited Liability Company (LLC)
- S Corporation
- C Corporation
You’ve probably heard of a few, if not all of these. I’ve placed them in this order because it is how I view the spectrum of liability and formality. I start at the top and decide if that is an appropriate fit or not. If it isn’t, I move to the next, stopping only when I feel it is an appropriate structure for the company I am about to start. We will do the same here.
Sole Proprietorship –
This is what you have if you just start a business, by yourself, without filing any papers with the state. There’s no filing requirement outside of any necessary business licenses for specific business activities. There is also no additional tax or tax formalities. Certain ordinary business deductions can be made on your personal 1040 and all revenue is reported as wages. In North Carolina, these earnings and deductions would be reported on your D-400 tax form.
As a sole proprietor, you must also pay your self-employment tax, which includes both halves of the FICA tax. In 2012, this rate is 13.3% of your income, normally 15.3%. You are entitled to a deduction on your income taxes for the 7.65% of the FICA that is attributed to the business side.
What is most concerning about sole proprietorships is the fact that they subject the owner to unlimited liability. Because the business and the owner are one in the same, any debts or wrongdoings of the company are debts and wrongdoings of the owner. Even with an otherwise amazing asset protection plan, this is not a good position to be in unless you’re 100% certain you and your company will not get sued.
Also called a general partnership, this is the entity that is formed when you start a business with multiple people as owners with no entity filed with the state. Partnerships require no filings upon formation or annual reports, but would still require any business license to be obtained.
General partnerships are owned and controlled equally by each partner, absent an agreement that stated otherwise. Because any one partner can control the company and make it do whatever that partner wants, it is very important to have a partnership agreement in place before starting the company. Also, partnerships are merely a collection of people, meaning that the partnership of Bobholz, O’Brien and Smith is just the collective efforts of Bobholz, O’Brien and Smith. If Smith were to pass away, the partnership would die with him. What each partner owns is an equal share of the assets and profits of the company. There’s no stock, nor any way to sell a partnership share.
As mentioned, partnerships should have partnership agreements prior to engaging in business together. This is a document agreed upon by all the partners that outlines how the company is to be run, how ownership is distributed, how earnings are distributed, and all the other very important details that should be discussed prior to entering into a partnership. Absent a partnership agreement, the terms are determined by the default rules in the North Carolina Uniform Partnership Act under Chapter 59 of the North Carolina General Statutes.
For taxes, there is a slight increase in the amount of paper work, but no additional tax to pay. You are once again taxed individually on your 1040, but your partnership is required to submit form 1065 to the IRS. In North Carolina, your partnership is required to fill out form D-403. Even money that is earned by the partnership, yet held onto is taxed individually. This is important to note in case your company earns money for years without paying the owners. The owners are still liable for tax on that income.
The FICA tax is worth addressing, even though the outcome remains the same. The amount each partner earns is taxed at 7.65% (5.65% in 2012). A partner is deemed to have earned the income as soon as the partnership does regardless of if he or she receives any income, granted the net income of the partnership is only calculated at the end of the year. On top of the individual share, the partnership would have to pay 7.65% of all income. Since a partner is deemed to own only an equal share of the assets, profits and losses, this calculation looks very similar to the sole proprietorship.
As is similar to that of a sole proprietorship, there is unlimited liability for a partnership. This means that any debt or wrongdoing by one partner can cause the other partners to get sued personally. The partner or partners who get sued may always sue the wrongdoer for contribution to repay them, but that only works if the wrongdoer is able to be found and has enough money to cover the expense.
Limited Partnership (LP) –
A limited partnership is similar to a partnership except the limited partners have no personal liability for the debts or actions of the partnership. Only the general partner or partners can be held personally liable; however, only the general partner or partners can manage the company. A general partner can be a corporation or LLC, but that asks the question: Why not just for an LLC or corporation?
With the advent of Limited Liability Companies, these Limited Partnerships have significantly decreased in numbers, since they require a filing with the state, retain some liability in the general partner, and are not as flexible with member/partner rights as an LLC.
