Reading Financial Reports For Dummies. Lita Epstein

      Unless a partnership seeks outside funding, its financial reports don't have to be presented in any special way because the reports don't have to satisfy anyone but the partners. Partnerships do need reports to monitor the success or failure of business operations, but they don't have to be completed to meet GAAP standards (see Chapter 17). Usually, when more than one person is involved, the partners decide among themselves what type of financial reporting is required and who's responsible for preparing those reports.

      

If the partnership seeks funding from a bank or investors, more formal reporting may be needed, such as audited financial statements and business plans.

Seeking Protection with Limited Liability Companies

      A partnership or sole proprietorship can limit its liability by using an entity called a limited liability company, or LLC. First established in the U.S. in 1977 in the state of Wyoming, LLCs didn't become popular until the mid-1990s, when most states approved them.

      This business form actually falls somewhere between a corporation and a partnership or sole proprietorship in terms of protection by the law. Because LLCs are state entities, any legal protections offered to the owners of an LLC are dependent on the laws of the state where it's established. In most states, LLC owners get the same legal protection from lawsuits as the federal law provides to corporations, but unlike the federal laws, these protections still need to be fully tested in state courts. If you choose to establish an LLC, be sure to discuss with your attorney state court cases related to liability protections to see if there are any red flags in your state.

Reporting requirements for LLCs aren't as strict as they are for a corporation, but many partnerships do decide to have their books audited to satisfy all the partners that the financial information is being kept accurately and within internal control procedures determined by the partners.

      Taking stock of taxes

      LLCs let sole proprietorships and partnerships have their cake and eat it, too: They get the same legal protection from liability as a corporation but don't have to pay corporate taxes or file all the forms required of a corporation. In fact, the IRS treats LLCs as partnerships or sole proprietorships unless they ask to be taxed as corporations by using Form 8832, “Entity Classification Election.”

      Reviewing reporting requirements

      The issues of business formation and business reporting are essentially the same for a partnership and a sole proprietorship, whether or not the entity files as an LLC. To shield themselves from liability, many large legal and accounting firms file as LLCs rather than take the more formal route of incorporating. When LLCs seek outside funding, either by selling shares of ownership or by seeking loans, the IRS requires their financial reporting to be more formal. Some partnerships form as LLPs, or limited liability partnerships. In an LLP, one partner is not responsible for the other partner's actions. In some countries, an LLP must have at least one general partner with unlimited liability.

Shielding Your Assets: S and C Corporations

      Company owners seeking the greatest level of protection may choose to incorporate their businesses. The courts have clearly determined that corporations are separate legal entities, and their owners are protected from claims filed against the corporation's activities. An owner (shareholder) in a corporation can't get sued or face collections because of actions the corporation takes.

      The veil of protection makes a powerful case in favor of incorporating. However, the obligations that come with incorporating are tremendous, and a corporation needs significant resources to pay for the required legal and accounting services. Many businesses don't incorporate and choose instead to stay unincorporated or to organize as an LLC to avoid these additional costs.

Before incorporating, a business must first form a board of directors, even if that means including spouses and children on the board. (Imagine what those family board meetings are like!)

      Boards can be made up of both corporation owners and nonowners. Any board member who isn't an owner can be paid for their service on the board.

      Before incorporating, a company must also divvy up ownership in the form of stock. Most small businesses don't trade their stock on an open exchange. Instead, they sell it privately among friends and investors.

      Corporations are separate tax entities, so they must file tax returns and pay taxes or find ways to avoid them by using deductions. Two types of corporate structures exist:

       S corporations: These corporations have fewer than 100 shareholders and function like partnerships but give owners additional legal protection.

       C corporations: These corporations are separate legal entities formed for the purpose of operating a business. They're actually treated in the courts as individual entities, just like people. Incorporation allows owners to limit their liability from the corporation's actions. Owners must split their ownership by using shares of stock, which is a requirement specified as part of corporate law. As an investor, you're most likely to be a shareholder in a C corporation.

      Paying taxes the corporate way

      If a company organizes as an S corporation, it can avoid corporate taxation but still keep its legal protection. S corporations are essentially treated as partnerships for tax purposes, with profits and losses passed through to the shareholders, who then report the income or loss on their personal tax returns.

      The biggest disadvantage of the S corporation is the way profits and losses are distributed. Although a partnership has a lot of flexibility in divvying up profits and losses among the partners, S corporations must divide them based on the amount of stock each shareholder owns. This structure can be a big problem if one of the owners has primarily given cash and bought stock while another owner is primarily responsible for day-to-day business operations. Because the owner responsible for operations didn't purchase stock, they aren’t eligible for the profits unless they receive stock ownership as part of their contract with the company.

Only relatively small businesses can avoid taxation as a corporation. After a corporation has more than 100 shareholders, it loses its status as an S corporation. In addition, only U.S. residents can hold S corporation stock. Nonresident aliens (that is, citizens of another country) and nonhuman entities (such as other corporations or partnerships) don't qualify as owners. However, some tax-exempt organizations — including pension plans, profit-sharing plans, and stock bonus plans — can be shareholders in an S corporation.

      One big disadvantage of the C corporation is that its profits are taxed twice — once through the corporate entity and once as dividends paid to its owners. C corporation owners can get profits only through dividends, but they can pay themselves a salary.

      

Unlike S corporations, partnerships, and sole proprietorships, which pass any profits and losses to their owners, who then report them on their personal income tax forms, C corporations must file their own tax forms and pay taxes on any profits. At the time of this writing, the corporate income tax rate was 21% plus any additional state income taxes. But there was consideration in Congress of raising that rate to 25 percent or 28 percent.

      Many corporations avoid taxes completely by taking advantage of loopholes and deductions in the tax code. Most major corporations have an entire