Legal Structure

Starting a Business: Lesson 4

Chuck Fisher, an Attorney with Grant Konvalinka & Harrison in Chattanooga ,Tennessee, discusses the topic of business legal structures.

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- Starting Out

The way most people start out a business is as a sole proprietorship or a partnership, which means they do business without any type of legal organization or structure. The income for the company is reflected on their tax return without any legal entity being involved. At some point, mainly to provide risk management, a business will decide to form legal entity for operation. The different types of these are a corporation, a limited liability company, and a limited partnership.

- Ways to Hedge Risks

There are three main ways that entrepreneurs hedge risks. They are the following:

Forming a contract with the customer to limit liability or forms of liability.
Having insurance to protect against 3rd party claims.
Forming a limited liability entity.

Business owners commonly choose to implement a combination of the three or all three ways to hedge risk. There are costs related to these choices that need to be considered by the business owner.

- Tennessee Franchise and Excise Tax Exemptions

The franchise tax is on the net worth on the assets of the business. This calculates out to 25 cents per every $100 of value. The excise tax is 6.5% of net income. These taxes are significant and cause some business owners to not form a limited liability entity, in order to avoid these taxes.

- Limited Liability Companies

The LLC gives a business owner better limited liability protection than a corporation, no corporate formalities, and can elect to be taxed in different ways. The default way that an LLC is taxed is as a partnership or a disregarded entity. However, the LLC can elect to be taxed as an S Corporation or a C Corporation. Often, owners will elect the S Corporation because it allows them to be compensated as W2 employees, instead of having to pay self-employment tax.

- Exemptions

The FONCE, Family Owned Non-Corporate Entity, exemption allows the LLC to shield passive investment income from franchise and excise tax. To qualify for this a percentage of the business has to be family owned, and a percentage of the LLC’s income has to be earned through passive investment income. You will have to apply for this exemption yearly by claiming it.

The OME, Obligated Member Entity, exemption allows the company to pay no franchise and excise tax. When receiving this exemption the owners agree to have liability for the company’s debts.

- Where to Form Your Entity?

The best place to form your entity would be Tennessee if you are regularly involved in commerce there. However, there are other locations such as Wyoming, South Dakota, and Delaware that can be helpful when starting your entity. Depending on the location, different benefits can be provided towards your entity. Wyoming provides the opportunity to achieve total amenity. South Dakota has a great tax scheme that benefits the entity. Delaware has corporate laws that bring certainty on certain issues.

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