Limited Liability Company (LLC) –
This is, by far, the most popular choice recently in North Carolina, and we will spend a fair bit of time discussing why that is. The LLC isn’t the best for all circumstances, but it is very flexible, tax neutral and has limited liability.
One of the most useful aspects of an LLC in North Carolina is the choice of how it is taxed. Because of the advantages of the partnership “pass-through” taxation, most choose that route so they are taxed only once as the income is earned. If you have an LLC with only one member, your LLC is treated as a disregarded entity for federal taxation purposes. This just means it is treated like a sole proprietorship instead of a partnership for taxation only. As a pass through entity, you will once again have to file form 1065 annually with the IRS and form D-403 for North Carolina. Each individual member will have to fill out his or her share on his or her 1040 and D-400. If the LLC is treated as a disregarded entity, everything will go on your individual 1040 and D-400.
For self employment or FICA taxes, the taxes remain the same as if you were a sole proprietor for single member LLCs and the same as a partnership for pass through LLCs.
To form an LLC, you must file your articles of organization with the North Carolina Department of the Secretary of State and wait about a week for your certificate of organization in the mail. LLCs can have a name separate from its owners, so long as it does not contain any of the reserved words and it includes some variation or abbreviation of “limited liability company.” It also cannot be the same name as another company in North Carolina, or suggest that the company performs a function that it does not. I could not name my law office “The Medical office of George Washington” because I do not perform medical services and I unfortunately cannot claim to be affiliated with George Washington. The cost for filing is $125 at the time I wrote this article. Once again, as with all entities, any business license must be obtained prior to starting business if one is required. With an LLC, you must also obtain an EIN from the IRS so that your company has a distinct identification number when opening bank accounts and filing taxes.
In order to maintain the LLC’s active status, a few important formalities must be followed. First, an annual report must be filed every year with the state. This is a very simple form that asks for general information about your company and registered agent. Along with the annual report, you must also pay a $200 fee. The second formality is maintaining the distinct nature of the LLC. This means that you have to operate as though you were caring for someone else’s stuff whenever you act, even if you’re the only member. You can do this by writing letters authorizing you to do any action and signing as “managing member” or however your LLC treats management. You also must maintain separate bank accounts, having no comingling going on, ever. As soon as you use the business debit card to buy groceries, you put yourself at risk of ruining the limited liability nature of the LLC. Third, but not least, you must keep good records. All of your transactions and company decisions should be written down and stored. It may seem like a lot, but the formalities merely take getting used to. After that, they make a whole lot of sense, and they become second nature.
As long as you’ve followed the formalities and didn’t do anything to bring liability on you personally, you will enjoy the limited liability of the LLC. No member automatically can be liable for the debts or wrongdoings of the LLC, its employees or its members. Furthermore, you can set up the LLC, fairly easily in fact, to ensure that if a member gets sued personally for an unrelated action that member’s ownership interest cannot be taken in the lawsuit. This is a big difference between LLCs and Corporations where the stocks are assets available to the creditors. What the creditors can receive from the LLC is what is called a charging order, which only allows the creditor to receive income payments that would have gone to the member who got sued. The limited liability nature of an LLC is the biggest advantage it has over the general partnership or sole proprietorship, and it shares this advantage with S Corporations and C Corporations.
The LLC is owned by members and the ownership interest can be divided up however the members choose. Without an agreement otherwise, we would look to the North Carolina statutes to see who receives what interest amount. I would always recommend writing up an operating agreement when writing the articles of organization. Even a simple agreement goes a long ways for resolving disputes down the road.
Another good part about LLCs is that membership can be bought, sold, traded, defined, inherited or transferred in nearly any other way. Since they are so flexible, you may also create different types of membership to create controlling and noncontrolling members. This is beneficial if the members want to raise capital but do not want to give up any control of the company. If the investor will agree, it is a nice strategy to have available. Because they are so new, and because they cannot be traded on the stock market, many investors still shy away from LLCs, preferring the C Corporation instead.
S Corporation (S Corp) –
An S Corporation is a corporation at the state level for all purpose except taxation. An S corporation is taxed just like a partnership, but only if it qualifies. To qualify, it must only have one class of stock, have on hundred or fewer shareholders, have no corporate or partnership shareholders, have only US citizens as shareholders, and the profits and losses must be proportional to each shareholder’s interest in the company.
There are very few reasons to elect to be an S corporation because of the limited nature of the entity when compared to LLCs and C Corporations. That said, they’re still listed here because there are times when an S Corporation is the best choice, and conversion between and S Corporation and a C Corporation is a very simple process.
C Corporation (C Corp) –
The C corporation is the traditional vehicle for investment backed companies or companies with ever changing ownership. Although an LLC can operate in much the same way, the C Corp is more familiar and has the coveted “IPO.”
To form a C corporation, you must file articles of incorporation with the North Carolina Department of the Secretary of State, file for an EIN through the IRS and pay the $125. At the time of formation, the shareholders must also elect board members to control the company and adopt bylaws to set the rules for how the company will operate.
C corporations are completely distinct from their owners. This means these entities are also taxed separately. Through the IRS, they must fill out form 1120, and in North Carolina, they fill out form CD-405. What is unpleasant about the C corporation is how distributions to the owners are taxed. Because dividends are not deductible, there is a “double tax” on the amount the corporation earns. First, that income is taxed at the corporate level when it is earned, but it is taxed again on the individual’s 1040 as dividend income. Of course, you can pay workers a salary to avoid this double tax effect because wages are deductible from the corporate tax; however, wages must be paid reasonably for actual work done, and wages are taxed by FICA. Combine the individual income tax and the FICA together, and you’ll generally have slight savings.
As with FICA, this is one entity where it is not going to automatically be necessary to withhold FICA taxes. It is possible to have no earned income and only receive dividend income, which is not subject to FICA taxes. If you work for the corporation and receive wages, you will pay your 7.65% (5.65% in 2012) and the corporation will pay its 7.65% of your income.
With all the other entities, when the company earned income, the owners had to report the income on their 1040s regardless of if they were paid. Those other types of companies could not hold onto large amounts of cash without forcing their owners to pay tax on income they had not received. A corporation is taxed itself, so while it doesn’t make distributions to its shareholders, its shareholders are not taxed. The saved money, however, can be taxed at the dividend rate if there is no legitimate reason to be storing up that money. This would lead to a “triple tax” situation, so it is best to ensure there is always a legitimate business reason when storing up money in the corporation.
The owners of a C corporation are the shareholders or stockholders. In a C corporation, shareholders can be people from any nation, companies, trusts or any other entity that is allowed to own assets in the United States. With no restrictions on who may own the shares, there is a much larger pool of potential investors available to a C corporation than to an S corporation, and with the stock markets, they are much easier to find than with an LLC.
The formalities of a C corporation are the strictest of all the choices. You must keep assets separate still. You must have bylaws and abide by them and the articles of incorporation. A C corp must have an annual meeting of the shareholders where they may vote on things like new directors or changes to the bylaws. Meetings like the annual meeting must be recorded in meeting minutes, and an annual report must also be filed. If the C corporation wants to be publicly traded, there are significantly more formalities and filing obligations through the state of North Carolina and through the SEC. Up until the point when you go public, these formalities, although rigid, are not too tough to follow. You’re obligated to follow them, but they also help keep your company organized.
There you have it. That’s a basic run down of the types of entities most commonly looked at and how to go about choosing one. Remember, you can change later on for a price, but it is a better idea to education yourself now and do it right the first time. No matter which one you choose, be sure to have a clear agreement set up with all the owners involved to prevent disputes later. And, finally, follow the formalities or it will not matter which type you choose.
Enjoy the process, and best of luck to you on your new venture.
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